Faith and Belief


–The key to eating an enchilada in a road-side Florida steak house, as Samuel Taylor Coleridge once wrote, is the “willing suspension of disbelief.” You have to believe that what’s in the baked tortilla (smothered with cheese and sour cream) is actually some combination of meat, beans, rice, and various vegetables. If you add enough guacamole, the illusion is complete.

–Unless they’re filled with poison, enchiladas will not kill you (although they may not make you stronger, either). Your editor had one for dinner a week and half ago in Titusville, Florida…and he’ still ticking. Which brings us to the subject of today’s Daily Reckoning: bank collateral.

–Obviously what you choose to put in your body is different than what a bank chooses to put on its balance sheet. Food is for nourishment. You can eat like garbage, but given the nature of digestive system, garbage in is garbage out. Unless you eat like a total pig, or are chronically undernourished, you can virtually anything without killing yourself (at least right away).

–But the balance sheet of a given firm needs more disciplined nourishment. Fill the assets column with sound assets, cash, and receivables, and you have a healthy little corporation. But if you fill the balance sheet with bad assets, the health of the whole financial institution can be jeopardised. Assets that go sour can wipe out a firm’s equity capital…and put it out of business.

–Why are we yammering on about enchiladas and balance sheets today? After all, the Australian Bureau of Statistics reported yesterday that Australian businesses have $139.5 billion in capital expenditure (capex) planned for the next fiscal year. There’s an epic boom, baby, and it just keeps getting bigger!

–The official resource forecaster (ABARE) says that the value of just 94 advanced mineral energy projects has gone up by 31% in the last six months to…get this…$173.5 billion. Most of that theoretic value is based on price increases in coal, iron ore, oil, and gas. And that’s where 92% of the capex is scheduled to go, according to ABARE (if and when it goes).

–With numbers like that, why not follow the money and see where the big winners are going to come from next? Well, we have four full time analysts doing just that, each following his own leads. But it’s also possible that the huge capex plans aren’t a buy signal at all. They’re a sell signal.

–Mining companies aren’t always the best forecasters of commodity prices. By nature, high prices attract investment. High cost producers—high cost because their projects are only marginal at lower prices—finally step in to bring more supply on line and cash in on high prices. They either over-estimate the durability of demand…or the eventual increase in supply  brings down prices.

–We’re generalising grossly today. For geopolitical reasons, some commodities are resistant to quick increases in new supply. Alex has found at least two of these in the last year at Diggers and Drillers. It’s unwise to speak of the commodity market as it if it was one homogenous whole. But it IS fair to say that high prices send a signal and that, all things being equal, huge investment in new capacity happens closer to the end of a boom than the beginning.

–That’s why we’re going to leave the commodity story to the rest of the world today and bring your attention instead to what an awful mess the European Central Bank is in. It comes back to enchiladas, or more specifically, central banks accepting risky collateral in exchange for loans t keep local and regional banks afloat. This story in Germany’s Der Spiegel has the details.

–The short version of the story is that Europe’s central bank has become the repository of huge piles of garbage securities posted as collateral in exchange for ECB loans. Those loans—to Irish, Portuguese, Spanish, and Greek banks—are secured by assets that may be significantly overvalued. The result is that the ECB itself—the institution responsible for bailing out Europe’s banks—could face big losses if it were forced to write down the value of its credits.

–Say..does anyone know how you recapitalise a central bank?

–The ECB is now trapped. If the banks it’s been funding with emergency loans fail, its own assets get destroyed too. “The ECB can then learn the basic economic truth that if you lend €160 billion to insolvent banks backed by an insolvent state, you are no longer a creditor: you are the owner,” says University College Dublin economics Professor Morgan Kelly.

–This little vignette—which is not so little really when you consider that it could mean the shambolic decline of the Euro as a reserve currency—is another reminder that the world’s financial system is still buried under a pile of bad debts from the great credit boom. That pile has been written down some since 2007. But what Europe shows is that the pile has simply been shoved from smaller intuitions (national banks) to larger ones (the ECB and the Fed).

