Monthly Archives: November 2010

Coffee meeting

No, I’m not writing this post over a macchiato. The title of the post has nothing to do with caffeinated beverages. Rather, it refers to the annual conference of “CofFEE”, the Centre of Full Employment and Equity, a research centre at the University of Newcastle.

The director of the center is Bill Mitchell, who may be known to Stubborn Mule readers as the author of Billy Blog. Two of Bill’s primary interests are the macroeconomics implication of the nature of money, a topic that comes up frequently here on the Mule, and the development of economic policies aimed at restoring full employment, chief among which is the idea of a “job guarantee”. For Bill these two areas are intimately linked. He argues forcefully that too much economic policy around the world today is mired in thinking that has not progressed past the days of gold standard currencies. A better understanding of the real nature of money in modern economies like Australia, the United States and the United Kingdom (but unlike those unfortunate countries struggling in the euro-zone) would release governments from baseless fear of government spending and the confusion generated by concepts like NAIRU (the idea that full employment would necessarily generate excess inflation) and empower more effective fiscal policy.

I will be attending the CofFEE conference later this week and the program reflects these twin themes of employment policy and the theory of money. Among the speakers are Marshall Auerback and Randall Wray who are both out from the United States and, along with Bill Mitchell, are well-known proponents of the “Modern Monetary Theory” approach to macroeconomics. Auerback and Wray will be sure to have some interesting perspectives on the financial crises and the failures of US policy responses to the ongoing recession over there.

I will be reporting back on highlights from the conference and, in the meantime, keep an eye out for tweets from @stubbornmule. If you have any questions you would like me to try to ask, let me know.

Do your block in!

Sydney’s property market is a subject that has found its way onto the Stubborn Mule more than once. In this post, regular guest contributor Zebra (James Glover) manages to combine property and television with some now-traditional beer coaster calculations.

Channel 9’s high rating renovation show The Block just finished its successful second series on Wednesday night. It concluded with an auction of the four properties that the contestant couples had spent 8 weeks, and in excess of $80,000 each, renovating. The prize for the contestants was the “profit” of whatever they made at auction in excess of the stated reserve. The reserves were varied to reflect unique features of each apartments such as views, an outdoor living area or double garage. The idea was that the couple with the best renovation skills would see their apartment achieve the most above the reserve. In the end the couple who won, John and Neisha, achieved a price of $1,105,000 with a reserve of $900,000 and so made $205,000 (they also won first prize and an additional $100,000 which we’ll ignore for now). Wow! $205,000! Okay that was for 8 weeks of back-breaking unpaid labour. But still. It makes you think that this renovating lark might be a pretty profitable way for making a living. A couple of apartments like that a year and you’d be in gravy! Or would you?

The first thing to consider is the fact that the other couples didn’t do quite so well, making $87,500 (Jake and Erin), $47,000 (Mark and Duncan) and nix (Brendan and Chez’s apartment passed in below the reserve). Okay, you say, but that is still an average of $85,000 for each couple or $42,500 per person for a couple of months’ work. So take $42,500, divide by 8 weeks times by 52 weeks, carry the 2, take off 20% for holidays less breakages tap, tap, tap, that represents an annual profit of about $200,000 each. Still not bad. Break out the champagne!

But buried in the self-congratulatory articles, no doubt generated by Channel 9’s PR department, are some sobering facts. Put away the Kristal and maybe open a cask of Ben Ean and take a seat. The entire unrenovated apartment block was bought for $3.4m. The total amount spent on renovations (not including the couples’ labour) was $470,000 (including $100,000 on common areas). That makes $3.87m. The total sale price was $3.89m. So the total profit was a pretty modest $20,000. And that doesn’t include stamp duty (about $200,000) or agent’s commission ($78,000 @ 2%) plus, let’s say, legal costs of $2,000. So, in reality, the washup of The Block is a loss of $260,000. They don’t mention that in the publicity.

My back of the beer coaster calculations show John and Neisha were still the “winners” having only lost $60,000 on their reno. Jake and Erin and Mark and Duncan each would have lost $66,000 and, still last, Brendan and Chez’s reno lost $67,000. Perhaps Channel 9 should deduct John and Neisha’s loss from the winners’ prize of $100,000 and present them with a cheque for the $40,000 difference.

