Bank plan sets scene for next subprime crisisChristopher Joye
05 Sep 2014
One of the dumbest policy solutions to emerge from the ashes of the global financial crisis is non-recourse “bail-in” bonds, which David Murray’s financial system inquiry is thinking about recommending.
This proposal, which has for self-interested reasons been embraced by banks everywhere, requires a bare-bones explanation to understand the strife it could cause down the track.
Imagine if all residential borrowers convinced the government to adopt the following brilliant way to avoid future housing crises. If it looks like you will not meet your monthly mortgage repayments – so you might default – the government has the ability to step in and make your debts disappear. (This is precisely what the banks are advocating.)
More specifically, the government has the unilateral right to swap your lender’s once safe loan into highly risky and perpetual equity in your home. All your repayment obligations conveniently vanish. It is, therefore, impossible for you to default and lenders can never take possession of your property and effect a distressed sale at a fire-sale price.
Genius, right? If you fail to save enough, spend too much money or just take on excessive debt, the government can bail you out. Borrowers never default and asset prices always go up.
The plan is not marketed this way, of course. Working together, home owners and governments tell lenders that their loans are now “loss-absorbing” capital that – wait for it – actually avoid public bailouts. You see, taxpayer money is not being burned. Only lenders wear the pain. But who is deciding whether these borrowers are good or bad credits? Who unilaterally converts their debts into equity in a manner that no other industry can avail itself of? Who is subsidising shareholders? Certainly not the private sector or free markets.
Lenders might reasonably wonder why hundreds of years of commercial and legal history that dictates that debt ranks ahead of equity, and gives debt the power to require owners (equity) to meet their obligations, is being thrown out the window. In the rest of the commercial world, when you fail to repay your debts lenders have rights and recourse under our insolvency laws to the assets you offer as security – like a home, a company and/or your personal wealth.
But in its desire to never let a borrower fail, the government is giving itself the option of writing off their debts as if they never existed. Under this scheme, the worst-case scenario for the lender is that the debts are zeroed completely. The best case is they’re stuck with much riskier and more illiquid equity in the asset the borrower used as security at the worst imaginable time.
By letting borrowers continue to take on significant debts, but simultaneously offering to bail them out by eliminating these liabilities when they get into trouble, governments implicitly present them with incentives to make even riskier bets, which is called “moral hazard”.
The alternative is to let bad banks fail when they make mistakes, as happens with companies in all other industries. It seems, however, that governments want to do everything possible to make banks impervious to the disciplines of free-market capitalism.
The financial system inquiry is rumoured to be thinking about going a step further by allowing the government to bail in even the safest, “senior-ranking” bonds into equity if a bank needs support.
Yet if we are trying to de-risk banks, and reduce the chance they default on their debts, why not simply do what every borrower has done for the past 500 years? What’s wrong with just forcing banks to hold more equity and less leverage, thereby reducing their dependency on debt in the first place?
After all, this is what banks have asked individual and corporate borrowers to do since the GFC. These days most banks require home buyers to have minimum equity of 5 per cent to 10 per cent in contrast to the zero-down deposits available before 2008. We’re still buying properties – just the mix of debt and equity has changed.
The government already guarantees bank deposits and is prepared to step in and provide $300 billion of “emergency” loans to banks at an insanely low annual interest rate of 2.9 per cent via the Reserve Bank of Australia’s new Committed Liquidity Facility. This bailout program was expressly designed to ensure banks don’t trade insolvent in a liquidity crunch that would kill most normal businesses.
Given the banks’ explicit government backing, equity investors should be prepared to accept total returns that provide a still decent, say 4.5 per cent to 5.5 per cent, risk premium above long-term government bond yields (or 8 per cent to 9 per cent in total today). Instead, Commonwealth Bank’s return on equity is north of 18 per cent.
Contrary to popular rhetoric, cutting bank leverage would actually help them raise debt and equity capital more cheaply, and would certainly make it easier to access funding during crises.
What the community does not need is Treasurer Joe Hockey letting the banks off the deleveraging hook by establishing non-recourse loans that ironically embed higher moral hazards than the “jingle-mail” products that caused so much havoc in the United States. (The mail jingled with the keys to the equity that borrowers were giving lenders as a substitute for repaying them.)
Governments should man up and force banks to take their own medicine. During the GFC banks furiously resisted government interference with the loans they had given to borrowers. Since then they have required corporate and residential borrowers to protect them by stumping up with more equity and less leverage. That sounds like a sensible idea.
Read more:
http://www.afr.com/f/free/blogs/christopher_joye/sowing_seeds_of_new_sub_prime_crisis_3fQbeBtAcOdain8H2FoBuK