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Australian banks must be re-regulated immediately!; Australia has taken a one-way bet on housing, with most of our wealth tied up in residential property
Topic Started: 24 Apr 2012, 11:55 AM (358 Views)
Bobby
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INTRODUCTION

I’d like to say a few words on banks, and one of the central technical issues I think we need to worry about. That is, risk weighting of bank assets. Since 2007 Australian banks have been able to make use of the Basel II the capital requirements. The calculation for the risk-weighting of mortgage assets is entirely at the discretion of the banks (i.e. internal risk models) and is not disclosed (commercial in confidence), and for an outside analyst, I see no way in which to replicate these calculations.

However, we do know that banks are required to hold no more than 2% capital against residential mortgages. These numbers are critical for the continued high return on equity our banks enjoy. Moreover, the amount of capital a bank has to put aside for each mortgage essentially determines the rate at which new loans can be made. So given how important this number is, it’s important to consider what determines risk weighting.

The Basel II framework requires models used for the calculation for risk weighted assets to include several general factors: Probability of default, Loss given default, exposure at default and expected losses – with these numbers based on fact and historical statistical values. The most important factor in this calculation is the probability of default. From the bank’s disclosures we do know that this is based on loan-to-valuation ratio bands and the historical performance of the various bands, over the last 5 years. That is, the risk weighting of assets is determined by what has already happened, not what is likely to occur in the future!

This is where there is a significant weakness in the whole methodology, and one which severely skews our financial system. As home values rise, as long as banks keep lending, the probability of default remains low – non-performing mortgagees can always sell into a rising market. Moreover, high LVR loans accumulate equity and become less ‘risky’ as valuations rise. This leads to a positive feedback loop – banks can lend more as risk-weightings reduce, this leads to higher asset values (it is undoubtedly the expansion of lending that leads to home value rises), larger bank profits, and a general reinforcement.

The problem is, this positive feedback loop will work in reverse too – as home values fall and non-performing loans creep up, risk-weighting increases, restricting banks’ ability to lend into property. Restricted lending leads to lower values, higher arrears rates, and the cycle continues. Now, it appears that APRA has begun to realise the Basel II structure can be gamed, and in the latest iteration of reforms requires more detailed assessments of future risks of loss under varying economic conditions, rather than based on historical statistics. Moreover, management and boards will now be held accountable for this process, meaning “we couldn’t have seen it coming” will not hold.

The question is, will these new regulations end up choking off the credit-fueled property market, and could they cause what regulators fear before banks have the chance to raise their capital and extend the duration of their liabilities? Or is it too late anyway? Regardless, it is clear that the flow of credit into property cannot continue indefinitely and the easy days for the banks are over.

DISCUSSION

These are excellent points in relation to bank capital requirements against residential mortgages and the deficiencies in the whole methodology, which results in risk-weightings reducing in response to higher asset values and the accumulation of equity in a positive feedback loop. Of course this process is also accentuated on the downside in terms of increases in non-performing loans, restricted lending, lower values, higher arrears and so forth. We also correctly note that Basel II structures were 'gamed' by banks due to assessment of risks being dependent upon historical statistics instead of exploration of varying economic conditions.

Stricter banking regulation is required in a range of areas

It would actually appear that much stricter bank regulation is required across a wide number of areas.

Professor Steve Keen's submission to the 2010 Inquiry into competition within the banking sector summarises the risks posed by the Australian financial sector. The major problems of the financial sector are macroeconomic and related to the level of debt, rather than microeconomic and related to the value of debt. These are that:

- Banks have an innate desire to issue more debt than is good for the economy as a whole, and increased competition tends to exaceReserve Bank of Australiate this tendency rather than control it.
- As a consequence of (a), debt has grown inexorably relative to incomes until the financial crisis began. This expansion of debt caused the apparent boom prior to the crisis, while the slowdown in the rate of growth of debt is the predominant cause of the crisis itself
- Banks are lending too much to homeholds and too little to business
- Lending has been oriented towards financing speculation rather than investment and the working capital needs of business

The huge run up in mortgage debt in Australia is not an isolated case. The madness also went global.

