Today’s “Chart of the Day” from Business Insider’s Clusterstock blog presents an alarming picture of the US economy viewed through the prism of bank business lending. The chart, which I have reproduced below, shows a precipitous collapse in lending*, described in dramatic language as “falling like a knife”. There is no doubt that the US economy remains in very poor health, but should we be getting as excited as Clusterstock?

Annual Change in US Commercial and Industrial Loans

Closer examination of the chart reveals that it is in fact quite misleading.

For a start, it makes the very common mistake of plotting a long series of data without adjusting for the fact that over time the value of the dollar has declined through inflation and the US economy has grown. As a result, more recent movements in the data take on an exaggerated scale.

Also, the chart shows annual changes without providing any sense of the base level of lending. Not only that, while attention is drawn to the US $300 billion annual decline in lending, the increase of close to US $300 billion just over a year earlier is ignored, when in fact the two largely offset one another. Certainly lending has declined, but rather than taking us into historically unprecedented territory, as the Clusterstock chart suggests, it actually means loan volumes are back to where they were in late 2007.

Both shortcomings are addressed in the chart below, which shows the history of loan volumes themselves rather than annual changes and overlays a series scaled by the gross domestic product (GDP) of the US to represent lending in “2010 equivalent” dollars.

US Commercial and Industrial Loans

Changes in lending do provide a useful reading of an economy’s health. But, it is important to be careful when using annual changes to read its current state. The change from January 2009 to January 2010 is affected just as much by what happened a year ago as by what happened last month. Since monthly data is available, we can in fact look at changes over a shorter period. The charts below show monthly changes, which are probably a little too volatile, and quarterly changes which are probably the best compromise. Since these charts extend only over a five year period, it is not as important to adjust for changes in the value of the dollar and the size of the economy.

Monthly Changes in US Commercial and Industrial Loans

Quarterly Changes in US Commercial and Industrial Loans

Both of these charts reveal an economy that certainly remains unhealthy and lending volumes are still declining. However, the declines of the last couple of years evidently reflect an unwinding of the enormous increases of a few years earlier. So rather than fretting that lending is “falling like a knife”, we can take some comfort from the fact that the rate of decline is diminishing from the worst point of the third quarter of 2009. The moral of the story is that charts can mislead as easily as words and should always be treated with caution.

* The data is sourced from the St Louis Fed “FRED” economic database.

Property prices have always been a popular topic of conversation in Sydney, but the subject has become more contentious since the onslaught of the Global Financial Crisis. Views on prospects for Australian property prices range from the bleakly pessimistic to the wildly optimistic. Iconoclastic economist Dr Steve Keen is one of the more prominent pessimists and expects a fall in property prices of as much as 40%. At the other extreme, research firm BIS Shrapnel recently released forecasts that prices in capital cities will rise by almost 20% over the next three years. Of course, both sides have their critics. Macquarie Bank economist Rory Robertson is so convinced that Keen is wrong that he has offered a wager in which the loser will have to walk to the top of Mount Kosciusko wearing a t-shirt saying “I was hopelessly wrong on home prices! Ask me how”. Meanwhile, many dismiss the optimists as mere shills intent on talking up the market in the interests of their clients.

Faced with a debate like this, the only recourse for the Stubborn Mule is to look at the data. Fortunately, I have been able to get my hands on a rich set of data (and ideas) from University of New South Wales economist Dr Nigel Stapledon*. Stapledon has painstakingly assembled data on Australian property prices back to the 1880s and rental data back to the 1960s. This data underpins a detailed comparison of the Australian and US property markets in Stapledon’s forthcoming paper  “Housing and the Global Financial Crisis: US versus Australia” in The Economic and Labour Relations Review, Sydney. By comparison, the House Price Indexes published by Australian Bureau of Statistics (ABS) commence in 1989.

A first glance at Stapledon’s index of Sydney property prices does indeed appear to show a meteoric trajectory that would inflame the passions of the pessimists.

Sydney House Price Index

Of course, asset prices tend to exhibit exponential growth, so it is far better to look at historical prices on a logarithmic scale. This reveals a striking trend. The growth of Sydney property prices has been remarkably consistent at around 9% per annum over the last 50 years.

Sydney Property Prices (log scale)

Prices for Australia overall show a similar trend, with average prices over the six major capital cities growing at an average of 8.6% per annum since 1955.

