Going back to the thick of the financial crisis…I remember it well! Here is a presentation about the market turmoil back in May 2008. Keep in mind that I wrote this after Bear Stearns collapse but before Lehman Brothers. Fast-forwarding a bit, here’s paper about the government guarantee for Australian banks, written back in October 2008. As you can see if you have a look at these, I was giving these topics a lot of thought at the time! Those two are somewhat sanitised versions of documents written for another audience, but I did also write a few posts on the subject for the blog as well. Australia and the Global Financial Crisis is still generating more traffic than most, and there were also posts more specifically focused on the guarantee such as this one.

Nevertheless, I don’t expect to you read all of those pieces so I’ll put a few thoughts in this comment as well. One point to make is that, while we will never really know what discussions took place behind closed doors between banks and the government, the sense I get from people who should have some insight into the matter is that the four major banks were not agitating for the guaranteed and were in fact taken by surprise when the announcement came out. The banks who stood to benefit the most in my view (they may dispute this of course!) were the smaller regional banks such as Suncorp and Macquarie Bank. I believe their funding difficulties were far more acute than anything the four majors were experiencing, although of course wholesale funding was very expensive for everyone at the time. To really go out into the realms of speculation, the cynic in me can’t help thinking that some in the four majors might have been disappointed by the guarantee as it robbed them of the schadenfreude of seeing some other players collapse! Who knows?

Whatever the real story behind the guarantee, the problem being addressed was fundamentally one of liquidity not solvency. Here’s a quote from the second document referenced above:

Banks can get into trouble if they make bad investments, lending to companies or individuals who default on their loans or if they investing in securities which suffer large price drops. This is solvency risk, the risk on the asset side of the balance sheet. However, even with strong assets, banks can still get into trouble on the liability side. Banks buy their assets using funds taken in as deposits and raised by issuing debt securities in the wholesale financial markets. Most of the deposits are at call or in short-term deposits and much of the wholesale debt is also short-term. On the other hand, their assets are mostly long-term. If a bank starts to lose deposits or struggles to issue new debt as wholesale securities mature, they cannot demand that borrowers repay their loans early. The worst case is a run on the bank, with every depositor trying to withdraw their money at the same time. This is liquidity risk and liquidity risk can trump solvency risk: no matter how good their assets are, no bank can survive a run.

Of course solvency risk and liquidity risk are intertwined: one reason a bank can have funding problems is precisely because of concerns in tha market about their solvency. However, this is not always the case. A good example is RAMs. They got into trouble not because their mortgage book had deteriorated but because they relied so heavily on short-term funding in the US CP (commercial paper) market and they simply could not refinance their debt.

Contrary to your suggestion that it is always possible to get funding–sometimes funding is available but expensive, sometimes it’s not available at all. You might argue that there’s a price for everything, you might just not like the price, but what if asset-backed commercial paper is trading at, say, 75 cents in the dollar (not out of the question at the time). That means to refinance $75 million dollars worth of debt, you would have to take out a loan that will require you to repay $100 million in the future, but would only give you $75 million today. What if you had assets worth $95 million, debt of $75 million and shareholder equity of $20 million (leverage of 4.75 times, which is not out of the question). If that debt was repayable, you simply could not borrow at 75 cents in the dollar as you would incur a debt of $100 million, which would exceed the value of your assets and you would automatically be bankrupt, no matter how good your assets were!

That may seem like an extreme and artificial example but it was essentially the situation faced by RAMs and potentially some of the smaller banks were not far from the same fate. So, the mere fact that the Australian government felt compelled to step in with a government guarantee does not in and of itself say very much about the health of the banks’ loan portfolios. I should also add that once the guarantee was in place, all the banks (majors included) naturally took advantage of it. After all, the guarantee fee (payable to the government) was 0.7% for the majors and at the time they would have had to pay a significantly higher premium over guaranteed debt than that if they tried to issue bonds without a guarantee.

Long comment….hope it makes some sense!

I consider myself to have been educated significantly by discovering Steve Keen’s ideas some years ago, but what would I know…. I’m just a regular old Engineer who can barely hold back his laughter when he reads mainstream economic theories that have the gall to suggest that macroeconomic systems are linear mean reverting systems…

I can’t even get the simplest of engineering systems to operate in linear modes at all times…. pray tell which cigarette are these guys smoking when they think a massively more complex macroeconomic system will behave linearly. Who needs comic fiction when you’ve got these comic gems!?

Anyway, I digress….

I’ve enjoyed the to and fro on this subject of Australian banks.

I’d be interested on your responses to looking at this problem from a different angle.

Step back in time to 2008-2009, during the first wave of the “GFC”.

Pray tell, if our Aussie banks are so safe and comfortably well buffered, how come they went on bended knee to the Australian Federal Government to secure Federal Government guarantees on the debt they needed to issue/rollover? I know this question is not directly related to house prices, but (I think) it goes to the heart of the matter of the true picture of the strength and solvency of the Aussie banks, and sheds an interesting light on same.

The knee-jerk answer would undoubtedly be “because the the debt markets had seized and the banks couldn’t get debt funding at all”. But this is not true. They could always get the funding, but at a much higher interest rate. It should be obvious (but I can’t prove it) that there are only two reasons why the banks took the action they did. It was either because:
(a) These effect these higher borrowing costs would have on their financial position was so serious that the banks found themselves desperately seeking lower borrowing costs via Fed guarantees to avoid potential calamity, OR
(b) The potential damage from the higher borrowing costs were not potentially calamitous to the viability of the banks, but the execs were so cocky that they went hat-in-hand to the Feds anyway merely to minimise the reduction in profit.

