Mortgage rate rises are too little, too late to save Australia’s bloated banking sector

Despite recent mortgage interest rate rises, Australian banks are more exposed to the risk of a housing market shock than ever before

Australia housingIn Australia, the big four banks are joining the mortgage interest rate hike bandwagon to boost additional capital in what is truly a high-risk banking and financial system.

Simply put, when it comes to lending, banks are facilitators. On the front end, banks’ assets are generated by providing credit (debt) to homebuyers and charging a specific rate of interest. On the back end, banks have liabilities derived from depositors and wholesale lenders, fetching an interest rate which is lower than that charged to homebuyers. The banks earn the difference in revenue.

Australian households owe creditors an unconsolidated $1.97tn as of the second quarter of 2015, comprised primarily of mortgages with a remainder of personal loans. Relative to GDP, this amounts to 121.5%, and the proportion increased by 150 basis points every quarter over the past year. Given this historically and internationally large stock of household debt, the banks are earning mega dollars via net interest rate margins.

Australian banks are raking in record-breaking profits due to the sheer volume of mortgage debt issued to homebuyers and residential property investors. This is the primary reason housing prices in Australia are at record levels, relative to inflation, rents and household income: a housing bubble generated by debt-financed speculation. Today, our banks are more exposed to the risk of a shock to the housing market than in any other moment in Australia’s economic history.

There are various reasons for banks to increase mortgage interest rates without a shift in the cash rate set by the Reserve Bank. In Australia’s case, policymakers and the prudential regulator, Apra, woke up – 17 years too late. They finally realised our banks would not be able to withstand a financial shock based on the colossal stock of mortgage and other debts on their balance sheets relative to the amount of security they have to defend their businesses in the event of a severe economic downturn.

To improve the ability of the big four banks to weather a financial storm, Apra has told them to hold more capital against the risks they have accumulated by lending out so much debt to the household sector. This explains the raising of capital to marginally reduce the risks inherent to each of their balance sheets, valued into the hundreds of billions of dollars.

Put another way, this would be like asking someone who lives payday to payday with a $400,000 mortgage, earning $70,000 a year with only $10,000 in savings, to put an extra $20 a week away in the kitty. If he or she loses their job, they are then supposed to magically come up with thousands of dollars to continue to fund the mortgage payments and other living expenses while looking for work. It makes no sense because the individual has placed themselves in a situation where they live beyond their means and increasing liquidity buffers will simply not be enough.

For many Australians, it may sound reassuring that Apra is seeking to make the banks fundamentally stronger – but there is bad news. With the implementation of macroprudential regulations, our banks will now go from being as fundamentally weak as the failed Anglo Irish Bank in 2007 to now holding enough capital to rival the risk profile of what was a much safer and famed global financial institution –Lehman Brothers.

In the short term, it’s not going to help and the RBA should have never cut the cash rate to record lows to stimulate the already vastly overvalued and overleveraged housing sector at the cost of screwing depositors. If anything, the big four banks are too big to fail. Their mortgage books are too large to save without nationalisation, regardless of RBA backstops and bailout mechanisms already in place – namely the so-called committed liquidity facility.

According to the Basel agreements that bind banking institutions around the world, banks may make their own internal (opaque) assessments of the future risk of default for home owners. Australia’s big four banks and Apra are particularly fond of this method, and the vast majority of housing loans in the mortgage portfolio are assessed using the internal ratings-based (IRB) approach that allows estimates of probability of default, loss given default and exposure at default.

Unfortunately the Basel algorithm to assess a banks internal risk profile is not specifically designed for a banking system so heavily leveraged towards a housing market like Australia’s. Hence the methodology more than likely underestimates the true risks that lie within our banks’ balance sheet while they continue to allow property speculators to increase leverage. A clear example is that buyers can still unlock newly found (but illiquid) equity of properties in their portfolios to be pledged as 20% collateral against a new mortgage for another purchase.

This is a pyramid or Ponzi scheme, that puts the speculator at risk of owing more to a bank than their property portfolio is worth (negative equity). This presents a clear and present danger to the banking and financial system, depositors, taxpayers and welfare of millions of Australians who have borrowed on a large scale as residential land prices escalate. The horse well and truly bolted from the stable a long time ago, and Apra is conducting 11th hour operations to save face.

 

Source: The Guardian

http://www.theguardian.com/business/2015/oct/24/mortgage-rate-rises-are-too-little-late-to-save-australias-bloated-banking-sector

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