When Kevin Rudd’s political obituary is written – perhaps as soon as today – a great deal of focus will be on the coup that deposed him as prime minister and the coup de grace that ended the political misery of the Labor party. For anyone interested in Rudd’s biggest impact on Australian life, the focus should be on how he encouraged tens of thousands of Australians to take on crippling debt and bet on higher house prices.
The First Home Owners Grant (FHOG) of 2008 was Rudd’s reaction to the Global Financial Crisis. The basic thrust of the response was this: borrow more and everything will turn out just fine. The government doubled the grant on existing homes from $7,000 to $14,000. It tripled the grant on new homes to first-time buyers to $21,000. The Big Four Australian banks have increased their share of the mortgage market to 86% since the FHOG was first introduced and then extended.
Rudd’s response was straight out of the Keynesian playbook. In Europe and the US and Japan, government borrowing increased in an attempt to stave off the end of the credit boom. Rudd followed suit there, too. Australia turned a $20 billion surplus into a quick annual deficit. That deficit has grown into a formidable $200 billion debt since. It shows no signs of getting smaller.
Rudd’s only particular twist on the Keynesian playbook was the FHOG. He wasn’t content with blowing up the government’s balance sheet. He set charges and the fuse under the entire private sector housing market. The bizarre result, as our friend Dr. Steve Keen has pointed out, is that Australia spent the Global Financial Crisis doubling down on housing and extending the household debt-to-GDP ratio to 150% – the highest level in the Western world.
No matter what happens to Rudd today, his financial legacy is already written in years of red ink. The story won’t end with his relegation to the backwoods of the Labor party. Australia’s banks are labouring under the global impression that they’re exposed to a housing crash. One particular solution to the bank’s “funding crisis” isn’t turning out the way anyone expected.
Ratings agency Fitch downgraded Commonwealth Bank, NAB, and Westpac to AA – from AA on Friday. Fitch’s move wasn’t groundbreaking. S&P downgraded the Aussie banks in November. But Fitch did add this bit:
A high reliance on wholesale funding makes maintaining investor confidence key. Factors such as Australia’s high household debt levels, elevated house prices and increasing reliance on Asia for trade may all impact this confidence, particularly if economic conditions in the region were to deteriorate significantly.
This is a mixed message. Australian banks rely on off-shore debt markets for 40% of the funding they need to make loans. It DOES sound confusing that a bank has to borrow money in order to loan it. Banks have to get their money from somewhere too, even with fractional reserve lending. It’s more expensive to get that money.
Deposits have grown at Aussie banks since financial markets tanked in 2009. That’s mostly thanks to high interest rates on bank savings accounts and an aversion to the stock market. But banks still need to refinance $90 billion in loans this year – without the benefit of a government guarantee. That’s not just pocket change.
Which brings us to the covered bond market. Covered bonds were cooked up last year by the banking sector and Treasurer Wayne Swan as a way for banks to secure access to more funding if global credit markets break down. Actually, that’s not fair. Covered bonds have been around in Europe for quite awhile. They ARE new to Australia though.
How a Covered Bond Works
The premise behind a covered bond is that it’s a secure debt. If you buy a bond from the bank – which is to say if you loan money to the bank – the bank pledges you collateral as security. As a secured creditor, you get first dibs on that collateral if the bank should ever run into a catastrophic event (that never happens in the banking sector, though).
The covered bond market was supposed to open up a new source of funding for Australian banks by “unlocking” their balance sheets. Banks are allowed to use different pools of assets to pledge as collateral for the bonds. The main two pools of assets are depositor funds (your money) and home mortgages (your house).
A funny thing has happened on the way to lower funding costs through covered bonds. They didn’t lower costs. The introduction of the covered bonds has actually shifted all borrowing costs higher for Australian banks. It’s created a new class system within the capital structure of a company, which is so exciting we’ll get to it shortly.
This all started to become clear when Westpac and Commonwealth Bank sold a combined $6.6 billion worth of covered bonds in January. The trouble was that both had to pay a higher interest rate than they expected. Without getting too complicated, the rate of interest on a covered bond is usually at a premium to a swap rate (which we won’t get into here). Westpac and CBA paid premiums much higher than they expected.
This has immediate consequences for other bonds issued by banks. “The high spread at which the covered bonds were issued effectively means investors in all other bank securities need to be paid a greater premium,” said Andrew Gordon at FIIG Securities Ltd in Sydney. In other words, the covered bonds are dragging yields on other bank debt up because covered bonds are secured and other bank debt is not.
The spread between the interest rate on covered bonds and the swap rate varies. Sometimes it’s bigger. Sometimes it’s smaller. The size of the premium depends on investor confidence and global credit markets.
But when you sift through all the financial details you see that Australia’s banks are playing a dangerous game. The assets of the big four – $932.5 billion in housing loans – are secured by Aussie houses. Assets can change in value, especially when house prices fall, like they did last year in the biggest calendar year drop on record, according to Bloomberg. Meanwhile, the banks are incurring new debts via the covered bond market, using the same assets as collateral.
In the class system emerging in financial markets, bank depositors are proletarians. Secured and unsecured bondholders can probably sleep well at night. If the bank can’t pay back its debts, creditors have first recourse to the bank’s assets (your house, your deposits). Equity investors should probably take a cold shower after reading this and ask themselves why you’d want to be at the bottom of the capital structure in the event of a liquidation of a bank.
The even better question is why you’d want to invest in a business whose earnings growth is dependent on the expansion of debt…when the world is in the throes of a credit depression? You’ll be swimming upstream for several years.
Of course the whole issue of who gets paid what in the event of liquidation only matters if the bank fails. And from a political perspective, it’s unlikely an Australian bank would ever be allowed to fail. Depositors would be bailed out via the Financial Claims Scheme. Everyone else – the secured creditors, the unsecured creditors, and the equity investors – would fight over scraps based on legal hierarchy.
None of that will ever happen, though, because Australia’s housing market could never crash. Even if homes are severely unaffordable…and even if the global credit crunch is driving up borrowing costs…and even if Aussie banks are having resort to more convoluted ways to borrow money…Aussie house prices will be just fine, which means bank assets will be just fine, which means everything will be fine.
Tomorrow…why everything may not be fine after all.
for The Daily Reckoning Australia