Category Archives: australia

Are Australia’s banks about to collapse?

UPDATE: In this post I repeated Business Insider’s mistake of attributing the presentation I criticise to Steve Keen. While Steve considers it an excellent presentation, he did not write it and I apologise for not confirming the source before publishing this post. I have now struck out the incorrect attributions. My criticisms of the presentation itself still hold, which is why I am leaving the post up in its edited form.

Steve Keen and his forecasts of a property market collapse have received plenty of local media coverage over the years. Now he has come to the attention of the international press as well.

In April, Keen hiked to the top of Mount Kosciuszko after losing a bet about the direction of property prices with Macquarie Bank strategist Rory Robertson. This event was enough to prompt an extensive review of Keen’s concerns in the New York Times. Curiously, Robertson himself did not receive a mention, despite winning the bet.

Now the US business site Business Insider, which has a penchant for drama, has published one of Keen’s presentations a presentation, incorrectly attributed to Keen, under the headline “Here’s What You Need To Know About The Major Property, Debt, And Banking Crisis Brewing In Australia”.

One of Keen’s central concerns is the size of private sector debt in Australia. This is a legitimate concern and should receive more focus than misguided fears about Australian government debt. However, I am far less pessimistic than Keen about the outlook for Australian property prices.

As for the Business Insider presentation, Keen takes his concerns it goes too far, to the point of unsupportable alarmism. The final slide of the presentation is evidence enough of this, not to mention being in extremely poor taste. This slide appears to have been added by Business Insider! If that is not enough to convince you, I will consider just one of the arguments offered by the anonymous author Keen.

On slide 22 of the presentation, he writes:¹

Look at CBA 2009 annual report—Leverage ratio is almost 20 times (total assets of $620.4 billion against $31.4 billion of equity). Of $620.4 billion of assets, $473.7 billion are loan assets. If around 6.6% of CBA’s loans go bad (any loans not just mortgages), 100% of its shareholder equity will be wiped out!!

(the bold italics are not mine, they appear in the presentation). Here the implication is something like “6.6% is not very much. Wow! CBA could easily collapse!”. But, that line of thinking does not stand up to even moderate reflection.

Crucially, we must understand what “going bad” means for a loan. It does not mean losing everything, which is in fact very rare for most types of bank loans.

Over half of CBA’s are home loans and these are secured by the property that has been mortgaged. According to their half-year presentation², based on current market valuations, the average loan-to-value ratio (LVR) for CBA’s portfolio is 42%. This means that, on average, the value of the property is more than twice the loan amount. This gives the bank an enormous buffer against falls in property prices. Of course, this average conceals a mix of high and very-low LVR loans. Even assuming that loan defaults occurred on a higher LVR section of the portfolio, say with an average LVR of 70%, and allowing for Keen’s oft-quoted figure of a 40% decline in house prices, CBA would still only lose 14% on their defaulting loans³. Even then, this does not take into account the fact that, like other lenders, CBA takes out mortgage insurance on loans with an LVR of more than 80%.

But we can be more conservative still. In their prudential standards, the banking regulator APRA considers a severely stressed loss rate on defaulting home loans to be 20%. To suffer actual losses of 6.6% in their mortgage portfolio, CBA would have to suffer a default rate of at least 33%! This would be astonishingly unprecedented. Currently, the number of CBA borrowers late on their mortgage payments by 90 days or more is running at around 1%. Most of these borrowers will end up getting their finances back in order, so for actual defaults to reach 33% is inconceivable. A default rate of a “mere” 2% would be extraordinary enough for CBA.

As for the rest of the $473.7 billion, it includes personal loans, credit card loans, business loans and corporate loans. The loss rates on some of these loans can be higher than for mortgage portfolios, but losing everything on every defaulting loan is still highly unlikely. So to suffer 6.6% in actual losses on these loans, defaults would have to run at a far higher rate. Furthermore, since the dire prognosis for the banks is rooted in the view that the property “bubble” is about to burst, presumably the argument would not simply be based on everything other than the home loan portfolio collapsing.