More revealing than the illusion that this was a profitable business from a renovators point of view is that the total reserve price was $3.55m. Now I’d expect the total reserve to at least equal the break-even cost of the apartments, or $4.15m. In fact it was $600,000 below the actual cost of buying, renovating and selling The Block. If in a very public show like this, with 1.2m viewers, the agents can so blatantly quote below the break-even reserve then what hope for the tens of thousands of buyers in suburbia struggling to match house ads with reality? It’s enough to do your block in.

Bank funding costs

This post returns to the theme of interest rates on Australian mortgages. The first post showed the extent of the increases in mortgage rates over and above the Reserve Bank cash rate. The rationale banks have been giving for these increases is that their own funding costs have been continuing to blow out in the wake of the global financial crisis. In the spirit of occasional Stubborn Mule contributor @pfh007, it is time for some beer coaster calculations to see how plausible this argument is!

A number of commentators have accused the banks of out and out dishonesty on the subject of their funding costs. A few weeks ago in the Sydney Morning Herald, Ian Verrender focused on banks’ offshore borrowing and argued

if that really is the case, and only half their funding is sourced locally, then logically they should be raising interest rates by only half the rise in the official cash rate

Last week, also in the Herald, Richard Denniss built on this argument and argued that not only are offshore borrowings unaffected by Reserve Bank interest rate movements but so are all of their customer deposits. This led to the following conclusion.

Only about one-third of the banks’ funds come from the Australian money market, which means that when the official rate rises by 1 per cent, the banks’ costs only rise by about a third of 1 per cent.

But these simplistic arguments are incorrect. In saying this I am not defending the actions of the banks. There is no divine right for businesses to be able to preserve their margins at all times. Margin compression is a fact of life for many businesses. But more importantly, the ability Australian banks have to recoup costs from existing borrowers not just new borrowers is inherently anti-competitive.

Nevertheless, given the heat in the issue, it is worth getting a better understanding of exactly what is happening to bank funding costs.

A look at the balance sheet of any of the major Australian banks will show that their liabilities (which effectively represent the “funding” for their assets) are drawn from a range of sources. While the makeup will vary from bank to bank and change over time, roughly 50% of their funding is sourced from customer deposit balances and 50% from the wholesale markets (both domestic and offshore). Within those two categories, further distinctions can be made.

Wholesale Funding

Wholesale funding is a mix of short term “money market” borrowings and longer-term debt. Again, very roughly, about 50% of this wholesale funding is short-term (prior to the financial crisis, quite a bit more would have been short-term) and 50% long-term. Somewhat arbitrarily, “short term” tends to be defined as borrowings with a term of less than one year. Much of this borrowing takes the form of “certificates of deposit” (CDs) which are mostly bought by other banks or financial institutions like fund managers (much of the “cash” component of superannuation funds is invested in these sorts of instruments).

The interest rate paid on these deposits depends on the term and will be closely related to what the Reserve Bank does with its cash rate. For example, since the Reserve Bank just raised rates to 4.75% and it is almost a month until the next rate decision, the 30 day rate on CDs is currently very close to 4.75%. When the Reserve Bank hiked last week, markets were caught by surprise and the CD rate, which had been 0.20% lower jumped up in response to the central bank’s move. The correlation between these short-term borrowing rates and the Reserve Bank’s cash rate is not perfect, but on average over time, they are quite closely linked. So, the cost of this component of the banks funding can be expected to move in line with the cash rate, but should not increase significantly more than the cash rate.

Things are a bit different when it comes to long-term debt. For a start, most bonds are fixed rate: the interest the bank pays investors does not change even if the Reserve Bank cash rate goes up or down. However, while a fixed rate may suit investors, most of the bank’s assets have variable rates. Banks deal with this mismatch by using interest rate swaps (and other derivatives) which effectively convert their fixed rate borrowing into floating rate borrowing. The diagram below gives a simplified version of the mechanics of an interest rate swap. The bank enters into a contract with another party (typically another bank) to receive a fixed stream of interest payments in return for paying a variable or “floating” rate of interest. The floating rate is reset periodically, usually quarterly or semi-annually, with reference to a published rate which tracks short-term bank borrowing costs. The swap is set up to ensure that the fixed rate payments it receives match the payments it has to make on the bond. In this way, the fixed rate the bank pays on the bond is effectively turned into a variable rate from the bank’s perspective.Swap Diagram

Interest Rate Swap

This starts to make the cost of long term borrowing look a lot like the cost of short-term borrowing, but there is another factor: credit risk. If an investor buys a 5 year bond issued by, say, ANZ then it runs the risk that ANZ will collapse some time over the next five years. As compensation for this risk, the investor will demand an extra “premium” on the interest rate. This premium, also known as the “credit spread” or “credit margin” was fairly small before the global financial crisis, but shot up when investors suddenly realised that banks were not so safe after all.

