Monday, September 29, 2008

Why $4 billion spent buying Australian mortgages is government money will spent

And why it's good Australian politics as well

Commentator Michael S wrote

"Sorry Peter, but this is a terrible idea. I don't know how you could support it. All that will result is even higher house prices, and people requiring even more complicated financing arrangements (such as Rismark's equity finance mortgages - hmm ... who is associated with Rismark?) to buy places for living.

Anyone who supports this actively wants affordability to decrease."

Commentator Darren Lewin-Hill asked the same question more politely.

So, why is $4 billion spent buying Australian mortgages government money will spent?

Australian mortgages should be cheap to fund. Strewth, they should be. The loans are nearly always repaid on time in full...

Foreign lenders used to recognise this. That was when they were eager to lend and when they believed what ratings agencies told them (which in the case of Australian mortgages was the truth).

Aussie, RAMS, The Adelaide Bank et al got access to this money and exposed Australia's big banks to real competition. So much so that from 1996 Westpac et al began to cut their margins of their own accord in order to hang on to their mortgage business.

The result was cheaper home loans - and less unearned margin accruing to the banks.

Call it economic efficiency if you like, call it real competition, call it the market working, it was good for just about everyone - except perhaps the Westpacs of this world.

Move forward 12 years and because foreign lenders no longer trust the ratings agencies and because they wrongly assume that Australian mortgages are low quality they no longer lend, or demand a fortune for doing so.

Aussie, Rams, The Adelaide Bank et al are virtually out of the mortgage business. And guess what - for the first time in more than 12 years the big banks have widened their mortgage margins.

They will keep them wide until competition returns.

What's needed? Medium term Joye and Gans propose an Australian government body essentially certifying that Australian mortgages are of good quality (which they are) and taking upon itself the very tiny risk that they are not.

The foreign money should flow more cheaply, restoring the competition that will stop Westpac et al from ripping us off.

Short-term they suggest the Australian government, through the Office of Asset Management, buying mortgages from Aussie and so on itselelf. They are of good quality. The government knows that. It will do well on the deal, and force Westpac et al to act competitively.

Competition and the keen prices it brings matter.

Michael S says that Christopher Joye's company will benefit. So what?

What's important is whether it is good policy. It is. It'll restart competition in the mortgage business, with big benefits for bank customers and political ones for the Rudd government down the track.

Michael S also says that cheaper mortgages will result in higher house prices. All other things equal, of course they will. But do we really not want keenly priced mortgages?

There are better ways of taking pressure of house prices than expensive mortgages - scrapping the 50% tax holiday on income from capital gains made from trading property would be start.


Julian said...

If WBC has been ripping people off since RAMS left the scene, care to explain why their shareprice is down 20% since?

Are you guys putting your money where your mouths are? Or is the market wrong again?

Marek said...

So while the plan in the USA is focusing on asset prices, we are recapitalizing the banking institutions, providing liquidity to those that need it(while earning interest on our money), our plan seem to make more sense as we are leaving assets pricing to the markets

thorpie said...

I thought that was why we used to have a commonwealth bank, so that the government could keep spreads and margins under competitive restraint.
Privatise the commonwealth bank, no restraint, shares in all banks go up by 1000%.
Maybe the government should start a new bank, but then they would have to pay compensation to the existing banks for loss of profit!
Capitalism, aint it wonderful!

Peter said...

thorpie, you are so right

Michael S said...

You don't make bananas cheaper by printing money, and you don't make houses cheaper by making credit easier to obtain.

Looking at affordability from the interest repayment angle is misleading. It is generally agreed that affordability is determined by two measures, house price as a multiple of household income, and yield in terms of rent earned. For both measures Australia has deviated from the long term average considerably.

There are some who suggest these measures are outdated - one might call them the 'new paradigm' mob - but lessons being learned overseas are that the return to mean is a more powerful force than even the most creative credit originators can combat.

So the government supports non-bank lenders? Let's hope they are not of the ilk that Seiza was - a lender that went into administration last week. They offered negatively amortizing cash-flow mortgages. Are these the kinds of lenders we wish to have in our market?

It seems there is an attitude in Australia that banks shouldn't be profitable at the expense of their customers. Why? Should banks only be profitable when they give away money to everyone? Or should we indeed prefer a banking system that is profitable while lending conservatively?

And perhaps we should think about whether it is right for homeowners to take on ever increasing debt burdens. Sure, if credit becomes easier and easier to obtain and service, this can persist in perpetuity, but as we know these situations do not persist, and I, and many others, would much rather prefer a debt burden of three times income rather than six times.

Let us also not forget, that with higher house prices, new investors will see diminishing yields, which will add a greater burden to the tax system via increasing negative gearing.

My point is, there is very little that is good about higher house prices.

Lastly, Paul Krugman provides the best argument against government policy being biased towards buying a house.

Anonymous said...

Thanks for this article Peter.

From reading the article you linked to by Gans and Joye, am I correct to say that the proposed policy is similar to what happened in the US a long time ago, with the creation of Freddie Mac and Fannie Mae?