Australian Property Prices

What these charts do not take into account is the effect of inflation. Indeed, inflation varied significantly over the last 50 years, so adjusting for the effect of inflation shows that the trend in Sydney house prices has not been so stable. Booms such as those from 1987-1989 and 1997-2003 are made very clear in the chart below. But it is also evident that  prices have failed to keep up with inflation over the last few years. Nevertheless, over the last 50 years, Sydney house prices have appreciated an average of 3.1% over inflation and that is before taking rental income into account.

Sydney Prices (inflation adjusted)

One difficulty with long-run property price data is that fact that observations are typically based on median house prices, which does not take into account changes in the quality of houses. The median house in 2009 may be “better” than the median house in 1955 and changes in price may reflect this change in quality as well as price appreciation. Stapledon has attempted to take this into account by constructing an index for Australian house prices (six capital cities) that is adjusted for both inflation and standardised to “constant quality”. The trend in real prices, adjusted for quality over the period 1955-2009 has been an increase of 2.1% per annum over inflation. This compares to an increase of 2.7% per annum over inflation without adjusting for quality. So, at a national level, quality changes overstate the trend growth rate by 0.7%. While Stapledon has not constructed a quality-adjusted index for Sydney, assuming that the national trend applied would lead to the conclusion that Sydney house prices have a trend growth rate of 2.4% over inflation.

Australian Prices (quality and inflation adjusted)

Interesting though this historical exploration may be, the question we would like answered is where prices may head in the future.

One approach to the problem is to assume that growth in property values in real terms may change in the short term, but over the long term will revert to a long term trend. Enthusiasts of trend following may see some significance in the fact that Australian prices still appear to be above the longer run trend, while Sydney prices have already fallen below trend. Of course, depending on the time period used to determine the trend, very different conclusions may be reached. If I were to base the trend on the full history from the 1880s, the last 50 years would appear to be well above trend.

Another popular approach is to consider housing affordability. This approach either looks at ratios of house prices to income or ratios of housing servicing costs (whether interest or rent) to income. The assumption is that these ratios should be stable over time and if increases in house prices result in reduced affordability this indicates the prices can be expected to fall in the future. Stapledon is critical of this approach, arguing that:

while income is expected to be a major influence on prices, there is no theoretical reason for any fixed relationship between prices and income or between rents and income

Over time, people may change their priorities and place a greater or lesser importance on housing and, as a result, be prepared to spend a larger or smaller proportion of their income on housing. Stapledon argues that a better approach is to examine rental yield, which is the ratio of rents to prices. Since the property prices can be expected to keep pace with inflation (and, in fact, outpace inflation), rental yields should be comparable to real yields (i.e. yields over and above inflation) on other asset classes. The easiest real yields to observe are those of inflation-linked Government bonds.  The Reserve Bank of Australia publishes historical data for inflation-linked real yields back to the late 1980s. The chart below compares these Government bond real yields to Stapledon’s history of rental yields. While the correlation is not perfect, both rental yields and real yields show a downward trend from the late 1980s/early 1990s which has only recently begun to reverse. Since rents have not fallen over this period, this provides an explanation for the strong growth in property prices over that period.

Australian Rents and Inflation-Linked Bonds

So what could this approach tell us about property prices? Rental yields have already risen further than bond real yields, but certainly could go higher. What this means for prices does also depend on where rents themselves may be headed. The chart below shows the contribution of rents to consumer price inflation as published by the ABS. While the rate of growth in rents has slowed, history would suggest that rents are unlikely to go backwards. A cautious, but not overly pessimistic forecast could see rental increases falling to an annualised rate of 1% while rental yields could climb back to 4%. The combined effect would be a fall of 12%. Since prices have already fallen by 7% over the year to the end of March 2009, this would amount to a fall of almost 20%.

Rent Inflation (Quarterly)

This is certainly a significant drop, but still half the fall that Keen expects to see.  For prices to fall by 40%, even assuming rents remain unchanged rather than growing by 1%, it would be necessary for real yields to rise to 5.8%, which exceeds the record level since 1960 of 5.4%. On this basis, I find it hard to be as pessimistic as Keen. Indeed, the latest data from RP Data-Rismark International suggests that prices are once again on the rise. The next ABS release is a little over a month away, so it will be interesting to see whether they see the same recovery.

