Saturday, September 22, 2007

Saturday Business: Customers queuing to get their money out of banks... How did it come to this?

In Britain queues formed outside a bank, in Australia there was a share market run on the Bank of Adelaide, and in the US authorities slashed interest rates in order to help keep financial institutions afloat.

We’re forever being told that the worldwide economic conditions are the best they’ve been for a generation.

So what’s going wrong?

It probably began with efforts by the US central bank, the Fed to keep conditions good in the aftermath of the September 11 terrorist attacks six years ago.

The Fed slashed official US interest rates and slashed them again until they reached an extraordinarily low 1 per cent (by contrast ours were above 4 per cent). It kept them at 1 per cent for more than a year.

The man who took that decision, the then Fed Chairman Alan Greenspan has just published an autobiography for which he received a reported $9.8 million in which he handsomely praises the economic management credentials of Australian Prime Ministers Bob Hawke and John Howard.

Greenspan’s concerns weren’t limited to the terrorist attacks... He was also worried about the wave of corporate collapses that had begun the year before in the wake of the high-tech stock collapse. His overwhelming aim was to avoid and then get out of a recession.

But by leaving rates low for longer than now seems wise he created another problem.

An entire industry grew up offering what was by now very cheap money to people who had never previously been able to afford it.

On Four Corners on Monday a California real estate agent Jim Adams explained how easy it became to sell houses to people who never really head a hope of hanging on to them.

“I keep relating it to buying a car. You go into a car lot and the sales people come swarming all around you and it’s the smell of the new car, the sound of that engine, the total excitement of being able to get into something new. It’s the same way with the house. It’s the smell, the looks, the excitement, it’s oh it’s new, we can do this. And then you start looking at the paperwork and they tell you … we’re going to make some money, yeah.”

Adams said the only criteria for getting a loan seemed to be that you were breathing. Credit was directed to “people who have not paid their bills on time, or had little to no credit, no credit history, no credit lines, maybe they’ve had a bankruptcy, a foreclosure or a repossession”.

Some required no documentation and no deposit. Reporter Paul Barry explained that some were called NINJA loans, which meant "No income, no job, no assets”. Others were called Piggy Back loans where two loans sat on top of each other to create 100 per cent finance. Colloquially they were known as LIAR loans because someone wasn’t telling the truth.

The most dangerous of them, and the one that is responsible for at least the timing of the present worldwide crisis was the so-called “2/28” sub-prime loan. It worked a bit like a time bomb.

At first the repayments were very low. But after 2 years they were to be adjusted up for the remaining 28 to a rate even higher than the standard one.

Because the defaults were at first low these loans were given a AAA credit rating and then packaged into bundles and sold around the around the world to unsuspecting organisations as far away as Sydney’s Manly Council.

Manly’s Mayor Peter McDonald says his council had half a million dollars invested in US sub-prime loans through Australia’s Grange Securities.

When it became apparent that in August that many US borrowers couldn’t repay their loans the value of Manly Council’s investment collapsed. It’s now worth only half of what it was.

As a result 45 Australian councils in similar situations and all sorts of other investors world wide suddenly reconsidered the wisdom of investing in mortgage-backed securities.

Britain’s Northern Rock bank sourced three quarters of its loans from such securities.

It asked fror emergency funds from the UK central bank and saw a stampede of customers clear out 5 per cent of its deposits.

In Australia on Tuesday rumors gathered that the Adelaide Bank had also asked for emergency funds, from the Reserve Bank. The rumors were false. But even after the Reserve Bank denied them the Adelaide Bank share price was savaged. The Adelaide Bank (which actually does much of its lending outside of South Australia) sources around half of its loans from mortgage-backed securities.

RAMS which sources all of its loans from mortgage-backed securities has seen its shareprice collapse from $2.50 last month to around 80 cents at the close of trade on Friday.

The Reserve Bank itself says that underlying quality of the assets against which Australian banks lend is sound.

The Governor Glenn Stevens said on Tuesday that loans that could be called ‘sub-prime’ in Australia account for only “about 1 per cent of the stock of total mortgages, compared with around 15 per cent in the US”. The proportion of borrowers behind on their housing loans remained “exceptionally low.”

But the problem was that “at times like this, investors are often unable, or unwilling, to discriminate between different underlying credit risks”.

The Governor said the wholesale mortgage market had “virtually came to a standstill” and that to remain in business some retail lenders would have to charge more.

“Some borrowers are being asked to recognise this higher cost in the rates they pay for their loans, a trend that will continue if the higher funding costs persist,” he said.

The Adelaide Bank has lifted the rate it charges for low-doc loans by 0.25 per cent, on top of the 0.25 per cent increase it passed on from the Reserve Bank in early Mortgage.

RAMS and the low-doc specialist Bluestone also lifted some of their rates by more than the Reserve’s Bank-sanctioned 0.25 per cent.

So far none of the big four banks have passed on higher costs to mortgage borrowers, although the ANZ has passed on higher costs to some non-mortgage borrowers.

It says the higher costs are costing it $20 million per month.

Even Australia’s big banks source 40 – 60 per cent of their loans from the wholesale mortgage market.

Wednesday’s move by the US Fed to slash its official rates for the first time in four years - by an unexpected 0.50 per cent - may not be of much help back here.

It is doubtless needed to attempt to contain some of the damage from the US housing crisis.

One estimate suggests that if all US homes with "For Sale" signs currently out the front were stacked one on top of the other, they would reach half way to the moon.

But by itself it won’t do anything to encourage foreign lenders to once again believe that mortgages are a good bet.

And the size of the 0.05 per cent cut may indicate that the Fed knows something that others only suspect – that the US mortgage is even worse than has so-far been revealed.

In the current environment Australia’s Reserve Bank would like not to have to increase the interest rates over which it has control.

But if Australia’s inflation result due in October is high (and there are signs that it could be) it may feel that it has no choice, given its anti-inflation mandate.

Many Australians would then have suffered two interest rate hikes since the last official one – one decided at the Bank board’s Melbourne Cup day meeting in November, and the other imposed as the whim of those lenders that are the first to crack and start charging more.

It’d make for a painful election campaign.