Does the fact that Freddie Mac and Fannie Mae just recently went broke suggest that this policy may not be such a good idea?


chris joye said...

In our paper we argued that when critical economic markets fail because of the absence of the ‘public goods’ of liquidity and price discovery, governments have a responsibility to (temporarily) intervene to assist in restoring normalised activity. We were careful to note that the government should intervene--not a subsidised private corporation such as Fannie Mae or Freddie Mac--and that such injections of liquidity should be justified only by extreme emergencies. In particular, we proposed that the government capitalise on its AAA credit rating to issue bonds and use these funds to acquire very high quality, low risk ‘prime’ mortgage backed securities in order to staunch the severe illiquidity that had resulted in the securitisation markets effectively closing in November 2007. We were also at pains to state that we were agnostic as to how our idea was operationalised, but did, for the record, advise the government to use the Treasury’s Australian Office of Financial Management (AOFM).

Despite the predictions of many, Australia’s mortgage securitisation market, which has served as such an important source of funding for non-bank lenders, building societies and smaller banks, has not yet recovered and remains economically shut to this day. By this we mean that the pricing available in the market is not sufficiently low to enable lenders to source capital to underwrite home loans on an economically viable basis. Even the RBA agrees with this point.

The closure of the securitisation markets has--according to Fujitsu Consulting--resulted in the big 5 (now 4) major banks’ market share of new home loans increasing from around 75% prior to the sub-prime crisis to circa 90% today. At the same time, many non-bank lenders have fallen by the wayside while the smaller banks and building societies have struggled to compete. As we anticipated, the illiquidity in this market has had other consequences, such as contributing to the severe credit rationing seen in the corporate and small business lending markets, and wreaking havoc on the conduct of monetary policy with a deterioration in the linkage between the RBA’s cash rate and actual lending rates.

We pointed out that market failures of the kind can occur because of information asymmetries, such as we have seen in the US with the non-transparent AAA-rated investment structures that held sub-prime securities, and because investors have a tendency to over- and under-react to events that can in turn trigger protracted asset-price booms and busts. George Akerlof won the Nobel prize in economics for showing that while markets are ordinarily the best means to allocate goods and services, when you have imbalances in the information that people possess when engaging in transactions--like an understanding of the true risks underpinning complex financial market securities--markets can fail with catastrophic consequences. The introduction of ‘mark-to-market’ accounting practices has only served to reinforce these distortions.

We also argued that that in today’s highly interconnected world global financial crises are being transmitted with ever greater frequency. In just the last decade we have been rocked by the Russian debt crisis and consequent LTCM collapse, the tech boom and subsequent wreck, and now the credit boom and bust. The point is that notwithstanding the intrinsic strength of Australia’s economy and financial system, we can be adversely affected by events that are seemingly far removed from our shores.

Despite some of the protestations to our proposal, the notion that governments have a critical role preventing financial market crises is, in fact, a cornerstone of our capitalist system. One of the main reasons central banks were established is to serve as a lender of last resort and prevent bank runs. Bank panics in the US led to the establishment of its centralised banking system in 1913. The stability of the financial system has also been a long-standing responsibility of the Reserve Bank, which “focuses on the prevention of financial disturbances with potentially systemic consequences.” The Reserve Bank also regularly intervenes in the currency market in order to stabilise our exchange rate on the basis of its belief that currency values have a tendency to deviate significantly away from fair value.

Another less noted, but equally important, issue we raised was that when Australia’s central banking system was set up in 1959, home loans were funded almost exclusively through deposits. That is, securitisation markets and non-bank lenders did not exist. So while today banks and building societies are regulated by APRA and have their liquidity needs protected by the RBA, the securitisation market that has grown to provide nearly a quarter of all the funding for home loans, and which was a key source of funding for so many non-banks lenders, building societies and smaller banks, benefits from no government infrastructure to protect it during times of crisis.

This speaks to going back to first-principles and thinking about how we can improve the current regulatory regime in order to accommodate recent capital market innovations such as the emergence of securitisation. As the RBA and Treasury have noted over the years, there is a fundamentally sound economic basis as to why securitisation should exist. But we currently have an asymmetrical regulatory system that disproportionately favours deposit-taking institutions—indeed, it barely acknowledges these new markets. The system should, therefore, evolve to accommodate these changes.

Peter said...

Julian wrote: "If WBC has been ripping people off since RAMS left the scene, care to explain why their shareprice is down 20% since?"

As it happened, their shareprice rose after RAMS left the scene. It has been up and down several times since, for all sorts of reasons. Right now it is down, probably for the same set of reasons as is just about every other stock.

Michael S wrote: "You don't make bananas cheaper by printing money, and you don't make houses cheaper by making credit easier to obtain."

The aim of the Gans/Joye proposal is not to make houses cheaper. It is to make credit cheaper, which is a worthwhile aim in itself.

There are other ways to make houses cheaper - I outlined one of them at the end of my post.