If property prices do fall sharply and our economy has another downturn, will bank earnings be affected? Of course. Are they teetering on the brink of collapse? Of course not.

¹ While there is a footnote on the slide referencing this post, what is not made clear is that the whole paragraph is a direct quote rather than Keen’s own words. Presumably he agrees with it though!

² Page 84.

³ If property prices fall to 60% of the original value, the loss on a 70% LVR loan would be (70% – 60%)/70% = 14.3%.

Resource Super Profit Tax Everything Correctly Explained (R.S.P.T.E.C.E.)

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This guest post from Mule Stable regular Zebra (James Glover) delves into the details of the proposed Resources Super Profits Tax.

The Australian Government (hereby known as the Govt) has proposed a Resources Super Profits Tax (RSPT) for mining companies. Superficially it appears to be a 40% tax on all profits (measured by Return On Investment or ROI) in excess of the Govt Bond Rate (or GBR, the interest rate at which the Govt borrows money, over the long-term).

The key points of this article are:

1. The GBR is the correct threshold level for RSPT,

2. If the Govt increases the threshold above GBR this will represent a subsidy of miners by taxpayers,

3. The RSPT will benefit small and marginal mining projects to get finance through partial Govt backing of risks.

So for example suppose miner Mineral Wealth of Australia (MWA) invests $1bn in the Mt Koalaroo Iron-Ore mine. MWA is a wholly owned subsidiary of Silver Back Mining (SBM). In the year following they make $200m profit or a return on investment (ROI) of 20%. If the GBR = 5.5% then the 40% RSPT means a tax revenue to the Govt of Tax = 40% x (20%-5.5%) x $1000m = $58m.

This seems very straight forward. It appears that the Govt is saying that GBR represents some “fair” level of return and anything in excess of this is a “super profit” to be taxed accordingly. Not at the normal company tax rate of 30% but a “super tax” rate of 40%. This is how it has been presented by both sides in the media. Arguments against the RSPT have focused on whether the GBR as a “risk-free” rate is the appropriate benchmark for a risky profit stream. Indeed it is not but in fact this isn’t what the RSPT is about. For example normally taxes on profits have no negative impact on the Govt if the company loses money. In the case of the RSPT though the Govt has stated that 40% of any losses can either be claimed back from the Govt (as a refund) or carried over to other projects.

So what is the RSPT? A good way to consider it is if the Govt took a 40% stake in MWA as a “silent partner”, leaving SBM with a 60% stake. In this case we would expect the Govt to contribute $400m of the investment costs (raised presumably through issuing bonds at the GBR or equivalent). In return it would get 40% of the profit. The Govt return would therefore be 40% of the profit less the cost of funding its 40% investment ie Tax = ROI x 40% x I – GBR x 40% x I = 40% x (ROI – GBR) x I.

This appears to be the formula that the Govt has presented to calculate the RSPT and in this derivation it is quite straightforward. However the Govt appears to be getting something for nothing since it isn’t actually stumping up the $400m in investment capital. So what’s going on? A clever piece of financial engineering that’s what. The Govt avoids raising the capital itself (and hence have it be counted as Govt debt) by getting the project to raise it on the Govt’s behalf.

(You can easily skip the next paragraph if you aren’t interested in the details of mine financing costs)

Whilst MWA raises 100% of the $1bn in capital the Govt appears to get the upside (and potential downside) as if it has contributed $400m without doing so. Money for old rope you say. However consider MWA not to be the stand-alone mining company SBM, but the joint venture beween the Govt and SBM. Suppose MWA borrows $1bn in capital at its Project Funding Cost (or PFC). This PFC will be lower than the SBM’s Miner’s Funding Cost (or MFC) as the Govt is now backing 40% of all liabilities. In fact in an efficient market we deduce PFC = 60% x MFC + 40% x GBR. If MWA then allocated these funding costs accordingly it would charge the Govt its share, risk-weighted, not PFC, but GBR. If the GBR = 5% and MFC = 8% then we expect PFC = 6.8% not the 8% if SBM was the sole investor. Under this arrangment SBM’s cost of funding (in % terms) its effective 60% share of the joint project is the same as its stand alone cost of funds, as it should be.