The relationship between rental yields and real yields is an interesting one, but ultimately does not provide definitive predictions, but rather an indication of a range of outcomes that would be precedented historically. Of course, as Nassim Taleb has emphasised, unprecedented “black swans” can occur so history does not allow us to rule out more extreme events. Furthermore, nothing here addresses the question why prices in the US have fallen so dramatically and yet Australian prices could suffer far milder falls. That is the primary focus of Stapledon’s paper and is a topic I may return to in a future post, but this one is long enough already!

UPDATE: In this post I noted that the historical data shows a marked shift in behaviour from the mid-1950s without providing any explanation as to the cause of this shift. Needless to say this is a subject Stapledon has given some serious consideration, and I will quote from his doctorate, “Long term housing prices in Australia and some economic perspectives”:

From a longer term view, a key observation is the clear shift in direction in house prices and rents from circa the mid 1950s. House prices, in particular, jumped significantly, best illustrated by the rise in the price to income ratio from about one: one to about 4:1 in the 2000s. Looking at demand and supply variables…indicates that this shift in direction cannot be adequately explained in terms of the demand variables of income and household growth. Supply side factors appear to be more crucial and there is a substantial literature emerging in the US emphasising the importance of supply side variables and specifically the propensity to regulate to constrain supply. The evidence presented in this thesis of the lift in the cost of fringe land in the major urban areas provides prima facie evidence that supply factors have been a significant factor explaining the upward trajectory in house prices in Australia since the mid 1950s.

* I would like to thank Dr Stapledon for generously making his data available to me.

UPDATE: finally, I have published the post on why I don’t think Australia’s property market will experience the same fate as the US market.

The phrase de jour (or du mois in fact) in financial markets is “green shoots”. Optimists, world equity markets included, are seeing tentative signs of improvement in the world economy. Google trends saw a blip in searches for the phrase green shoots back in January when UK Government minister Baroness Vadera used the phrase and was lampooned for what was perceived as premature optimism. Moving forward a few months and searches have surged again, but this time consensus seems to be far more supportive of a positive outlook.

Champions of the botanical analogy in Australia have had some help from the Australian Bureau of Statistics (ABS) over the last couple of days. Yesterday Australian consumer spending took most analysts by surprise, printing an increase of 2.2% when the median forecast had been for a more modest 0.5%. Surprising though this figure was, it was quickly explained away as the result of people anticipating their Government stimulus payment and going shopping on the credit card before actually receiving the money. Today’s employment number was much harder to explain. The consensus was that total employment would fall in April 2009 by 25,000. The more pessimistic forecasters expected a fall of closer to 50,000 and no-one I am aware of expected employment to rise. But that is exactly what it did: employment was up by 27,300 (in seasonally adjusted terms). Growth in full-time employment was stronger still, growing by 49,100. Part-time employment did fall by 21,800, some of which probably represents a transition from part-time to full-time work.

Now, admittedly employment figures are based on surveys and so are noisy. But, the ABS estimates that the standard error for the employment number is 41,700 (36,800 for full-time), which suggests that even if the real figure is really lower, employment conditions in April were still probably better than anyone was expecting. While the green shoots theory is a global one, the economic data is starting to suggest that Australia continues to be better positioned than much of the rest of the world. The chart below* shows the history of the unemployment rate here and in the US. After many years of being used to having higher unemployment than America, over the last couple of years our labour market has proved more resilient. US unemployment figures will be released on Friday and it will be very interesting to see whether unemployment there continues to worsen, widening the gap between the two countries.

I have written before about Australia and the global financial crisis, looking at the extent to which we have been better insulated from the worst of the crisis than the US. Partial insulation combined with significant Government stimulus appear to be supporting our economy. Nevertheless, optimists should be aware that green shoots are fragile, and there will continue to be big economic challenges for Australia, not just the rest of the world.

* Data sources: Australian Bureau of Statistics, Bureau of Labor Statistics

UPDATE: on Friday, the US Bureau of Labor Statistics published US employment data. Unemployment was up to 8.9%, so for now the US and Australia are continuing to diverge.

To date, in their efforts to make the Global Financial Crisis (GFC) even more disastrous than it already is, the US Government has pumped an extraordinary $170 billion into the American International Group (AIG), the humbled and humiliated insurance giant. AIG’s biggest problems arose from entering into enormous credit default swap (CDS) transactions. The reason this creates systemic risk is that CDS are bilateral transactions between two counterparties and so if AIG is in trouble, so are the counterparties on the other side of the transaction. CDS are a little like insurance contracts (albeit with far less regulation), which is perhaps why AIG was attracted to the business, and with AIG selling protection, the buyers of protection are nervous.

