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.
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).
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