An argument against raising the threshold above GBR is that this will effectively lower the miners’ cost of funds, the difference being borne by the Govt and hence us taxpayers. No wonder miners are arguing so vehemently for the threshold to be raised. In fact it can be shown that raising the threshold to 11%, as some propose, and using a GBR of 5.5% would effectively reduce the miners’ cost of funds by a whopping 3.67%! If you want a formula for the Miners’ Taxpayer Subsidy(MTS) it is: MTS = 2/3 x (Threshold – GBR) in terms of the miners’ funding cost discount (paid for by the taxpayers remember); or MTS = 40% x I x (Threshold – GBR) in $ terms. For the Koalaroo mine this would represent $22m of funding cost transferred from the mining company SBM to the taxpayer. That’s you and me. You don’t see that in their ads.

From the Govts perspective the advantage to them is that the investment does not sit on their balance sheet but the project company MWA’s and in effect SBM’s balance sheet. From a financial engineering point of view all this makes perfect sense. Having said that, it was precisely this sort of clever off-balance sheet flim-flammary that got Greece (and Lehman’s et al) in trouble. We need to make absolutely sure it is properly accounted for.

Update: Several commenters have pointed out the effect on mine financing of the RSPT. Specifically with the Govt backing 40% of any losses smaller stand-alone projects will find it easier to get project finance. As discussed above the funding cost will be lower with the Govt’s partial backing. The operating profit (so called EBITDA) of the project is unchanged so this makes them more, not less, viable. This is at odds with what the miners have been saying. Even existing projects with refinancing clauses in their loans should find it easy to convince their lenders to reduce their interest payments. For large global miners such as BHP-Billiton, who issue bonds, it will be harder to disentangle the Australian RSPT benefit to their overall cost of funds and hence spreads. But the market should over time price this in with lower spreads on their bonds. With a reduced cost of funds miners will be able to leverage their existing equity across more projects and make up for the 40% the Govt now takes out of individual profits (and losses) through the RSPT.

Update: Tom Albanese, CEO of Rio Tinto was on Inside Business on ABC on Sunday May 30. It is interesting that in arguing against the RSPT he referred to the unfairness of the Govt coming in as a 40% “silent partner”, and not about the GBR threshold. He clearly understands the true nature of the RSPT. While it was self-serving he emphasised (in my terminology) the determination of Investment or “I” for existing projects. Depreciation comes into it but some of these projects are decades old and it would an accountant’s dream/nightmare to work out the correct value of I to base the Govt’s GBR deduction on. He also questioned the “principle” (his word) of the Govt forcibly coming in as a “silent partner” on projects which are clearly profitable going forward, having survived to this point. After all they are not compensating mining companies for mining projects that failed in the past. I’m afraid I have to agree with this point, though I think it is more complex than I currently comprehend. It is good to see the RSPT being debated for once without the disinformation we have seen from less eloquent opponents. After all the Govt did say at the beginning that it was these sort of aspects of the RSPT they were prepared to negotiate on, not the 40% and not the GBR threshold.

UPDATE: Zebra looks at a fair value approach to the RSPT.

Where is debt headed now?

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There have been a lot of posts about debt on this blog and the chart comparing government and household debt, which appeared in two of those debt posts, has proved particularly popular in discussion forums focusing on Australian property prices. Since producing the chart, the Australian government stimulus spending has continued to work its way through the economy and has been pushing up the levels of government debt. While I would still argue, as I have done many times before, that we should not follow the likes of Barnaby Joyce in getting agitated about public debt, it does seem worth updating the chart to illustrate recent developments. The regions shaded red denote Labor party governments in power.