Given the amount of money that the US Government has provided to AIG, it is reasonable for US taxpayers to expect some transparency from the recipient of their hard earned dollars. Today AIG has begun taking steps in that direction with the release of a number of documents under the heading “AIG Moving Forward”. Among these documents was a list of collateral postings made to AIG’s CDS counterparties. While this does not give the full picture of the vast CDS transactions volumes AIG built up over recent years, it gives an interesting glimpse of some of the larger participants in this dangerous game. The collateral postings are similar to margin payments made on margin loans when share prices fall: as AIG loses money on its CDS, it makes collateral payments to the counterparty to mitigate the risk that AIG may not be able to pay up in the future.

The counterparty list includes many of the usual suspects: Deutsche Bank, Goldman Sachs, UBS, etc. There are, however, a few interesting names. The one that struck me was DZ Bank,. Never having heard of DZ Bank, I had to look them up. It turns out, that Deutsche Zentral-Genossenschaftsbank is the fifth-largest bank in Germany and operates as a central bank for small German co-operative banks.  It is not a listed company as it is collectively owned by the 1,000 or so cooperative banks it serves. It seems that providing services to these banks was not enough for DZ and so they branched out into the exotic world of CDS. Based on AIG’s disclosure, DZ have received a total of $1.7 billion in collateral (split between direct payments from AIG up to December 2008, and payments from the Maiden Lane III vehicle established as part of the Government bail-out) and so they ventured into CDS in scale. I can’t help thinking that in doing so, they didn’t know much more about what they were taking on than Waverly Council. It also helps to explain how they managed to lose €1 billion in 2008.

One last point on the subject of AIG. Despite managing to destroy such large amounts of value, it seems that they still want to pay bonuses of $165 million to senior executives. Timothy Geithner, Obama’s new Treasury Secretary, described this as  “unacceptable”. I think he was politely trying to say “wake up and see what’s going on around you!”.

There is no doubt that the big four Australian banks have navigated the global financial crisis better than many banks around the world, particularly in the US and UK. However, there seems to be a pervasive tendency in Australia to overstate the success of the Australian banks.

A couple of weeks ago, Michael Duffy wrote in the Sydney Morning Herald that

There are only 15 banks in the world which now have a AAA credit rating. The four major Australian banks are among them.

It would be nice if it was true. However, no Australian bank has a AAA rating, they are all in the AA band.  There are a few Government-owned or guaranteed banks around the world with a AAA and the only privately-owned bank with a AAA rating these days is the Dutch Rabobank.

More recently, Kerry O’Brien was interviewing the astute Morgan Stanley analyst Gerard Minack when he made the comment

Given that the big four banks in Australia are now in the top 12 around the world, what risk still applies to Australian banks as this scenario that you’ve described unfolds?

Gerard blinked for a moment before moving on, so I suspect he knew that Kerry did not have his facts straight here. By my reckoning (with a bit of assistance from Bloomberg),now that Westpac has taken over St George, it just scrapes in at number 12. ANZ, however, is all the way down at number 33 and the other two are somewhere in between. If I have missed any of the major world banks in my calculations, that would only push Australian banks further down.

The chart below shows data I have uploaded to Swivel giving the market capitalization for 40 of the biggest banks in the world in billions of US dollars. Figures are in thousands of millions (i.e. billions) of US dollars. While management of the big four Australian banks should be pleased with how they are faring, there is no need to blow their trumpets to the point of ignoring the facts.

One final point: it is interesting to note that the three biggest banks in the world today are Chinese banks.

For those who read my earlier Amazing Shrinking Banks post, you may notice that I have added a few more banks, including the large Chinese banks.

Last year, I wrote quite a few posts on the subject of the credit crunch, aka the GFC (“Global Financial Crisis”) or GD2 (“Great Depression 2″). Whatever you want to call it, it has been unfolding for almost two years, and does not show any signs of letting up yet. The hardest hit to date have been banks. Many, including Northern Rock, Bear Stearns, Lehman Brothers, Wachovia, Washington Mutual and every Icelandic bank have fallen along the way, via bankruptcy, merger or Government bailout. Others limp along with the odd adrenaline shot from Government to shake a little more life back into the patient.