Risks with current banking practices

Professor Keen goes on to identify numerous other risk factors with current banking practices:

- As well as the dramatic increase in the level of debt, banks have allowed loan to valuation ratios to blow out from the conservative 70% of the 1960s and early 1970s to the 97% levels on offer today
- This dramatic increase in the size of mortgages relative to incomes (and consequent drop in the initial equity that borrowers have in their properties) has meant an enormous increase in cost
of servicing mortgages, despite lower margins
- Detailed property valuations have been replaced by “drive by” checks that do no more than confirm via a “cursory glance” that a property had a dwelling on it
- Detailed evaluations of the borrower’s capacity to service a loan, and a commitment to keep loan repayments below 30% of gross borrower income, have been replaced by automated
checks that the borrower had sufficient income left after loan repayments to be just above the Henderson poverty line
- The proportion of mortgage debt that has financed construction of new homes has fallen from 60 percent for investors in the late 1980s to barely 5 percent today, while the proportion of owner-occupier loans that financed construction has fallen from 20 percent to about ten percent. By implication, the vast majority of mortgage finance has financed speculation on the values of existing properties, driving up home values without adding to the property stock of the country
- In 1996, prior to the Wallis reforms, the average first home loan could be serviced with 30 percent of the after tax salary of the average wage earner; today, the figure is 80 percent. It is no longer feasible for a single person on the average wage to buy a dwelling today, and even a couple has to devote more of their take home pay to servicing a mortgage than an individual did just 15 years ago

Problems with interest-only property loans

Approximately half of all property investors in Australia are 'specufestors' insofar as they have interest only loans. Meaning, they have no interest in paying off the principal on the loan and have made a bet that home values are only going one way, and that they will handsomely profit from capital gains. The reality is that by allowing the market to become so lopsided, these investors will flee en masse when the market starts to tank, as they cannot afford to realize losses on their property. This adds unnecessary volatility to the Australian property market and encourages boom-bust cycles.

The size of the 'interest only' loan market has recently been estimated in mid 2011 as possibly 10% of all homes in Australia (or 1.5 million properties). Many of these homes sit vacant purely for investors who are anticipating capital gains and who would rather have the home sitting empty than dealing with tenants. This unreasonably puts pressure on renters in the rental market, artificially constraining the availability of rental stock and putting upwards pressures on rents. This is a viable option financially, as the repayments are far less on the interest only loan compared to loans where the principal is being paid back. It is questionable banking practice that would allow such a large percentage of loans to be made with 'interest only' provisions - this is a clear indicator of Ponzi financing which is unsustainable in the long term.

Problems with valuation of property

If you think about how a share is valued, it is based on the present value of expected cashflow adjusted for the risk of the underlying asset. The same methodology is applied to fixed interest securities and listed property trusts.

Residential property could be valued in the same manner, but typically isn’t. What a property valuer will do is look for similar valued properties that have recently sold in the neighbourhood and then make adjustments up or down based on the relative qualities of the property. The subsequent final value is an estimate of what the property may sell for in the near future. This is not a true asset valuation process.

Systemic risks posed by the reckless bank lending in Australia

- Mortgages now account for over 57 percent of the banks’ loan books, an all-time high. They also account for over 37% of total bank assets—again an all-time high, and up substantially from the GFC-induced low of 28.5% before the First Home Vendors Boost reversed the fall in mortgage debt
- Real estate loans are a higher proportion of Australian bank loans than for US banks, and their rise in significance in Australia was far faster and sharper than for the USA. More significantly, real estate loans are a higher proportion of bank assets in Australia than in the USA, and this applied throughout the sub-prime period in the USA
- Since real estate loans are worth roughly 7 times bank Tier 1 capital—up from only 2 times in 1990—it wouldn’t take much of an increase in non-performing property loans to push Australian banks to the level of impairment experienced by American banks in 2007 and 2008
- If the banks face insolvency, the Government and Reserve Bank will bail them out as the US Government and Federal Reserve did—though let’s hope without also bailing out the management, shareholders and bondholders, as in the USA

Inadequacy of current capital ratios

Australia’s major banks have very thin capital buffers on residential mortgages. My strong belief is that this system is set up to fail or be rescued. Australia’s big four banks are allowed to use an Internal Risk Based approach under Basel II to calculate risk weighted assets and minimum capital requirements. APRA follows the Basel II standards and regulates the approach under Prudential Standard 113 (APS 113)... To state simply, the methodology used under APS 113 to calculate minimum capital requirements for residential mortgages encourages a bank to increase risk through the provision of increasing credit and lowering underwriting standards because the formulas will actually calculate low risk capital requirements whilst significantly increasing future systemic risk. The more a bank lends on property the lower the risk calculated and the higher the return on capital. I think this is perverse, many others clearly think otherwise.