Fortunately for banks (unlike their poor customers), they only had to pay the higher margin on new bonds. Even today, banks would still be paying off bonds issued before the crisis which have very low margins compared to the new bonds they are issuing. The average term of bonds issued by banks is around 3 years and the chart below shows how credit spreads have behaved over the last 12 years* along with a 3 year rolling average which gives a reasonable indication of the overall credit spread Australian banks are paying.

Financials Spreads

Credit Spreads for Financial Institutions (1998-2010)

The first thing to notice is that, although credit spreads have reduced since the peak of the financial crisis, the rolling average effect means that the effective cost of wholesale funds is still going up. Having old, cheap bonds maturing is adding to their cost of funds more than the fall in current spreads is saving them. On this point, at least, it would appear that banks are telling the truth!

But what about all of their borrowing outside Australia? Contrary to Verrender’s argument, Australian banks are not getting huge benefits by borrowing in countries with lower interest rates. Anyone with memories long enough to recall the notorious Swiss franc loans taken out by farmers and other small businesses in Australia in the late 1980s would appreciate that low interest rates do not count for much if the Australian dollar drops, thereby pushing up the amount of money you owe. Banks have no interest in running this sort of currency risk and so, much like their interest rate risk, they use swaps to hedge themselves. A “cross-currency swap” can be understood with a very similar diagram to the one above. Simply replace “Fixed” with, say, “US$ interest” and “Floating” with “A$ interest” and you have the picture for a cross-currency swap. This means that hedging is not a matter of paying some sort of small insurance fee, rather it effectively converts foreign interest rates to Australian interest rates. Even though perhaps half of the term funding raised by Australian banks is sourced offshore, it may as well be raised locally as far as the costs are concerned.

But how much is this increase in spreads costing the banks? As mentioned above, long term wholesale funding provides about half the wholesale funding for Australian banks, which is in turn about half of their total funding. So, a back-of-the-envelope estimate can be made by taking 25% of the 3 year rolling average. While I am at it, I will also project the rolling average forwards, assuming that credit spreads stay where they are today.

Low Funding EstimatesEstimated Impact of Term Spreads on Bank Funding Costs

This suggests that banks will see their funding costs continue to rise for about another year, but the overall impact of elevated costs in wholesale markets is only about a 0.45% increase. Compare this to what has been happening to mortgage rates.

Mortgage Spreads from 1998

Australian Mortgage Spread to the Cash Rate 1998-2010

The increase in mortgage rates over and above the cash rate has been about 1.2%, which is a lot more than 0.45%. So, while it may be true that wholesale funding costs are still increasing, it would appear that banks have already charged home buyers far more than the increase in costs the banks have suffered.

There is another source of costs for the banks that we need to consider: customer deposits. As wholesale funding costs rose during the financial crisis, banks began to compete aggressively for customer deposits as a (somewhat) cheaper alternative to wholesale funds. So, it is only fair to take the cost of customer deposits into account as well.

Customer Deposits

It is certainly true that on some of the customer deposits there is little or no interest paid, but there are also customer deposits which, particularly in recent years, pay very decent rates of interest. These include corporate deposits: imagine if a large mining company were to deposit a lazy $100 million into their account with one of the majors and was offered no interest…how long would it take for that money to move to another bank prepared to pay something very close to wholesale funding rates? Not long.

On this basis, we can reasonably assume that the cost of raising at least a portion of the banks’ customer deposits has risen as much as the increase in wholesale funding costs. To be generous, I will assume that all of their customer deposits have experienced this cost increase (although there are, of course, still plenty of low interest deposit balances out there…have a look at your own savings interest rates). Based on this assumption, I have recalculated the estimates of the increase in bank funding costs (i.e. taking 75% of the rolling average increase in wholesale spreads).

Spread Impact (High)

Estimated Impact of Wholesale and Customer Spreads on Bank Funding Costs

This revised estimate gets to an increased cost for banks of 1.3% which, given that the calculation is definitely too generous on the customer deposits side, is reasonably comparable to the increases passed through to mortgages.