Just one of these terminal patients is the Royal Bank of Scotland, whose market capitalization has fallen by 90% over the last two years, despite large injections of capital by the UK Government. The bank’s chief executive, Sir Fred Goodwin, has just resigned and was described by the Telegraph as “the most reviled man in Britain”. The once gargantuan Citigroup has shrunk even more and is now 92% smaller than it was in January 2007. In contrast, whether by good luck or good management, Australian banks have held up  well. Nab has been the worst affected, thanks in part to some pesky CDO write-downs, shrinking by 55%. Westpac has weathered the storm better than any major bank in the world, with a fall of only 17% in its market capitalisation. (Quick note to shareholders: your investment will have fallen by more than this since market capitalization equals share price times number of shares and like all banks, Westpac have raised additional capital during the course of the crisis and of course they have also bought St George).

The differing fortunes of the world’s banks in the face of the GFC has led to a significant re-ranking of the size scoreboard. The chart below was inspired by JP Morgan’s “pea chart”, which was doing the rounds last week*, and shows a ranking of 25 of the largest banks today and compares their current market capitalization to that of January 2007. How much has changed in two years! Once the largest bank in the world, Citigroup now languishes at number 20 in this list and is smaller than Westpac, CBA and nab. Even ANZ is now larger than Deustche Bank. How the mighty have fallen!

For those who are interested in poring over the gory details, I have posted a monthly history of the market capitalization of these and a number of other banks over on Swivel. All the figures have been converted to US dollars based on exchange rates at month end. All the data was sourced from Bloomberg. I have tried to include all the major publicly listed banks around the world (which excludes Rabobank, for example), but do let me know if I have missed any important ones.

* If you follow the link and look at the picture, please read the comment about the somewhat misleading use of circles in the chart!

UPDATE: Thanks to BC for pointing out that I completely forgot about Canadian banks! I have updated the chart, which now includes Royal Bank of Canada, Toronto-Dominion and Bank of Novia Scotia. These three have pushed ING, Deutsche Bank and Nordea from the top 25. The original chart is available here. If you know of any other big banks I have omitted, please let me know!

Yesterday’s quarterly inflation release, which showed prices falling by 0.3% over the December quarter across Australia, cemented expectations of a 1% cut in interest rates in February. How things have changed! My very first Stubborn Mule post back in May 2008 examined the inflationary pressures that had so concerned the Reserve Bank and led them to keep interest rates high well into the financial crisis. In that post I used a heatmap to dig down into the drivers of inflation, and a quick comparison of the latest December inflation rate with inflation six months earlier gives a very clear illustration of where prices are falling.

Austalian Quarterly Inflation – Dec 2008
(click to enlarge)

The big blue square standing out in the December chart is “Private Motoring”, which makes up almost 20% of the Consumer Price Index (CPI). Of course, the dominant factor here was the fall in petrol prices. The average price for a litre of petrol in Sydney in September was $1.52, but by December the price had fallen to $1.05.

Austalian Quarterly Inflation – Jun 2008
(click to enlarge)

The chart for the June quarter is clearly redder and overall prices rose 1.5%. The only striking price falls were in fruit and vegetables, which fell by 6.9%. However, even this move was largely a reversal of the 6.2% rise seen in March.

For some months now, the Reserve Bank has signalled that the focus of their concern has shifted from inflation to the weakness of the Australian economy, so markets were right to conclude that the December price fall reinforces the case for a large rate cut ahead. However, a look at oil prices suggests that petrol prices are on the rise again. An update of my Sydney petrol price model, suggests that wholesale oil prices will be pushing petrol prices back closer to $1.20/L. If these prices are sustained, we can expect to see Private Motoring bringing some inflationary pressure back into the June 2009 numbers.

Nevertheless, given the state of the world economy and the US economy in particular (which Citigroup’s chairman has described as being in a “death spiral”), it will take a bit more than climbing petrol prices to lead the Reserve Bank to tightening monetary policy again.

* Source: Australian Automobile Association.

One of the more peculiar stories of late in these times of turbulent financial markets is how, briefly, Volkswagen became the biggest company in the world. In the process, hedge funds around the world suffered losses estimated at over US$35 billion.

Over the last few years, Porsche has been building a stake in Volkswagen. By November 2007, the size of their stake had reached 31%, much of which was achieved by means of share options* rather than direct share purchases. Significant increases in the Volkwagen share price meant that these options delivered large profits for Porsche, prompting criticism that the company was acting more like a hedge fund than a car manufacturer.

In response, many real hedge funds took the view that, in the light of the ongoing financial crisis, the share price had risen too far and so began betting against Volkswagen. For critics of short-selling, this should have been very bad news for the Volkswagen share price. But things do not always go the way hedge funds plan and events turned out very differently.