Australian Government and Household Debt (1976-2010)

As expected, government debt levels exhibit a marked up-swing (note that the government data includes Treasury projections to the end of the current financial year). What is striking, however, is that the levels of household debt have not yet fallen. While some of the weakness in the economies of countries like the US and the UK is attributed to consumers “deleveraging” (a fancy term for paying down debt rather than buying flat-screen televisions), Australian households are showing no signs yet of reducing their debt. And 90% of that debt is for housing.

While it may not be evident here, there is in fact a tight relationship between debt levels in different sectors of the economy. If I spend money then either I reduce my financial assets (drawing on my savings) or I increase my liabilities (borrow on my credit card or some other form of debt). Exactly the reverse is true of whomever I give my money to (let’s call them Joe for argument’s sake): Joe’s assets go up or his liabilities go down. Spending money is an example of a “zero sum game”. If I add the change to my net worth (assets minus liabilities) to the change of Joe’s net worth it adds to zero. My negative change offsets Joe’s positive change. Aggregating over the whole economy, the sum is still zero.

Now consider what happens if we divide the economy’s net financial worth into that of the government sector, the private sector and the foreign sector (which includes overseas governments). Any changes in net worth across all three have to add to zero. As a result, the change in the government position is the opposite of the change in the private sector and international positions combined. If the government debt is going up, debt must be going down somewhere else. Now we know the household sector is not reducing debt, but what if we look at the private sector overall, including businesses? A different picture emerges.

Australian Government and Private Sector Debt (1976-2010)

Taken as a whole, over the 12 months to the end of 2009, private sector debt fell by about 2.5% of GDP. This was almost as much as government sector debt rose (about 3% of GDP). The difference can be explained both by the role of the foreign sector as well as slight differences in data collection methods across different sectors. Keep in mind that chart includes the government debt projections out to June 2010, while the private sector debt data only extends to the end of January 2010.

Since household debt has continued to increase, what this means is that Australian businesses have in fact been reducing debt significantly. The reduction in non-household private sector debt over 2009 was almost 7% of GDP. Businesses appear far more concerned about their debt levels than home-buyers do. It will be very interesting to see what happens once the first time home buyers scheme is fully unwound.

Data sources:

Government debt to 2008: A history of public debt in Australia
Government debt for 2009: Reserve Bank of Australia – Series E10
Government debt for 2010: Australian Treasury – Budget Estimate

Private sector debt: Reserve Bank of Australia – Series D2

Gross Domestic Product: Australian Bureau of Statistics – Series 5206.0

Who are the big carbon emitters?

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Earlier this week, @pureandapplied brought to my attention the emissions data that has been published by the Department of Climate Change in Australia. Their report comprises data for the 2008-09 reporting year provided to the Greenhouse and Energy Data Officer by corporations whose greenhouse gas emissions exceeded 125 kilotonnes*. A few corporations are missing from the list for a number of reasons, including failure to provide their data in time for the report’s publication (a sorry excuse indeed). Nevertheless, the data makes for some interesting reading. As @pureandapplied remarked, for example, Qantas was responsible for more emissions than Shell: those air points are producing a lot of CO2-equivalent emissions!

The data is reported in two categories, “Scope 1” and “Scope 2” emissions. The definitions of the two scopes are as follows:

Scope 1 emissions are the release of greenhouse gases into the atmosphere because of activities at a facility that is controlled by the corporation. An example of this would be gases emitted by burning coal to generate electricity at an electricity production facility (i.e. a power station).

Scope 2 emissions in relation to a facility, are the release of greenhouse gases emitted at a second facility because of the electricity, heating, cooling or steam that is consumed at the facility. An example of this would be greenhouse gases emitted to generate electricity, which is then transmitted to a car factory and used there to power the car factory’s lighting. The greenhouse gas emissions are part of the factory’s scope 2 emissions. It is important to recognise that scope 2 emissions from one facility are part of the scope 1 emissions from another facility.