However, the increases passed through to other types of loans (small business, credit cards, corporate loans, etc.) have been even bigger than those passed through to mortgages. So the only conclusion that can be drawn from this beer coaster is that:

  1. The banks are not lying when they say their margins are still increasing, but
  2. They have already gone beyond recouping these increased costs from their customers.

* Data source: Merrill Lynch. This data is the average asset swap spread across the financials sector and includes non-bank financial institutions and thus the spreads for the Australian major banks would, if anything, be slightly lower. I have now also got hold of data on some individual bonds issued by the majors and I will also analyse that to confirm it fits the same pattern.

Sister can I lend you a dime?

Today’s post is written by Zebra (James Glover), an occasional contributor to the Stubborn Mule, who turns his mind this time to microcredit, and the internet lending site Kiva.

Dolly lives in a mobile home and works in the fast food industry. I met her on the internet 5 weeks ago and almost immediately I lent her $500. She said she wanted the money to start her own business. Nothing too strange about that you might think. Single, lonely man meets woman online is a story as old as the internet. Nothing strange except Dolly’s mobile home is actually a tent. And when I say tent I mean a ger (or yurt), and Dolly lives in Ulan Butor in Mongolia not a trailer park in Baton Rouge. Perhaps this sounds like one of those internet scams but I didn’t meet her on either and she is a married woman with four children. In fact three of them go to university. Here is a link to Dolly’s profile so you can look and tell me if I am a sucker for an online scam.

You’ll be relieved to know that Doljinjav (her real name) has since paid back all of that loan. The website is, dedicated to facilitating microloans to poor entrepreneurs in third world countries like Mongolia.

Microcredit works by making small loans to third world entrepreneurs like Dolly who would otherwise be unable to borrow from banks due to lack of credit history, assets and being female. It originated in Bangladesh in 1976 when Prof Muhammad Yunus set up a research project to better enable rural villagers to develop. He identified that it was lack of capital that was majorly inhibiting economic development. This is not surprising – imagine the sclerosis if financing was removed from the western economic system.  In 1983 Grameen Bank (“Grameen” mean “villages” in Bangla) was set up to facilitate microloans. In 2006 Yunus and Grameen Bank were awarded the Nobel Prize for Peace. (Incidentally, Grameen Bank is the only business corporation to win a Nobel Prize).

Since then microcredit has been enormously successful. Part of the reason is that the default rate (1-2%) is negligible by standards based on historical criteria. This is attributed to the borrowers initially being collectives of women who borrow the money to set up small businesses. If one is unable to meet her obligations the others step in to support her. In practice these days, microloans are made to men as well as women, individuals as well as collectives and even in the US.

Microcredit turns around the banking paradigm that poor+woman = bad credit risk, which of course, on paper, they are. In fact it has been so successful that mainstream banks are getting in on the act themselves. Organisations like Kiva have also been set up to facilitate loans from charitable minded westerners who perhaps want an alternative to passive giving.

Kiva works by listing applications for funds by people like Dolly, which registered lenders can match in part or in whole. Typically the loans range from a  few hundred to a thousand dollars. The lenders themselves have committed funds to the Kiva organisation for dispersal. Kiva don’t lend the money directly themselves but work with local partners who arrange the loans and collect the repayments. In practice the loans have already been made and the lenders are “backfilling” them. This has been a source of controversy (see below) but ultimately makes the whole process more efficient and from the borrowers point of more predictable.

It all sounds like a virtuous circle. Lenders get a more active giving experience,  borrowers get access to credit they wouldn’t be able to normally access and as the loans are repaid lenders are able to relend it to others. While the lenders themselves aren’t paid interest the borrowers are charged interest. Theoretically the interest goes to pay any administration costs and any funds left over go to grow the balance sheet of the partner organisation.

But all is not well in Kiva land. Next to each applicant are posted statistics of the partner organisations and these reveal an uncomfortable truth. Typically the interest charged is 20-40% which is very high by western standards. Kiva also publishes the median interest rate of non-partner lenders in the region (ie. “money lenders”) but these are often twice as high. There has been an ongoing discussion online from dissatisfied lenders who would happily lend the money at a zero interest rate. After all they don’t get the interest themselves and besides they aren’t in it for the money. Kiva acknowledges these concerns but says the profits to the partner organsisation, after costs, are modest (typical ROA is 2-6%) and most of these are not-for-profit so goes to grow the balance sheet and increase lending. Here is a blogpost on the controversy and how Kiva responded.