In October 2008, Porsche revealed that they had effectively built their holding in Volkswagen up to 74%. In most countries, share-holdings of this size would be subject to continuous disclosure requirements. While Germany is no exception, Porsche had taken advantage of a loophole which exempted cash-settled options (as opposed to options which allow the holder to purchase shares) from these reporting requirements. This had allowed them to build their enormous stake while leaving the rest of the market in the dark.

The problem for the short-selling hedge funds was that all of the banks who had transacted these options with Porsche would had been buying Volkswagen in order to hedge their positions. So, although Porsche did not directly hold 74% of Volkswagen, these shares were effectively tied up. Add to this the 20% stake held by the German state of Lower Saxony and only 6% of the shares in Volkswagen were available for trading in the market. Given that hedge funds had short-sold around 12% of shares in Volkswagen (unwittingly selling to the banks hedging the options they had sold), the Porsche announcement was the equivalent of shouting “Fire!” in a crowded theatre. Every hedge fund manager started running for the door, desperately trying to buy back Volkswagen shares to close out their short positions.

As a result, the Volkswagen share price soared, briefly trading over €1005 (Euro), then closing on 28 October at €945. This put the market capitalisation of Volkswagen at around US$370 billion, more than Exxon Mobil’s capitalisation of around US$340 billion, thereby making Volkswagen the biggest company in the world for a day.

Humiliated hedge fund managers cried foul, claiming the event made the German exchange the laughing stock of financial markets. While the share price has since fallen back to a mere €392, it has been estimated that the experience cost hedge funds around the world over US$35 billion** and, needless to say, generated further profits for Porsche. No doubt some of the fuming hedge fund managers would have found insult to add to their injury as they stared at the Porsche logo on their steering wheel as they drove home.

*UPDATE: Michael Michael has asked for an explanation of share options, so here is a brief explanation. A “call” option is a financial contract which gives the buyer of the option the right to purchase shares at a specified price (called the “strike” price) on a specified date (called the “expiry” date). For example, consider a call option on Volkswagen with a strike price of €200 expiring in three months time. If the share price of Volkswagen at the time was €185, this call option might cost around €2. In three months time, the share price had risen to €220, the holder of the option could “exercise” the option, buying shares from the option seller for €200. Since these shares could immediately be sold for €220 in the market, the option holder has made a profit of €18 (€20 less the €2 cost of the option). If the share price at expiry was only €190, there would be no point exercising the option and they would expire worthless. Exercising these options involves the direct purchase of shares and they are referred to as “physically settled”. A variation would be a “cash settled option”. This is very similar but, in the €200 call option example, rather than buying shares from the option seller, the holder of the option would be paid €20 (the difference between the market price and the strike price). If the Volkswagen share price goes up, the value of a call option goes up as well (whether physically or cash settled), so the buyer of the option makes money and the seller of the option loses money. For this reason, if the seller of the option wants to “hedge” this risk (i.e. reduce the risk as much as possible), one approach is to buy shares, which is exactly what the banks which sold options to Porsche did. Since a holder of a call option has the right to purchase shares in the future, it is common for regulators to require such options to be subject to disclosure rules for large holdings. At first glance, it may not seem necessary to include cash-settled options in this requirement as the options do not involve any direct share transactions. However, as this Porsche/Volkswagen example shows there are in fact very good reasons to include cash-settled options.

**UPDATE: This figure is almost certainly an over-estimate and the real figure is likely to be closer to US$20 billion (thanks for pointinf this out Mark).

Over the last few months I have written a lot about the global financial crisis. My posts have focused on specific events as news has broken, ranging from a programming bug by Moody’s to the enormous US bailout plan and Government guarantees from Ireland to Australia. Here I will instead take a broader perspective and provide an overview of how the crisis has unfolded and, more specifically, how Australia came to be caught up in the mess.

A year ago, many commentators were extolling the idea that Australia’s economy had “de-coupled” from the United States and Europe, and would continue to be powered by the rapid growth of China and other developing nations. Concerns about inflation meant that interest rates were rising and many felt Australia would escape the incipient economic slowdown in the developing world. Events have instead unfolded differently. The Federal Government has taken the extraordinary step of guaranteeing deposits held in all Australian banks, building societies and credit unions and the Reserve Bank of Australia has delivered an unexpected 1% cut in interest rates, citing heightened instability in financial markets and deteriorating prospects for global growth. This was an extraordinary turnaround. It is, of course, the result of Australia becoming ensnared in the global financial crisis that began in mid-2007 and has intensified ever since. But how and why did Australia get caught up in a mess that started with falling property prices in the US?