The major banks use the formula and APS 113 to their advantage to minimise capital, all with the approval of APRA by using short term performance during rising home values as normal. Surprisingly there is also no definition of “default” which leaves the whole Probability of Default (PD) assessment open to gaming... the banks have less than 2% capital against the total residential mortgage book including mortgage insurance, with little capital adjustment in operating risk calculations to increase that amount of capital overall. The banks with the approval of APRA are incentivised to write more and more residential mortgages in preference to all other loan classes.

The point is that because APRA uses a sliding scale of Capital requirements for secured mortgages then the higher the value of secured property (and therefore the lower the LVR of their existing loans) the less capital banks need to backup those loans. This means that banks can stretch there existing capital further and further to take on new loans. However as values fall the reverse is true, and all of a sudden banks require large injections of new capital.

The negative feedback loops that will occur when property value falls will create huge issues for Australia’s banking system. A scenario where falls in Australian property lead to insufficient capital ratios, ratings downgrades, offshore investor exodus, rising interest rates triggering further falls in property values etc.

The message I take from this is that there is clear and present systemic risk, as 2% capital held against a trillion dollar plus residential loan book that has property valued in the stratosphere is inherently risky behaviour.

Asset-based lending inevitably results in a financial crisis

What is the end result of all this highly leveraged lending to the homehold sector for the purchase of real estate? Professor Steven Keen on the danger of 'asset-based lending'.

But when borrowing becomes based instead on expectations of profiting from rising asset values (“asset-based lending”), then a positive feedback loop is set up that, almost inevitably, leads to a blowout in debt levels and an eventual financial crisis. Rising debt levels themselves drive up asset values, individuals accept a higher debt to income ratio than they otherwise would in the belief that debt can be repaid from the proceeds of asset sales, and an actual boom is generated in the economy as the increase in debt spurs aggregate demand. Once such an apparent “virtuous circle” is in train, it is almost impossible to stop, since virtually everyone in society has an interest in its continuance: the banks, stockbrokers and real estate agents because their profits are higher, the general public because they feel wealthier as asset values rise (and some of them do profit from buying and selling on a rising market), and even the government because the Ponzi boom generated by rising private debt makes it seem to be a “good economic manager".

But the boom must ultimately end in a crisis, because it drives up debt levels without adding to the economy’s income-generating capacity. Ultimately, a level of debt will be incurred that cannot be serviced, and the economy will collapse into a Depression... Without asset-based lending, though the debt level rises, it does not get out of hand and cause a crisis.

Size of the mis-allocation of capital in Australia

The Australian property sector is the country’s largest and, arguably, most important asset class. The total value of homes across the country as at December 2011 was $4.54 trillion.

Admittedly, RPData's estimate of the value of Australia’s property market is above the official Reserve Bank of Australia (Reserve Bank of Australia) estimate of $4,13 trillion as at June 2011. Australia’s expenditure-based GDP in calendar year 2011 was $1.44 trillion, meaning that the Australian property market was 3.15 times the size of the Australian economy according to RP Data! (or 2.95 times as at June 2011 according to the Reserve Bank of Australia estimate).

Note that the ratio in America is 1.06. Effectively, this means that Australia has taken a one-way bet on property, with most of our 'wealth' tied up in residential property. A significant downturn in property would seriously impoverish the average homehold as 60% of the composition of our financial assets is tied up in real estate.

BANKING REGULATORY CHANGES THAT ARE REQUIRED

Adopting Professor Keen's recommendation to base lending for property on the rental income (actual or imputed) of the property being purchased, and to limit the debt that can be secured against a property to ten times its annual rental income. The property reform would break the positive feedback loop that currently exists between leverage and property values - values rise because some borrowers are willing to take on more leverage to trump other borrowers, and the increased leverage drives values up, feeding back into the leverage-value bubble process. With this reform, all would-be purchasers would be on equal footing with respect to their level of debt-financed spending, and the only way to trump another buyer would be to put more non-debt-financed money into purchasing a property. This system could also require a transition to valuations whereby dwellings may be valued only on the rental income they offer to landlords.

More direct measures may also be called for, for example in other jurisdictions deposit and LVR requirements are specifically legislated. For example, this could include: deposit requirement for owner-occupiers (20%), more for investment or holiday homes; maximum LVRs of 80%; and mortgage and other costs for owning the property usually cannot be more than 30% of your income during loan assessment i.e. a return to traditional debt-servicing ratios based on gross borrower income calculations to be regulated. There would be limitations on withdrawing equity built up in a property investment. Far greater regulation of 'interest only' loans for property need to be investigated - this may require much greater risk weighting in determining a bank's capital ratio (see further below).