The good news here is that the costs and profits are transparent and info is posted on the website. Kiva addresses its lenders concerns honestly and at the end of the day it is up to us to decide if we are happy with the process. Personally the question I ask myself is if the borrower is happier than the alternative – no credit or much higher interest. It makes you think about their situation. To consider the saying: “Walk a mile in my shoes” and then decide if you want to deny them this loan. This, in my opinion, is really  the main benefit of giving, not the feel good factor. It is a privilege to be given this insight. To quote E.M. Forster, who himself lived for a long time in India, all we can hope for is “to only connect”.

I hope your interest in microcredit has been pricked. If you are already on Kiva or decide to sign up then we (the Mule and me that is) have set up a Kiva lending team called “Stable Hand” you can join. Lending teams don’t decide on how your funds are distributed but are a way to make contact with others with a similar interest. Please consider joining.

Standard variable rate mortgages

The last post looked at the increasing margins on Australian mortgages and small business loans. On the way is another post that tries to estimate how much the banks’ own margins have been increasing. Interesting though that may be, the real problem with Australian mortgages has nothing to do with whether bank margins are or are not going up. The problem is the product itself. This post explains why.

There was an article in the the Sydney Morning Herald today which explored exactly this issue, pointing out that Australia’s “standard variable rate” mortgage, which is the most common type of mortgage in Australia, is quite an unusual type of mortgage by international standards.

Banks tend to talk about “standard variable rate” mortgages, but a better term used in the industry is “discretionary variable rate”. The problem with Australian mortgages is encapsulated in that word “discretionary”. I can clearly remember almost 15 years ago trying to explain to European and US investors who were considering buying Australian mortgage-backed securities how a discretionary variable rate mortgage worked. The conversations went something like this:

INVESTOR: So, the bank can change the interest rate whenever they like to whatever they like?

ME: Yes.

INVESTOR: Why would anyone ever accept a mortgage under those terms?

ME: Well, it’s the standard product, so people are used to it and in practice the banks tend to just change the interest rates in line with the Reserve Bank cash rate.

INVESTOR: But they don’t have to do that?

ME: No.

Why were these investors so surprised by these sorts of mortgages? It’s certainly true that in many other countries, such as the US and France, the most common type of mortgages have fixed rates, but variable rate mortgages are found all over the world too. The difference is that most of these variable rate mortgages are pegged to some kind of indicator rate that the lender cannot control. Sometimes referred to as “tracker rates”, these mortgages would specify a fixed margin (say 2%) over a benchmark rate. This benchmark may be a central bank cash rate or some other kind of short-term market rate, but the important point is from then on that margin can never change. In contrast, with Australian mortgages, variable rates move up and down with market interest rates, but banks can also tweak the margin over market rates whenever they see fit.

Last year Westpac was pilloried when it tried to use the analogy of a banana smoothie to explain why mortgage rates were rising. It may not have worked for Westpac, but the analogy can help to highlight how strange discretionary variable rate mortgages are. Imagine that the cost of bananas goes up due to a cyclone-induced banana shortage. It may well be that the price of banana smoothies goes up (although it may also be that café owners take a portfolio view of their business, value their customers and absorb a bit of margin compression on their smoothies, but that’s another story). What certainly does not happen is that café owners go around to everyone who has bought a smoothie in the last year, explain to them that bananas are now more expensive and demand that their customer pays a bit more now for last year’s smoothie.

That is essentially what happens with discretionary rate mortgages. You might have taken out a mortgage a few months ago after doing extensive research comparing interest rates and deciding that the best value mortgage you could find was from the Commonwealth Bank as it was 0.1% cheaper than the next best offer (this may or may not have actually been the case). So far Commonwealth Bank is the only bank to have hiked their mortgage rate by 0.2% more than the Reserve Bank and now your “cheap” mortgage is 0.1% more expensive than the bank you turned down. So much for shopping around! Banks may argue that you are free to change to another bank if you are unhappy (although you can expect exit fees, particularly if you received any kind of rate or fee reduction when you first took on the loan). This does not change the fact that it is a rather unusual product that allows the seller to increase their margins after they have done the deal.