The crisis has unfolded in stages. First came the bursting of the housing bubble in the United States. This in turn led to a cycle in which the prices of many mortgage-backed securities plunged, triggering the liquidation of a number of hedge funds holding these securities, which in turn led to further collapses in security prices. Following this hedge fund liquidation phase, the focus of concern moved to banks. Banks were slow to admit to the extent of their exposure to mortgage-backed securities and related derivatives, which led to a breakdown of trust in the markets. Banks became extremely reluctant to lend to one another and, despite repeated efforts by central banks to inject large amounts of cash into the banking system, the result was a liquidity crisis. This phase of the crisis has been both longer and more severe than most observers expected and has resulted in sweeping changes to the US banking landscape through both mergers and collapses. While the United States has been at the epicentre, each phase of the crisis has been echoed in Australia.

Back in June 2005, The Economist published these prophetic words: “Never before have real house prices risen so fast, for so long, in so many countries. Property markets have been frothing from America, Britain and Australia to France, Spain and China. Rising property prices helped to prop up the world economy after the stock-market bubble burst in 2000. What if the housing boom now turns to bust?”. These frothy property prices were fuelled by a combination of low interest rates, loosening lending standards, growing consumer appetite for debt and extensive use of securitisation, which effectively allowed home buyers to access capital from all around the world.

It has been estimated that from 2004 to 2006, more than 20% of new US mortgages were taken out by “sub-prime” borrowers with poor credit histories and limited capacity to service their loans. These borrowers instead relied on ever rising property prices allowing them to sell for a profit or refinance their mortgages at a lower rate once they had accumulated more equity. Of course, once prices started to fall, these borrowers began to fall behind in their payments or simply to walk away from a debt now much larger than the diminished value of their home.

When it came to the second phase of the crisis, Australia was not so lucky. Many investors held securities with direct exposure to the ailing US sub-prime mortgage-backed market. Two prominent casualties were high-yield funds managed by Basis Capital and Absolute Capital. Mortgage-backed securities that had been repackaged in the form of collateralised debt obligations (CDOs) had also been widely distributed to so-called middle market investors: local councils, universities, schools and hospitals. Non-bank mortgage lender RAMS also found itself in trouble. RAMS was heavily reliant on short-term funding, much of which it sourced from US investors who were no longer interested in purchasing asset-backed commercial paper regardless of whether the underlying mortgages were in the United States or elsewhere. Unable to fund itself, RAMS became the first Australian corporate victim to the financial crisis. Other non-bank mortgage lenders also came under pressure as global securitisation markets effectively shut down. The one bright spot was that, unlike European and US banks, Australian banks appeared to have minimal direct exposure to sub-prime mortgage-backed securities and their derivatives on their balance sheets.

As the crisis shifted into the liquidity phase, the impact on Australia intensified. Institutions that were heavily reliant on financing, particularly from offshore, found it more and more expensive to refinance maturing debts. Among the companies caught in the crunch were Centro, MFS, ABC Learning and Allco. Of course the biggest institutional borrowers in Australia are the banks. They had come to rely increasingly on offshore markets in order to fund Australia’s growing borrowing habits. By 2007, Australia’s net foreign debt exceeded $500 billion, representing more than 50% of the country’s annual gross domestic product. A significant proportion of this debt is raised by banks. Despite their relatively clean balance sheets, Australian banks were forced to pay the same high margins on their borrowings that investors were demanding of European and US banks. Even money markets in Australia were affected, pushing up the interest rates banks had to pay for short-dated borrowings. Like other central banks around the world, the Reserve Bank responded to the liquidity crisis by injecting additional cash into the system. As part of this effort, in September 2007 it significantly expanded the range of collateral it would accept from banks in exchange for funds, even going so far as to allow mortgage-backed securities, albeit highly-rated ones. Despite the global and local turmoil, the Reserve Bank remained concerned about inflation, raising rates four times during the credit crisis. In an effort to recoup some of their soaring funding costs, banks broke with tradition and raised mortgage rates over and above the Reserve Bank moves.