Australia's financial system should also learn from the mistakes of other countries and explicitly outlaw any steps towards:

- The government acting as a mortgage insurer e.g. Canada Mortgage and property Corporation (CMHC)
- Providing government security guarantees (although I acknowledge the taxpayer guarantee for funds up to 250K in Australian institutions is currently in place)
- Establishing government sponsored enterprises (like Fannie Mae & Freddie Mac in the US)

The bank's capital ratios are clearly insufficient to buffer against a significant property downturn and the risk weighted assets methodology used by the banks is not transparent. Therefore, with Basel III reforms on the horizon, the Reserve Bank of Australia should be assisting APRA to determine a more risk averse Probability of Default and increasing transparency of how the big four banks calculate their capital requirements. This may require a doubling or tripling of the capital ratios. Originally, Basel I set a minimum 4% capital requirement for residential mortgages - this was perceived (and was generally) to be much higher than the real risks (perhaps this is what is required as a minimum base level).

Other possible actions and regulations to limit the broader risks posed by banks and other financial institutions:

- Limit bank size. There is a lot of evidence that size does NOT bring efficiency, and market concentration presents lots of disadvantages for the market and the economy. Therefore, promotion of competition in banking activities is fine, but mergers and acquisitions should be discouraged (plus, you don't want institutions to become so large, so that their failure implies systemic risk and hence 'to big to fail'). Forced splitting of banks into smaller entities (via APRA or other legislation) could be enacted. Long term they would shrink by 50 - 75% and become utilities with return on equity averaging around 5 - 9%.
- Separate retail banking, and in particular deposit collecting activities, from wholesale and market activities. This was the intent of the Glass-Steagall? Act in the US (until repealed in 1999). That is, limitations are imposed on commercial bank securities activities and affiliations between commercial banks and securities firms. Other elements of this original legislation which could be considered in Australia includes provisions to restrict “speculative” uses of bank credit e.g. monitoring local member bank lending and investment to ensure there was not “undue use” of bank credit for “speculative trading or carrying” of securities, commodities or real estate; and limitations on the total amount of loans a member bank could make secured by stocks or bonds
- Longer term, banks should be run as safe utility like businesses. In terms of their legal structure, banks could return to being partnerships i.e. must be owned by majority and held in unlimited liability, by the partners. That is, banks would not be publicly listed companies
- Clear direction from the government is required that bank debt will not be guaranteed by the taxpayer

In the event of a systemic crisis e.g. debts that cannot be paid will never be repaid, (mass default), instead of any liquidity backups or debt facilities we have the following:

- The government MAY (not automatically) choose to nationalise the bank (i.e take a 51% stake for $1 AUD, the remaining shareholders take a haircut). The government may also choose to let the bank go to the wall, or otherwise be bought out
- In the event of nationalisation, all debt owned by the bank will be immediately converted into equity (i.e forgiven) e.g a home mortgage that was “worth” $300K and paying 6% in interest, and the home was worth say $350K, is then converted into a $300K equity stake in that property (with the remainder owned by the homeowner, but has seniority), that has ZERO cash-flow – i.e no interest and no rent payable, until sold later on a secondary market (at the homeowner’s discretion – could be 20 years later…)
- These two provisions would go some way in re-rating the risk of banks (by shareholders) and their practices. That is, they know that if they write bad debt, they won’t get bailed out, it will just turn into a lien on someone’s home or business that they may never get back. Further, if a bank is assessed as having a lot of toxic debt, the government is not obligated to put the taxpayer on the hook in the first instance

In summary, by forcing more reasonable lending practices for property, banks would be forced to direct more credit towards productive enterprises like business lending - addressing the imbalance currently present with around 60% of the loan book of the big 4 consisting of residential loans (this is the highest in the world).

Without changes, the risk to the asset base of the banks is high given the significant borrower repayment risk, particularly in the event of a downturn (given mortgage debt to GDP has approached 100% in this country). Other recommended changes outlined above, such as greater capital requirements, and no guarantee of taxpayer bailouts, would reduce overall systemic risk going forward.
'Chess is war over the board. The object is to crush the opponent's mind' - Bobby Fischer

Beware the Real Estate Astroturfers, for they are among you!
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