UPDATE: In this post I repeated Business Insider’s mistake of attributing the presentation I criticise to Steve Keen. While Steve considers it an excellent presentation, he did not write it and I apologise for not confirming the source before publishing this post. I have now struck out the incorrect attributions. My criticisms of the presentation itself still hold, which is why I am leaving the post up in its edited form.
Steve Keen and his forecasts of a property market collapse have received plenty of local media coverage over the years. Now he has come to the attention of the international press as well.
In April, Keen hiked to the top of Mount Kosciuszko after losing a bet about the direction of property prices with Macquarie Bank strategist Rory Robertson. This event was enough to prompt an extensive review of Keen’s concerns in the New York Times. Curiously, Robertson himself did not receive a mention, despite winning the bet.
Now the US business site Business Insider, which has a penchant for drama, has published one of Keen’s presentations a presentation, incorrectly attributed to Keen, under the headline “Here’s What You Need To Know About The Major Property, Debt, And Banking Crisis Brewing In Australia”.
One of Keen’s central concerns is the size of private sector debt in Australia. This is a legitimate concern and should receive more focus than misguided fears about Australian government debt. However, I am far less pessimistic than Keen about the outlook for Australian property prices.
As for the Business Insider presentation, Keen takes his concerns it goes too far, to the point of unsupportable alarmism. The final slide of the presentation is evidence enough of this, not to mention being in extremely poor taste. This slide appears to have been added by Business Insider! If that is not enough to convince you, I will consider just one of the arguments offered by the anonymous author Keen.
On slide 22 of the presentation, he writes:1
Look at CBA 2009 annual report—Leverage ratio is almost 20 times (total assets of $620.4 billion against $31.4 billion of equity). Of $620.4 billion of assets, $473.7 billion are loan assets. If around 6.6% of CBA’s loans go bad (any loans not just mortgages), 100% of its shareholder equity will be wiped out!!
(the bold italics are not mine, they appear in the presentation). Here the implication is something like “6.6% is not very much. Wow! CBA could easily collapse!”. But, that line of thinking does not stand up to even moderate reflection.
Crucially, we must understand what “going bad” means for a loan. It does not mean losing everything, which is in fact very rare for most types of bank loans.
Over half of CBA’s are home loans and these are secured by the property that has been mortgaged. According to their half-year presentation2, based on current market valuations, the average loan-to-value ratio (LVR) for CBA’s portfolio is 42%. This means that, on average, the value of the property is more than twice the loan amount. This gives the bank an enormous buffer against falls in property prices. Of course, this average conceals a mix of high and very-low LVR loans. Even assuming that loan defaults occurred on a higher LVR section of the portfolio, say with an average LVR of 70%, and allowing for Keen’s oft-quoted figure of a 40% decline in house prices, CBA would still only lose 14% on their defaulting loans3. Even then, this does not take into account the fact that, like other lenders, CBA takes out mortgage insurance on loans with an LVR of more than 80%.
But we can be more conservative still. In their prudential standards, the banking regulator APRA considers a severely stressed loss rate on defaulting home loans to be 20%. To suffer actual losses of 6.6% in their mortgage portfolio, CBA would have to suffer a default rate of at least 33%! This would be astonishingly unprecedented. Currently, the number of CBA borrowers late on their mortgage payments by 90 days or more is running at around 1%. Most of these borrowers will end up getting their finances back in order, so for actual defaults to reach 33% is inconceivable. A default rate of a “mere” 2% would be extraordinary enough for CBA.
As for the rest of the $473.7 billion, it includes personal loans, credit card loans, business loans and corporate loans. The loss rates on some of these loans can be higher than for mortgage portfolios, but losing everything on every defaulting loan is still highly unlikely. So to suffer 6.6% in actual losses on these loans, defaults would have to run at a far higher rate. Furthermore, since the dire prognosis for the banks is rooted in the view that the property “bubble” is about to burst, presumably the argument would not simply be based on everything other than the home loan portfolio collapsing.
If property prices do fall sharply and our economy has another downturn, will bank earnings be affected? Of course. Are they teetering on the brink of collapse? Of course not.
1 While there is a footnote on the slide referencing this post, what is not made clear is that the whole paragraph is a direct quote rather than Keen’s own words. Presumably he agrees with it though!
2 Page 84.
3 If property prices fall to 60% of the original value, the loss on a 70% LVR loan would be (70% – 60%)/70% = 14.3%.