This hypothetical example highlights one of the real problems with the discretionary variable rate mortgage. It is inherently anti-competitive. There is little point shopping around for the cheapest mortgage when after next week it may not be the cheapest any more and you are locked in for 25 years. Is it any wonder that most people shrug their shoulders, say that the banks are all as bad as each other, hold their noses and just pick one almost at random?

There is another problem with discretionary variable rate mortgages, as one Mule reader pointed out in an email. It has the surprising effect of creating some credit risk for the borrower. Normally, depositors are exposed to the risk that the bank will fail, while banks are exposed to the risk that the borrower will fail. But, if you take out a discretionary variable rate mortgages, you may end up paying more if the credit quality of the lender deteriorates. The Herald article gave this hypothetical scenario:

Suppose one of our banks got downgraded from a AA to B. What would happen at the moment is they would just increase the margin on their mortgage rates to cover the extra costs they would face, whereas that risk should fall on the management and the shareholders.

But this sort of thing actually has happened! Many of the non-bank lenders like RAMS got into trouble during the global financial crisis and found funding through securitisation difficult, if not downright impossible. Some collapsed or turned to banks for support, but all of them suffered fast rising costs. Many borrowers who took out mortgages with these lenders saw their interest rates go up as a result. Some were able to refinance their mortgages with another lender, but those struggling the most to pay the higher interest rates would also be the ones least able to get refinancing approved.

In my view, abolishing discretionary variable rate mortgages, though unlikely to happen, would be a good thing for the Australian market. There’s certainly no guarantee that margins would drop. But it would change the stakes for banks considering raising rates to preserve their margins. Rather than being able simply to recoup that margin from their existing mortgage book, they would have to seriously consider the impact the move would have on new business, because it would only be new loans that would be paying the higher margins.

Banks, banks, banks

There has been a frenzy of bank bashing in Australia over the last few weeks. The attacks intensified on Tuesday when the Commonwealth Bank decided to raise their standard mortgage rate by 0.45%. As the national broadcaster did not want us to miss, this was almost double the Reserve Bank’s interest rate increase of 0.25%. Politicians have been particularly keen to get into the action, with some peculiar results. One minute shadow treasurer Joe Hockey was pilloried for advocating tighter regulation of banks when supposedly representing the party of free markets, while days later the Commonwealth Bank’s move made him look penetratingly prescient.

Home ownership is a topic close to the hearts of many Australians and it should come as no surprise that, as mortgage rates rise and some borrowers start to experience real financial distress, the actions of banks should come under the spotlight. Unfortunately, very few commentators seem to have a good understanding of how banks operate which means that while there are some good questions being asked (such as why are banks so quick to put the squeeze on the customers who can least afford it while they are turning record profits and paying themselves such generous bonuses), there are also plenty of red herrings cropping up (like the idea that banks are getting a free kick from their offshore borrowing since interest rates are lower overseas).

For a few weeks now I have been contemplating a blog post that attempts to make the mechanics of banking a little clearer. There is too much to fit comfortably in one post, so here are some of the subjects I’ll aim to cover over the next week or so (in no particular order):

  • Are bank funding costs really still going up?
  • If bank lending creates deposits, why do they need to borrow in offshore markets at all?
  • How does offshore funding work and how much does it cost for the banks?
  • Is there a problem with competition in banking in Australia and (if so) what can be done about it?

While I will not get to any of these questions in this post (other than touching on the first), I will give some historical perspective on mortgage rates and other lending rates.

The chart below shows the history of some key interest rates over the last 20 years. The lowest of these is the Reserve Bank cash rate, and coming in at the top is the average rate banks charged small businesses for unsecured loans. Interest rates for small business loans secured by property are somewhat lower. The mortgage rates are based on a simple average of the rates offered by the four major banks on loans for owner-occupiers.

Interest Rates

Australian Interest Rates 1990-2010

Since everyone’s eyes have been on changes in mortgage rates compared to the Reserve Bank’s overnight cash rate, here is a chart showing the difference between these two rates. It is not clear yet which (if any) of the other banks will follow the Commonwealth Bank’s lead in raising mortgage rates by 0.2% over the Reserve Bank move, but for the purposes of this chart I have assumed half the banks lift their rates 0.25% and half 0.45%, thereby pushing the average spread up 0.1% to 3%.

