It All Comes Down to Debt Again for NAB

What housing finance crisis, you say? Okay, maybe not a crisis. But as we booted up the computer of the foothills of the Rockies today, we were not surprised to learn that an Aussie home lender is in trouble.

Bloomberg reports that RGH Ltd. (formerly Rams Home Loans) may default on nearly $2.5 billion in loans. The possibility was triggered by a ruling of the New South Wales Supreme Court. In that ruling, the Court said that RHG was already in default on $324 million in notes held by a German lender that were used to finance new Australian mortgages.

The default on the $324 million in notes may trigger "cross defaults." That's a fancy way of saying other lenders to RHG may force the sale of their securities held by RGH in order to recoup the money they've lent. Or as Moody's analyst Arthur Karabastos puts it, "The secured creditors may wish to take steps to enforce their security including the appointment of a receiver to the underlying pool of mortgages."

Bloomberg says the court case hinged on whether a pool of mortgages pledged as security to a loan made by German bank HypoVereinsbank has breached a "maximum level of arrears." The case apparently hinged on what the definition of "in arrears" was. The court said RHG's method of defining what "in arrears" meant was, "reminiscent...of Humpty Dumpty."

Without knowing the details of RHG's loan portfolio it's hard to say if this is indicative of a wider problem in Australia. What it DOES show, though, is how no amount of time can make a bad loan go good if the underlying asset was over-priced to begin with. The idea that you can avoid a loss by holding a loan-to-maturity (and not marking the loan to market today) is absurd if underlying assets (residential housing) are losing value.

Time and again we come back to the solvency of the banking system. It's on both sides of the balance sheet. Liabilities secured by damaged collateral threaten to swallow assets, which are themselves dependent on a huge recovery in house prices (which frankly isn't happening). U.S. banks are still incredibly exposed to housing, not to mention commercial real estate.

What about Westpac? It bought Rams in October 2007 after the Rams realized it couldn't fund new loans through securitization in a credit depression. It isn't clear how much - if any - exposure Westpac has to RGH. Westpac shares were down slightly. This is what we meant though, on Monday, when we said that the Big Four still have exposure to the higher-risk mortgage market.

It's a dangerous financial liaison. The banks want exposure to this sector of the housing market (because it's profitable). But they prefer to compartmentalise the risk (if possible) and keep the affair under someone else's name (like registering into a hotel with a different name to conceal your identity).

Also in the Department of Aussie-banks-exposed-to-default risks is the National Australia Bank. Only this time it's not bad mortgage risk, it's sovereign debt risk. In documents published late last night, NAB revealed it has $12.78 billion in exposure to Italian government debt. Its Italian exposure is about 2% of its total asset base of $654 billion.

NAB came by the bonds because it accepted them as collateral for what it described as an "interbank reverse repurchase agreement." Got that? From what we can gather, NAB may be obligated to take on certain loan obligations of its bank partner "under certain circumstances." The Italian sovereign debt is collateral against those potential obligations.

Is it such a bad thing owning Italian government debt? S&P says the debt is rated A+ and stable. Italy's public debt-to-GDP ratio is 115%--bigger than most but smaller than some. Its annual fiscal deficit is 5.3% of GDP. Again that's smaller than some, but not hardly the level that inspire confidence in the soundness of your monetary policy or your sovereign debt.

None of this means NAB is in imminent danger of losing $12.78 billion. Italy would have to default on its debt. Or the market would have to begin re-pricing the sovereign debt of countries like Italy, Greece, Ireland, and Portugal to reflect the unsustainable nature of fiscal and monetary policy in those places.

But for NAB, it all comes down to debt again. Sure, there's good debt and there's bad debt. And you'd think that sovereign debt is generally pretty safe (especially since the FSA and APRA have concluded that only sovereign debt meets the liquidity requirements under consideration for bank assets). But sovereign debt isn't safe if the financial crisis is turning into a sovereign debt crisis. And in 2010, it sure looks like funding model of nation states will be under severe pressure.

All of which is a big argument for staying away from the banks. But to be fair, a whole heap of Aussie stocks are treated as "risk assets" to be bought when the U.S. dollar is weak and sold when the dollar rallies. With the dollar rallying, the Santa Rally may falter.

Speaking of melting Santa Rallies...it's a sunny 15.5 Celsius here in Colorado. Growing up in the mountains, the winters were full of monster snow drifts and grey skies. But Colorado gets heaps of sunshine. And though the Rockies were blanketed with white as we flew over them yesterday, today's weather is nice enough to have a barbecue in, which we'll do with family in a few short hours. Until tomorrow!

Dan Denning
for The Daily Reckoning Australia

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