And Anonymous wrote: "Am I correct to say that the proposed policy is similar to what happened in the US a long time ago, with the creation of Freddie Mac and Fannie Mae?"

Fannie and Freddie were private, but the principle was similar. But Fannie and Freddie corrupted it. Ecah borrowed against the assets they held - massively, Fannie by a reported 20:1, Freddie by a reported 70:1.

More details from Chris Joye, above.

Jennifer said...

I understand your points Chris Joye, but fundamentally they boil down to, "the market has got it wrong about the riskiness of Australian mortgages right now, and we need the government to step in and get it right for them." For the past 9 months, I have been listening to colleagues say exactly that about credit spreads on the corporate bond market (the implied default in these credit spreads is unheard of...we're holding these to maturity...the market prices is just about liquidity, etc etc). And look who seems more likely to be right now? The market.

While I accept that the market does overshoot from time to time (bubbles which are better known on the upside than the downside), my experience of working in or close to funds management for 20 years suggests that very few people know whether it is an overshoot at the time. Governments have a very very poor history of second guessing market prices - I don't think now is the time to add them into the mix at a time when it's probably not a bad idea for our banks to be making a bit of money.

Two reasonably large overseas banks failed in time for the Tuesday morning papers - Bradford & Bingley and Fortis. It didn't even make the front page it's become so routine.

Peter said...

Jennifer, I appreciate your point. No-one can know the future. But I wonder what your evidence is for the conclusion that "governments have a very very poor history of second guessing market prices".

In the foreign exchange market Australia's Reserve Bank has a very good record. Although this wasn't its aim, it has made big profits by leaning against the excesses of the market.

Jennifer said...

A fair question Peter. I'm not sure that I can point you to specific bad decisions - late night rhetoric, I suppose. But I live in NSW, and it hasn't given me a lot of faith in a government's ability to understand the marketplace.

And although the market does behave in quite herd-like ways at times, it's often pointing quite clearly at an outcome that politicians really don't want to hear - all the rage against short sellers being a case in point. In many cases, the short sellers have been right.

Peter said...

Thanks Jennifer

Chris Joye said...

Jenn, I am generally sympathetic to your logic, all other things being equal. But of course, they are not right now. And Peter is spot-on about the RBA (although as I recently wrote in an op-ed in The Oz, I am not supportive of the Governor’s suggestions that the RBA should be using interest rates to pre-emptively strike against asset-price bubbles--it would be akin to undertaking brain surgery with scissors). One key issue here, which Joshua and I have regularly highlighted, is that you have a categorical market failure rather than some minor asset-price distortions, which is being exacerbated by the absence of any underlying government infrastructure (ie, the banks get the benefit of massive liquidity injections from the RBA while those who are reliant on securitisation suffer). This is in turn just a function of the fact that our regulatory systems have not evolved to reflect the innovations that have materialised over the last 15-20 years (viz., the emergence of the primary RMBS market and the resultant change in the funding base for our $250 billion per annum home loan market--ie, to the point where around one quarter of all home loans were funded through securitisation and many smaller banks, building societies and non-banks built their business models on the assumption that there would be a minimum level of liquidity and price discovery in this market). Of course, it is somewhat asinine to argue, as Andrew Cornell at the AFR has, that this is just bad luck and that any business model in need of government support does not deserve to survive. He makes this case by comparing the securitisers to the purported strength of our banks, which he implies benefit from no such subsidy. But Cornell forgets to mention that a major government institution, the RBA, is providing unprecedented amounts of liquidity on unprecedented terms to our banks every day. In the absence of such, there would almost certainly have been some departures from the scene. In a single day last week, the RBA injected $3 billion of liquidity into the banking system and it has been reported that the RBA has provided similar levels of support this week. Joshua and my argument is, therefore, that we need to consider evolving the system to provide a similar liquidity backstop to the securitistion market when it fails for reasons that are far removed from the quality of the underlying assets.

Michael S said...

This seems to work on the assumption that the amount of liquidity in the marketplace prior to the credit crisis was correct.

Many have the view that it is rather a long-term excess of liquidity that has caused this problem, originating from the Fed and other central banks who had kept cash rates at lows ever since the initial LTCM/Russian crisis, and continued to do so through the earlier part of this decade.

Excess liquidity eventually results in bad investment. If this persists, you soon enough approach a 'Minsky' moment. The US financial system has probably hit that moment a number of times over the past decade, and each time it has been met with greater liquidity.

Perhaps more liquidity is not the answer. Perhaps instead we should take a renewed look at how central banks operate, and whether the 'goldilocks era' was in fact a huge failure that involved poor investments made by Western economies. Perhaps central banks should take steps towards targeting true inflation, rather than the misleading CPI figure.

The Weatherman said...

Is anyone else wary about these repeated announcements concerning the supposedly gilt-edged nature of Australian mortgages? With unemployment at generational lows this simply hasn't been tested. Not for a long time. Certainly not since lending multiples of 5x (as opposed to 3x), LVRs above 95% and lo-doc/no-doc loans became de-rigeur.

Anonymous said...

Thanks for your informative response Peter.


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