Mortgage SpreadAustralian Mortgage Spread to the Cash Rate 1990-2010

This chart provides an interesting historical perspective. As interest rates began to fall in the early 1990s, banks were slow to push through the reductions to borrowers, thereby building up healthy margins. This helped them recover from a rather painful period for Australian banks. Westpac in particular had come close to collapsing in 1992. Then in the mid-90s, aided by securitisation non-bank lenders like Aussie Home Loans and RAMS introduced new competition to the market, pushing the margins down. Margins were then stable for a number of years. During this period, then treasurer Peter Costello established the political sabre-rattling to keep banks in line, which cemented the idea that mortgage rates should move in lock-step with Reserve Bank cash rate moves. Prior to this, the relationship had not been so stable.

Now, in the wake of the global financial crisis, driven by a combination of increased bank funding costs and the fading of non-bank competitors, the spread to the cash rate has been on the rise once more, although it is yet to reach the levels of the early 1990s. However, as the chart below indicates, small businesses have seen their margins rise even more rapidly. A few commentators have noticed this fact, but most of the indignation of pundits and politicians has been focused on mortgages.

Australian Interest Rate Spread to the Cash Rate 1990-2010

Despite the fact that the link to the cash rate is so well established, the cash rate is not the primary driver of banks’ funding costs. Changes in the rates on bank bills with maturities in the range of 30 to 90 days give a better indication of day to day changes in bank funding costs. On top of that, funding they source from domestic and international bond markets adds a margin on top of these bill rates. Although there is a high correlation between changes in the Reserve Bank cash rate and bank bill rates, the relationship is not perfect. This means that the spread between lending rates and the 90 day bank bill rate (labelled BB90 in the chart below) provides a better indication of changes in bank margins, although it does not capture increases in bond market margins in the wake of  the global financial crisis.

Spreads to bill rates

Australian Interest Rate Spread to 90-day Bank Bills 1990-2010

One thing that this chart highlights is that the strong link to the cash rate in fact introduces quite a bit of volatility in bank margins. Over time this volatility averages out and banks can also use derivatives (primarily “overnight indexing swaps”) to smooth this volatility.

Without taking into account the margins banks face in the bond market, these charts are not enough by themselves to determine whether banks are reasonably passing on rising margins or are simply lining their pockets. That is a question I will return to in a later post.

Data Source: Reserve Bank of Australia.

Thanks to @Magpie for the link to this piece by Christopher Joye which has a detailed discussion of the issue of interest rates for businesses, a topic which generated a lot of discussion in the comments here on this post.

The dangers of prediction

The recent post about Australia’s coal supplies took issue with the convention of quoting coal and other commodity reserves in terms of years remaining at current production levels. The problem is that it is too easy to assume that these figures give a good indication of how long the reserves will actually last, when in fact the chances are they will do nothing of the sort.

In the case of coal, production in Australia has been growing exponentially for some time, while estimated reserves have not changed very much. If this trend continues, the standard “years remaining” figure will overestimate the life of Australian coal reserves. Estimates of other mineral resources, however, have been growing more rapidly than consumption, which means that they may last longer than the standard figures suggest.

Geoscience Australia regularly reports on Australia’s mineral resources. In the 2009 report, there is a table showing economic demonstrated resources (EDR) expressed in the standard “years remaining” format at various points back to 1997. This data highlights the shortcomings of this convention.  The chart below illustrates how the figures for a few of the minerals have evolved over time. In each case the dashed line shows the trajectory the “years remaining” should take from 1997 if each passing year simply reduced the remaining years by one and so falling by 11 years to 2008. This is the path that would be expected if “years remaining” was in fact a reasonable forecast of how long the mineral reserves might last.

EDR Life

Over the space of a mere 10 years, we have gone from having 190 years’ worth of black coal left to only 90 years. This is simply due to the fact that production grew steadily over that time, while reserves did not change very much. In this way the chart gives an alternative perspective on the argument of the earlier post, namely that the 90 year estimate for the life of Australia’s black coal looks optimistic unless production drops or new reserves are discovered at a comparable rate to production growth. Both of these are, of course, possible but the trend does not look encouraging.

The picture is very different for a mineral like nickel, which has managed to extend its remaining life from 55 years to 130 years over the same period. In this case, reserves grew faster than production.

In every case, the minerals quite clearly fail to track a simple year by year remaining life trajectory. Once again the lesson is that it can be misleading to quote mineral reserves in terms of remaining years at current production, without any qualification as to how production or reserve estimates may change over time.