In today’s financial multiverse we find smart people saying seemingly sensible (but utterly destructive) things about debt. We also find Australian household debt-to-GDP ratios leading the Western world at 112%. And we find heaps of evidence that your best bet for a financial future is to retire now.
More on all that in a moment. First up today is this little pearler from Bloomberg, “Australian banks, including Westpac Banking Corp. and Commonwealth Bank of Australia, risk more loan defaults as the government unwinds economic stimulus and the central bank raises interest rates, according to Fitch Ratings.”
Fitch says it’s the small and medium size businesses that are starting to show “signs of stress.” The $42 billion in stimulus money – to the extent it went to these businesses – is all spent with little multiplying effect. The government (bearing down on an election) can’t give more money away. And with rates rising, businesses are feeling the pinch of higher loan costs.
Fitch reckons all of this will add up to higher bad debt charges for Aussie banks. It says the threat of “large corporate collapses” has receded, though. And the banks themselves don’t seem too terribly fussed. They say even the chance of higher mortgage defaults in Australia is “manageable.”
Frankly, the banks and the media and the financial industry are incredibly blasé about the risks to the economy and the financial system. We’re not two years removed from a major systemic crisis, and most financial professionals are treating it like it was an anomalous “near miss” and not a sign of a more fundamental rot in the very DNA of the financial system.
That rot, we would contend, is the attitude towards debt and leverage. It’s a series of embedded assumptions about how to use borrowed money and what to expect (in terms of risk and performance) from asset markets over time. The financial world is using 20th century assumptions for a 21st century world in which the basic premises (the cost and availability of capital) have radically changed.
Take the Commonwealth Bank and its mortgage fund Colonial First State. It has again halted withdrawals from its $850 million mortgage fund after “being caught out by a spike in lending losses,” according to Eric Johnston in today’s Sydney Morning Herald.
“With rising interest rates likely to spur further mortgage stress, Colonial First State’s move suggests the nation’s troubled mortgage fund market could face a fresh round of problems after the $30 billion sector was hit by the introduction of the bank deposit guarantee about 14 months ago.”
There are three issues here and each gets to the heart of the modern problem with debt, investing, and banks. First is asset quality. The mortgage funds are pools of mortgages or mortgaged backed securities. Colonial First’s has a reputation for being conservative. Right.
But in a note to clients yesterday it reported that, “Since the withdrawal offer opened on November 25th, 2009, we have identified a small number of mortgages in the fund’s portfolio that have the potential to become bad bets…We have commenced a review of the fund’s assets to fully assess these loans and determine the impact on the fund and investors.”
We’ll take the fund at face value on these comments, although that is generous these days. The withdrawal offer, by the way, is the fund allowing withdrawals as of November 25th. They had previously been halted. That limited lifting seemed to be a sign of normal times.
But these are not normal investments. Any time a security is backed by a pool of mortgages – no matter how vigilant the underwriting standards – asset quality is going to be an issue. Asset values are variable, and funds made up of variable assets are generally not as safe and sound and their prospectuses make them out to be. Keep an eye on the default rates in prime U.S. mortages and you’ll see what we mean.
The second issue with the mortgage gunds is that government bank deposit guarantee that came into effect last year. Talk about unintended consequences. When the Rudd government slapped a government guarantee on bank deposits last year, it may have done the Big Four a favour by driving scared depositors into their arms. But it hit the mortgage funds especially hard.
Investors treat those mortgage funds like a high interest bank account that produces a steady, reliable, and secure income. Fixed income with a high yield! But minus a government guarantee, the $30 billion fund industry with over 150,000 investors saw so many redemptions that it had to halt them and freeze investors out from getting their cash.
Reminder: your money isn’t really yours unless it’s in your hot little hand.
The funding model for the funds industry was seriously strained by the outflows. As we understand it, the funds have three sources of funding: deposits, bank credit facilities, and the mortgage payments it receives from mortgagees (commercial and residential). The bank credit facilities are exercised either to make new mortgage loans or pay out withdrawals that exceed what the fund takes in via mortgage payments.
You can see this train wreck coming. If bank credit tightens up, asset quality declines, and withdrawals (for any reason) accelerate, the model gets stretched. Not to the breaking point. But to the point where you look at the model and reach the conclusion that this is not a safe, steady, reliable way of generating income.
But then there is a whole funds industry in Australia (and the world) built on turning debt into an income-paying asset. Often that debt is collateralised by a real asset (like a house, or a toll road). Just to be clear, however, there is no Income Fairy that makes sure you always get paid in these investments. They only work if the funding pipeline is clear and asset quality doesn’t deteriorate.
The trouble in a credit bubble, though, is that plenty of assets get built and valued and prices far above their ability to pay themselves off AND generate returns for investors. What’s more, sometimes the assets fail to generate an income stream capable of sustaining the debt service costs. The inevitable result is falling valuations or insolvency. For investors in these schemes, the result is a loss.
The last point worth making about this story is about the idea of income investing itself. We were yapping with our colleague Kris Sayce about the issue the other day. Kris was looking at high-yield listed investments in Australia and examining how they produced the payouts made to investors. Some of them would make Rube Goldberg, Ken Lay, and Bernie Madoff envious with their ingenuity.