–Writedowns in the value of the pile—the collapse of the collateral—still threatens the stability of the financial system. If you make that claim in polite conversation, people may look at you like you have a third eye. But the willing suspension of disbelief of most investors doesn’t make the claim less true: many firms and some nation states are headed for insolvency.

–It’s not like the ECB is stupid, though. You’re beginning to see a finely tailored grab for Europe’s gold take place. Yesterday, the European Parliament’s Committee on Economic and Monetary Affairs said it would allow counterparties in Europe to accept gold as collateral to meet margin liabilities. Hmm.

–This sounds like an indirect way of saying that if countries like Greece—once its sold all its assets to cashed-up bidders at fire sale prices—want more loans from private banks or the ECB, they’ll have to pledge their national reserves of gold as collateral. This tells you that once all the financial wealth of a country has been stripped bare, the bankers still recognise that gold—being no one else’s liability—is a highly desirable and liquid form of collateral.

–At least the ECB has learned its lesson. It has reportedly purchased some €47 billion in Greek government bonds to help Greece work its way out of its debt problem. But exactly what kind of asset is government debt? And what kind of collateral is it for further loans?

–Lousy, on both counts. Most government bonds are backed by exactly one qualitative kind of collateral: faith. U.S. bonds, as you know, are backed by the “full faith and credit” of the U.S. government. It’s always amusing to remember that credit is derived from the Latin “credere,” to believe.

–If you’re thinking that Greece is not any different from the United States, you’re mostly right. The main difference between the two is size. Greece is a country of 11 million people with a GDP of around US$300 billion. The US is a country of over 300 million people with a GDP of over $14 trillion.

–Don’t think the financial markets aren’t already busy figuring out how bad it could get in the U.S. The Financial Times reports that, “Traders and investors have stepped up purchases of insurance against a US sovereign debt default, amid heated political wrangling over raising the US debt ceiling… One-year US credit default swap (CDS) spreads have recently jumped on the back of a handful of trades. On May 20, the cost of protection for US sovereign credit jumped 22 basis points to 50bp. That was seen by traders as reflecting the need to cover the risk of Congress failing to pass the debt ceiling by August.”

–The world owns a lot more U.S. debt obligations than Greek ones. The rumblings in US debt markets are enough to shake the whole world’s financial system…again. But don’t count out the significance of Greece as a predictor of things to come. Social unrest, repudiation of debts, violence, withdraw from the Euro…all of these possibilities will have far reaching effects on the global credit markets. They’re going to make it a lot more expensive to borrow money.

–For Aussie banks, that means paying much higher rates of interest to foreign lenders. Maybe this is why Aussie banks are already pitching the government on a plan to expand the types of assets that can be counted as collateral for the issuance of covered bonds. We’ve written about this subject before, here and here.

–Covered bonds are a way for banks to use assets on their balance sheet as collateral for new bond issuance. This is a new, cheaper source of bank funding that borrowing from lenders overseas, the banks claim. “Bank-issued commercial paper, state government debt and residential mortgage backed securities (RMBS) are among assets banks would like to qualify as eligible securities,” reports the Australian Financial Review on Friday, May 20th.

–Let’s get this straight then: Aussie banks want to use RMBS as collateral to secure more funding to make more housing loans which they can then package up as RMBS and use as collateral to raise more funds. It doesn’t exactly inspire confidence in the bed-rock value of the collateral, does it?

–After all, the ultimate collateral is the pool of mortgages that have been securitised…and what are those but a collectivised promise to pay made by tens of thousands of Aussie borrowers? And according to ratings agency Fitch, some Aussie borrowers (the first home buyers) are already showing signs of stress.

–The Herald Sun reports that, “Home loan defaults continue to soar as more households crumble under financial stress and fail to make mortgage repayments.  As banks and other lenders forecast a rise in mortgage stress, a new report from Fitch Ratings found a 30 per cent increase in arrears during the three months to March.”

–Granted, that 30% increase is off a low base. The study showed that the number of customers  who were at least 30 days late on a mortgage payment went up from 1.37% to 1.79%. Those are small percentages, for now. Just keep in mind that the folks at the margin are always the first to feel the pinch. Higher interest rates and lower home prices are bound to put more people into difficulty.