The report is very careful to note that these two scopes should be used warily. In fact, it warns that the two figures “should not be used individually, or added together” to estimate liabilities under any emissions abatement scheme. That is a red rag to a Mule, so I will indeed look at them individually and added together. The chart below shows the top 25 emitters in the Scope 1 category.

Top 25 Scope 1 Emitters

It should come as no surprise that the big Scope 1 emitters are primarily power generators, although there are a number of mining companies in there, along with Qantas thanks to its burning of jet fuel. Scope 2 tells a somewhat different story.

Top 25 Scope 2 Emitters

Here “poles and wires” make an appearance: Transgrid and the like, move energy from place to place that has been generated elsewhere. So, the Scope 1 emissions are counted by the generator, but the tranmission company wears the Scope 2 emissions. Woolworths manages an impressive fifth place, perhaps thanks to the lights in all of their supermarkets? Wesfarmers, the owners of the Coles supermarket chain, rank higher still.

Finally, here are the top 25 emitters by the combined total of Scope 1 and Scope 2 emissions. Not surprisingly, the generators dominate once more.

Top 25 Scope 1+2 Emitters

Also included in the data is the total amount of energy consumed by each corporation. It is in these numbers that I stumbled upon something of a puzzle. Envestra produced a reasonably sizeable 627,161 tonnes of Scope 2 CO2-equivalent, but had one of the lowest levels of total energy consumption at only 193 GJ. What have they been up to? Guesses are welcome!

* Also included are those corporations holding a reporting transfer certificate.

The Mule on Mortgages

Rethinking the basis for the Australia Day holiday

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In anticipation of tomorrow’s Australia Day holiday here in Australia, this guest post by John Carmody examines whether or not 26 January is really the most appropriate date for Australia Day. John Carmody is a Sydney-based writer on medical and cultural history and (in the interests of full disclosure) is closely related to the Stubborn Mule.

January 26 is a nettlesome date for the official celebration of the Australian nation and as a commemoration of our colonial foundation. Apart from the significant nuisance that it falls so close to the end of the holiday season when our minds and emotions are trying to deal with more pressing obligations, it really asks a serious philosophical and moral question.

For indigenous Australians, conscious of their fraught history since 1788, it is no cause for celebration at all. Understandably, they consider that it was the beginning of an invasion and see no reason to rejoice in it. White Australians and, indeed, all immigrants can only respect that attitude; but we must do that reflectively. The fact is that there are several distinct reasons to discard 26 January as that festive occasion.

The first point is that the date is not when the founding fleet arrived in Terra Australis: that was, rather, at Botany Bay on 19-20 January, 1788. It was only because the officers were so disillusioned by how little resemblance that coast bore to Joseph Banks’s glowing descriptions and because of an indifferent water supply, that Governor Arthur Phillip made a reconnaissance to Port Jackson (which Captain Cook had not entered) that the venture was transferred to Sydney Cove. Even then, in the afternoon of 26 January there was little time for formalities or any grander celebration than hoisting a flag and drinking the health of the King and the success of the colony with a few glasses of Porter, followed by the flourish provided by a round of rifle fire.

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Hot and Dry Days Ahead for Australia

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Earlier this month, the Australian Bureau of Meteorology released the October figure for the Southern Oscillation Index (SOI). It showed a precipitous plunge of almost 20 points down to -14.6. Just how significant a drop this is can be seen in the chart below, which shows the distribution of monthly changes in the SOI going back to 1876 (-14.6 is at the lower 5% quantile, which means that a fall as big as this, or bigger, has only occurred 5% of the time).