Figure 2 – Growth in Australian Foreign Debt*

Increased funding margins for Australian and international banks also led to a more general widening of credit spreads** outside the financial sector. This spread widening took its toll on the performance of Australian fixed income funds, which had traditionally invested in corporate bonds (particularly banks) as a means of enhancing portfolio yields. The stock market also began to suffer. Admidst the gloom, there were some periods of respite for investors. Spreads tightened and the equity market recovered some lost ground after the bailout of Bear Stearns in March 2008, but only until news of further write-downs and capital injections for Merrill Lynch, Citibank, HBOS and others further eroded market confidence.

Despite the funding challenges faced by the banks and the volatility in Australian fixed income and equity markets, it was not until September 2008 that alarm spread outside financial markets. As governments around the world began guaranteeing bank depositors, Australians began to realise that their own deposits were not guaranteed. This led to fears that Australian financial institutions, particularly regional banks and credit unions, could experience a run by depositors, something that none could withstand regardless of the underlying strength of their balance sheets. Fearing the catastrophic effect this could have on the Australian economy, the Federal Government swiftly moved from plans to guarantee sums of up to $20,000 to announcing on 12 October 2008 a comprehensive guarantee of all retail deposits for three years. At the same time, they announced a guarantee scheme for bank wholesale borrowing to ensure Australian banks could compete for funding against other Government-guaranteed banks around the world. Nevertheless, Australian banks still have had no need of the capital injections received by many banks around the world.

While moves by Governments and regulators around the world appear to have averted systemic financial failure, concerns remain about the impact the global financial crisis will have on the real economy. With tighter lending standards, weak consumer and business confidence and signs of slowing international demand for Australian commodities, Australia is unlikely to escape this phase of the financial crisis. The Government hopes that a $10.4 billion stimulus package will help protect Australia from the anticipated global recession, but few commentators still believe that Australia’s economy has “de-coupled” from the United States and rest of the developed world. Mind you, that is partly because Asia and developing nations around the world now seem well and truly coupled to the US-led financial crisis.

*Data sources: Australian Bureau of Statistics, Standard & Poor’s/Case-Schiller
**Credit spreads are the difference between interest rates that corporates pay on their bonds and benchmark interest rates (e.g. Government bond yields or swap rates).

In a post earlier this week, I wrote

The Government was right to step in with the guarantee and it has doubtless provided some stability for a financial system that remains jittery, but the sooner the details are sorted out, the better.

The main outstanding question I was referring to was how the guarantee would apply to wholesale debt. Uncertainty on this point has been creating significant concern for investors in cash management trust and other managed funds. The amount of money moved from these funds to bank deposits may be over $1 billion.

Finally today, the Government announced the wholesale guarantee fee, which will also apply to retail deposits over $1 million. While there had been speculation that the fee would vary based on the time to maturity of each security, the Government has instead opted for a fixed fee. The fee varies with the credit rating of the bank taking up the guarantee.

To put these figures into perspective, the Bank of England is charging 0.50% plus the average over the last year of each bank’s 5 year credit default swap spread. For those who have not been following prices in the credit default swap market, these margins have been very high lately. This means that the Australian fee will be significantly lower, particularly if the fee is paid only once rather than annually (the Treasurer’s release does not make this clear).

Nevertheless, for the short-term securities favoured by cash management trusts, the 0.70% fee may seem a little high. Since the use of the wholesale guarantee is optional, banks may not take up the guarantee for these securities. If so, the exodus from cash management trusts is likely to continue, at least for smaller investors.

My own view (not that I’m giving advice!) is that leaving money in a cash management trust is not particularly risky. The deposit guarantee is undeniably good news for Australian banks as it essentially eliminates the risk of bank runs, so even uninsured debt is looking better than it was a few weeks ago. In any event, for anyone who is in the position of making a decision about a cash management trust, there is still time to make up your mind: until 28 November everything is guaranteed. After that date, wholesale debt will not be guaranteed unless the fee is paid.

UPDATE: Treasury have released a document entitled “Design and Operational Parameters” which gives a little more details, including confirmation that the fee is charges on an annual basis, although it is not clear whether securities shorter than a year will only pay a pro-rata share of the fee or the full 0.70%. The document also notes that details may change further in the future:

The deposit and wholesale guarantees contain features and variables that may require refinement or adjustment in light of market developments. These include the setting of the appropriate fee level and structure, the threshold for the deposit guarantee and the overall coverage of the scheme. The deposit and wholesale guarantee scheme will be reviewed on an ongoing basis and revised if necessary.