–Europe is a long way from Australia. And enchiladas are not balance sheets. But quality assets are definitely not someone else’s liabilities. While the big drama in the financial markets takes place in Greece and in the U.S. debt market, Aussie banks are busy recreating the exact same dynamic here…financing loan growth and funding an asset bubble with risky financial practices that depend on perpetual house price growth and access to ever more credit.

–Aside from the risk this poses to the bank’s balance sheets in the long term—and by extension to all the Australians who own the banks through super funds—there is another factor to keep in mind. Even if they are allowed to issue covered bonds that have RMBS as collateral, who is going to buy those bonds?

–The RMBS market in Australia is currently generously supported by yourself, although you may not know it. The Australian Office of Financial Management (AOFM), has spent $12.7 billion so far buying RMBS issued by Aussie banks. It has done so at the discretion of the Treasurer to “support” mortgage competition (keep in business lenders who finance their operations through securitisation not deposits).

–As far as we know—and we admit we could be dead wrong on this—the AOFM finances its purchases of RMBS by selling Australian government debt. It’s debt issuance schedule is here. If you’re following along at home here’s where things stand: the AOFM sells government bonds (which you have to repay) in order to buy packages of home loans made by Aussie banks that can’t sell those loans to anyone else.

–Unless we’re mistaken, a double transfer of risk has taken place. First, the government has created a liability (a bond) in order to raise the cash to buy a liability it takes off the hands of the private sector (the RMBS). This “frees” the banks up to loan more, assuming they can always offload the liabilities to someone else (the government, or by extension, you).

–If this seems like a recreation the situation in Ireland and America where banks funded an asset boom and transferred all the liability to the taxpayer…well…that’s what it seems like to use as well. It’s easy to see why the banks would be all for it. It’s also easy to see why the government would be all for it: they’re either very stupid or very sympathetic to the financial interests of the banks.

–In any event here we are on a Friday. We have a global financial system capitalised by trillions in dubious collateral. And the banks and the government here in Australia are busy beavering away to recreate the same scenario where all the risks of a credit boom are transferred from the private sector to the public sector.

–This amounts to a giant subsidy to real estate and banking sectors, although it’s done in such a convoluted and low-key way that most Australians would not be aware of it, much less concerned with it. So what?

–Here’s the thing…when the economy of a nation gets hijacked to serve the interests of the financial sector…and the financial sector’s main interest is fuelling a credit bubble t it can earn big lending profits…while off-loading its liabilities (directly and indirectly) to the government…it’s the little guy that’s going to get screwed eventually.

–Sorry that’s not a more cheerful way to end the week. But we’re off to look at the Aussie gold price, which has been remarkably stable in the last year. We don’t plan on using it as collateral for any margin loans. But in a global destruction of credit and credit-backed money, it might make a pretty handy asset.

Dan Denning
Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.


  1. I think you are correct in your assumptions regarding the financing of the RMBS purchases. The link to the 2010 cash flow clearly shows the application of treasury funds to purchase the RMBS.
    More interesting are the claims of a reasonable return on the investments of 5.2%, as contained in the second link to the 2010 annual report, but neglecting to point out average treasury bond financing cost of 5.14%. On an investment of $7 billion this is a return of around $4 million. A pretty impressive return, with only a $72 million unrealized loss on the investment.
    Link to 2010 cash flow:
    Link to 2010 annual report showing funding and RMBS investments:
    Link to RMBS investments by AOFM:

  2. A couple went to a priest asking him “could you please explain to us the difference between faith and knowledge?”. The priest replies with an answer, “Woman, how many children do you have?”

    “Five” she replies.

    “Man, how many children do you have?” – “Five”, he replies.

    The priest gives his lesson: “Woman, you have knowledge. Man, you have faith!”

  3. While it’s true that Samuel Taylor Coleridge once mentioned Taco Bell in passing, during an opium-induced couplet in 1802, it’s unlikely he ever imagined this as analogous to Australian RMBs over two centuries later. ;)

    DRA’s current obsession with bail-outs, as expressed in the entertaining piece above “…we admit we could be dead wrong on this…” might possibly be inspired by a sequence of failed bets. It would be too cruel to list them… .


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