Not all dividend yields are created equal. There is an assumption among today’s investors, bred by complacency, that higher yield is always available if you’re prepared to take the risk. But the way some of those income streams are manufactured, and the way the funds are structured, is, if not misleading, certainly not safe.
Not that you’re going to retire rich on bank interest. But be wary of funds promising safe yields with no risk. It doesn’t exist. In fact, we’d be wary of nearly the entire universe of financial investments at the moment. We’ll tell you why tomorrow.
You can’t blame investors for chasing yield. With real incomes falling in the Western World – as a result of a corporatist policy to off-shore high-wage jobs – the only way most people can achieve a standard of living that matches cultural expectations is to borrow money from the bank. Debt is just a means to an end. And that end is social respectability.
Perhaps that is why bankers have become so blasé about how they risk shareholder money. We’re referring to the response of former banker Saul Eslake to the news, commented on by Terry Barnes in the Age on the 13th, that Australian households have $1.2 trillion in debt – or 112% of GDP according to the ABS. That’s $56,000 for every man, woman, and little nipper in the country.
In today’s Age, Eslake says debt won’t “roon” us and that the debt-to-GDP numbers don’t convey anything significant. The important numbers, he says, are the debt-to-asset ratio and the debt payment as a percentage of disposable income. By both measures, Eslake says there’s nothing much to worry about.
To prove his point, he uses a hypothetical example where a customer walks into the bank with $100,000 in cash, annual after tax income of $100,000 and a request to the bank manager to borrow $200,000 for the purchase of $300,000 home. Elsake says, “The manager would not reject the customer’s request for a loan on the grounds that he or she would then have a debt-to-income ratio of 200 percent.”
“Rather, the manger would look at the customer’s debt-to-assets ratio, which in this hypothetical example would be 67 percent [a $200k mortgage as % of a $300k house]. Banks will normally lend for owner occupied housing up to 80 per cent of the value of the property (or up to 90 per cent with mortgage insurance. No problem there.”
No problem there?
We can think of at least one. The main one is the point we made before: the value of the property. The assumption embedded in Eslake’s risk assessment is that that the loan-to-value ratio can be that high because house prices generally go up. The borrower is getting an appreciating asset in exchange for his debt. That’s a good trade as long as asset prices rise.
It’s just worth pointing out the nonchalant assumption. Of course if house prices don’t rise, or if they fall, the debt-to-asset ratio would get closer to parity. In practical terms, the mortgagee has a debt that doesn’t change and an asset whose value does. During certain phases of the real estate and credit cycle, that is a formula for indentured servitude to the bank.
But what about the ability to service the debt? Eslake says that, “The manager would also consider the customer’s capacity to service the loan out of his or her income. Assuming a mortgage rate of, say 7 per cent, interest payments would be absorbing 14 per cent of his or her disposable income, plus a little more for principal repayment. Banks will typically lend amounts requiring up to 25 or even 30 per cent of a customer’s disposable income before becoming seriously concerned about his capacity to service the mortgage.”
What’s left unsaid here is just as important as what’s assumed. What’s left unsaid because it’s assumed is that the borrower will have an income. That’s a basic assumption, it’s true. But is full time employment over the life of the loan something you can take for granted in an economy like this? Perhaps these kinds of assumptions explain the track record of global bankers in making good loan decisions over the last ten years.
But what’s left unsaid is that the bank is obviously happy for the borrower to maximise the amount of his income that goes to service the loan. After all, the bank is getting paid. What does it care how much stress it puts on the borrower? For the bank, the borrower and his stressed out mortgage payments are just as much an asset as the collateral itself, the house.
For the bank, the borrower is a kind of fixed income investment. Mortgagees are literally a cash crop to be planted, farmed, rotated, and reaped cyclically. The bank only really risks a loss if the cost of servicing the loan breaks the back of the borrower. The banks allow for that in their loan loss and bad debt provisions. But generally, if you break your financial back it’s your problem, not the banks.
We’re not bashing on the banks, mind you. They sell money. It’s a valuable service. But we are showing that if the underlying assumptions behind their lending practices are faulty, or not in your interests, you should be very cautious when they tell you it’s okay to go into debt. They’re in the business of selling you debt. What else would you expect them to say?
Eslake adds, that “Not only would the customer’s request be approved more or less on the spot, but mindful of the ‘cross-selling’ targets, the manger would have had, he or she would have probably also offered a further $100,000 loan for a geared investment in the share market.”
To give him the benefit of the doubt, we detect a note of irony in Eslake’s telling of this anecdote. He’s not endorsing or approving of the scenario. But we think he is saying that under common practices, this is how a bank would behave and that this behaviour is reasonable, prudent, and ultimately, wildly profitable for the bank.
That tells you a lot about the banking sector. It shows you why the financial services industry has every incentive to load you up with debt so you can buy houses and stocks. And in boom times, that strategy appears to make people richer. But when the cost of capital goes up and debt deflation sets in, both banks and their borrowers will regret the debt.
And not just in a financial way, which is bad enough. Debt is not inherently evil. But it is a burden. And a society that loads itself up with obligations it strains to pay the interest on, much less the principal, is a very unhappy, heavily burdened society.
There was a lot more we meant to get today, including cyclical attitudes toward debt. But we’ve gone on too long already. More on why you should retire now and other financial taboos in Friday’s episode. Until then!
for The Daily Reckoning Australia