If instead you’re answer is along the lines of “well yes they obviously recognised they would find it difficult financially to secure funding at, but it wasn’t going to cause a critical situation by any stretch”, then this is very similar to asserting that the Australian government put taxpayers on the hook merely to maintain banks enormous profit levels rather than saving them from going to the wall (or something very close to it). If that were the case and the word got out then a whole bunch of Australians would be justifiably frothing at the mouth with anger that the Feds would serve the interests of the banksters so egregiously.

In short, if the banks are comfortably cushioned via low LTV’s and safely solvent, how come the Fed guarantees on their debt?

Remember, these Fed guarantees were requested while the Aussie CRE market was still relatively OK and the Residential RE market was still chugging upwards. So absent any major RE issues, the banks still had this major problem that required the remarkable degree of intervention, presumably to keep them viable?

So, one can’t help but wonder what position the Aussie banks may quickly find themselves in if we have another round of debt deleveraging (if it even has stopped at all since ’07) and another flight out of international debt markets AND even minor declines in the Aussie RE market….

I readily accept that Aussie banks are, generally speaking, better cushioned than most US and European banks. But the picture, to this poor engineer, appears under the surface to be (on balance) more akin to regarding the Aussie banks as ‘relatively less sick’ than as ‘relatively healthy’.

Counterpoints welcomed.

As for your other questions, they are all good ones. I should emphasize that, while I do see various differences between Australia and the US when it comes to the property market and home lending, I am certainly not of the “the only way is up” school. Although looking at property prices in terms of rental yields paints a less dramatic picture than in affordability terms, it is hard to imagine rents will keep rising at the rate they have over recent years. I don’t expect to see a 40% crash (although it’s certainly possible), but I would not be at all surprised to see volatility in prices with not much in the way of net gains and indeed possible net declines in coming years.

As for the specific questions, here are some thoughts. (1) a spike in defaults would certainly put a big hole in bank earnings (although I don’t think the majors would collapse) and the economy would be very sick. It would be very bad news for Australia, but would not cause ructions for the rest of the world (there are plenty of other things that could do that, of course).

(2) The scenario you paint could certainly cause nasty feedback.

(3) Without a doubt!

(4) If the downturn is severe, there could certainly be insurers going out of business (it’s happened before). At that point, any losses on mortgages not yet covered would come back to the banks. Overall though, taking probability of default and loss given default into account, I would say an 80% LVR loan without mortgage insurance is riskier for a bank than an 85% LVR loan with mortgage insurance.

So, I am by no means a blind optimist. My main argument with bubble-proponents is that I don’t see a bursting as inevitable. Possible certainly. My main argument with the presentation discussed here is that even if there is a bursting of the bubble, it is not inevitable that the major banks will collapse (although they would certainly have some disappointed shareholders looking at shrinking dividends).

“Portfolio average LVRs are instead calculated as averages weighted by the loan amount not the property value, which is the approach I used.”

Although this may be common practice, it seems kind of weird, doesn’t it?

However, once we accept this, the rest of your numbers certainly make sense: for instance, the 12% loss (with 100% default) vs 6.6% loss (with 58% default) makes sense: twice the default rate, twice the loss.

I see what you mean with the weighted average thing, as well.

BTW, I believe Chris interpreted the “average LVR” in the same way as I, for his numbers seem to match mine.

Regardless, I trust you to know your finance stuff, better than I.

Still, this does not address what I consider the most pressing matters:

(1) As a consequence of an external shock, could mortgagors start defaulting at rates high enough to destabilize the system? This is critically dependent of the ability of people to service their debt and on the sensibility of the system to defaults. You might have heard of recent renewed reports on home owners using their equity as ATM.

As you’ll imagine, this ultimately, is motivated by the chart I keep insisting on.

(2) Can investors and developers start selling off housing stock as a consequence of their own endogenous dynamics?

If investors count on capital gains, any slowdown in price growth could diminish their demand, and selling off stock.

If developers count of capital appreciation, they could find themselves unable to service their debts, and selling off stock, as well.

The combination of the two things could could feedback on slower prices.

And recently there have been reports on lower clearance rates at auctions and even prices starting to fall. Just last night Allan Kohler was talking about house prices increasing only in Victoria and that because of the Victorian state government’s very own “FHBB”, by the way (you’ll remember Mark and I have talked about this at the Stable).

(3) Is it possible some kind of interaction between (1) and (2)?

(4) Even if banks are properly insured, the amounts we are talking about are quite considerable. Are we sure insurers can actually service them?

Insurance, as we all know, only spreads the losses among others. It’s the proverbial fan. In the US case, the crap fell largely overseas (it put the global into GFC).

As I said before: someone could end up with a lot of loose and bloodied “cojones” in their hands.

Let me be frank: I am not saying that we should run for the hills, just yet. But I think there are a whole lot of reasonable questions (at least they seem reasonable to me) that need to be answered. And although you made a gallant attempt, I don’t see anybody answering them.

In the meantime, your approach to calculating average LVR would explain the differences between us. However, the problem with the “Total Loans”/”Total Value” approach is that it gives too much weight to the low LVR loans. If you have two loans secured by property A and property B and borrowed collateralised by B defaults, you cannot draw on the value of property A to mitigate your loss. For this reason, this is not the method used by banks to report portfolio average LVRs.

“Total Loans”/”Total Value” is effectively an average LVR weighted by property value (you can see this in the case of just two loans in this equation). Portfolio average LVRs are instead calculated as averages weighted by the loan amount not the property value, which is the approach I used.