Distribution of SOI changes (Jan 1876-Oct 2009)

But what exactly is the SOI and what is the significance of this decline in the index? The index is the standardised anomaly of the monthly average difference in sea-level air pressure between Tahiti and Darwin. “Standardised anomaly” means that the index measures the deviation of this pressure difference from the long-term average and is scaled by the standard deviation of the pressure difference and then multiplied by 10. The significance of the index lies in its relationship to the El Niño weather phenomenon. According to the Bureau of Meteorology:

Sustained negative values of the SOI often indicate El Niño episodes. These negative values are usually accompanied by sustained warming of the central and eastern tropical Pacific Ocean, a decrease in the strength of the Pacific Trade Winds, and a reduction in rainfall over eastern and northern Australia. The most recent strong El Niño was in 1997/98, although its effect on Australia was rather limited. Severe droughts resulted from the weak to moderate El Niño events of 2002/03 and 2006/07.

The chart below gives a historical perspective of the SOI over the last ten years. To get a better sense of the trends in the index, I have overlaid two different types of curve smoothing: a lowess (“locally-weighted scatterplot smoothing”) curve and a spline curve. The two give very similar results and make the 2002/03 and 2006/07 SOI downturns clearly visible. The timing of these downturns suggest that the corresponding droughts follow with something of a lag.

Southern Oscillation Index (Jan 2000-Oct 2009)

Over the last couple of years, the SOI has been solidly in positive territory and, again with a lag, there has followed an improvement in drought conditions. Indeed, New South Wales recently replaced the tight water restrictions which had been in place for a number of years with the less onerous “Water Wise” rules. Unfortunately, this change may turn out to have been premature. If the downward trend in the index seen over the last few months persists, Australia may face a return to severe drought conditions.

For anyone who is interested in how these charts were created, here is the R code. It is also available from the Stubborn Mule files section.

UPDATE: at the request of singingfish, here is a chart showing the full recorded history of the SOI back to 1876. The blue line is a spline smoothed curve.

Southern Oscillation Index (1876-2009)

Melbourne Cup by Numbers

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I don’t know anything about horses. Ever since I was bitten by one at the Easter Show as a small child, they have ranked very low on my animal preference list: only just above geese. Still, at this time of year almost everyone in Australia gets caught up in some way with the Melbourne Cup, the race that stops the nation. As usual, I expect that my involvement will only stretch as far as participating in the $2 sweep at the office, thereby avoiding the need to actually make any kind of ignorance-based horse selection.

But, with a mule as this blog’s mascot, you would think that I could do better than that, so I have thrown my charting skills at the history of previous winners in as slap-dash a manner as I can to see where playing the historical odds would get me.

I thought I would start with colour because, even as a racing-form novice, I suspect that should have no bearing on the result and so it seems like a safe place to start. Based on the winners going back to 1861, here is the distribution of winning colours.

Cup Winners by Colour (1861-2008)

This suggests that bay-coloured horses have an edge (or maybe it is just a common colour for a horse). What about the “sex” of horse (please do not ask me what all of these terms mean, but apparently “horse” is a sex)?

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Petrol Price Update

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Another five months on since my last petrol price update and oil prices have continued to rise, but so has the value of the Australian dollar. So while crude oil prices in US dollars are up around 75% since their lows in February, they are only up 29% in Australian dollar terms.

West Texas Intermediate Oil Prices

The Australian dollar has been rising steadily for the last six months, pushed along by the Reserve Bank of Australia which has started raising their target cash rate. Higher interest rates in Australia make it more attractive for offshore investors to buy Australian securities and they have to buy Australian dollars to do so. Australian investors holding foreign assets may do the same.

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A better view of the asylum-seeker league tables

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The last post looked at how many applications for asylum Australia and other countries have received this year on a per capita basis. The top three countries in the resulting league table are Malta, Cyprus and Norway and their figures are so much higher than other countries that they skew the data, making it hard to differentiate the lower rankings. To remedy this, I have reproduced the chart using a logarithmic scale.

Asylum-seekers per capita 2009

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