Still lucky

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The next few days should be telling ones for both gold and equities. Gold has come off its new highs. But you haven’t seen a huge amount of selling either. As our friend Phil Anderson pointed out the other night, you often see two to three days of lower closes after a new high. That gives you a good time to enter into a position.

But so far, September hasn’t been the historical disaster we’ve come to expect. Mind you, it’s early. Yet outside some whisperings of capital raisings by major European banks which we’ll get to in a moment, the Aussie papers are full of seemingly good economic news that just keeps getting better.

Yesterday’s ray of sunshine came from the labour market. Full time employment in Australia jumped by 53,100 in August, according to the Australian Bureau of Statistics. The jobless rate in the Lucky Country is now just 5.1%. And even the deficit spending laggard states of Victoria and New South Wales managed to buck the trend and add jobs.

In fact, with the employment figures so positive, everyone’s trying to figure out if the Reserve Bank of Australia will raise interest rates again this year to prevent the economy from overheating. This metaphor assumes the economy is machine which can be operated by an engineer (wrong) and that Australia is leading the developed world out of the global recession (highly debateable).

Incidentally, the banking issue we referred to is Bloomberg’s report that Deutsche Bank is considering selling US$11.4 billion in stock to meet stricter capital requirements imposed from the Basel III round of bank regulations. That sounds sort of ominous. But what does it really mean?

According to the article, “Proposed rules under consideration by the Basel Committee may lead banks to raise reserves. Germany’s 10 biggest lenders, including Deutsche Bank and Commerzbank AG, may need about 105 billion euros in fresh capital because of new regulations, the Association of German Banks estimated on Sept. 6.” Hmm.

The Basel rules are designed to boost bank capital in the event of another shock to financial markets. Of course, the stress tests this summer were supposed to ensure that the European banks were just fine and didn’t need any more capital. As the Wall Street Journal reported last week, though, the Stress tests did not test how big European banks would react to losses on sovereign bonds, much less an outright default by one of the more distressed debtor nations in Europe.

Are the Germans just stealing a march on the rest of the banking sector and stockpiling equity capital against future losses? If they were, it would tell you that there are going to more losses in the European banking sector and that despite a quiet Northern Hemisphere summer, the banking sector remains undercapitalised relative to the losses everyone knows it’s sitting on.

But who cares. In keeping with our theme of stating the geographically obvious this week, Australia is not Europe, even though parts of Melbourne may sound like parts of Athens. Opa! But when it comes to the quality of bank collateral, Australia has nothing to fear, right?

Aussie banks should do just fine under the new Basel rules, according to a Reuter’s story that cites research by JP Morgan and Fujitsu. It looks like Basel III will require banks hold up to 9% in Tier 1 capital. That’s highly liquid capital like cash and AAA credit that can cover the unexpected losses from a sudden shock. The hope is that an adequately capitalised bank won’t have to be bailed out by the government (taxpayers) again.

Now, at the risk of sounding like a crank, we’d have to take these research reports with a big lick of salt. We’re not accusing the banks or the firms that cover them of lying. After all, most of the people covering bank risk are careful, methodical, if unimaginative people. Their models tell them everything will be fine.

It’s the models that are rubbish.

If one thing has been consistent over the last three years of financial crisis, it’s the tendency of professional analysts and policymakers to underestimate risk and overestimate asset quality. Of course that is not a nuanced argument against the quality of the commercial and residential real estate assets of the Aussie baking sector. It’s really just a deep suspicion that these guys blew it last time and are going to blow it again. But as ever, we could be wrong.

By the way, you know by now that Aussie banks have to borrow about $150 billion a year from overseas lenders to keep the wheels of domestic commerce from squeaking. Does that make the Aussie economy vulnerable to external credit shocks, even if you generously assume banks will not be troubled by asset write downs? Yes!

But wait Australia’s most obnoxious property spruikers say! Aussie banks did not go on a reckless lending boom. Loan quality here is good. Non-performance figures and delinquency rates are not a concern. And we have borrowers cannot walk away from a mortgage here like they can in America. Even IF Aussie banks had made loans to risky borrowers (which they didn’t, of course), those borrowers would be locked into the loans till richer or poorer because of the nature of the loan.

Do you believe any of that? Really? And how is it good that someone is locked into paying down an asset which is falling in market value? That just makes the entire housing market less likely to find a clearing price when it does crash because the labour force is essentially immobile and chained to heavily-mortgaged homes.

And for what of it’s worth, we’re reasonably certain there were plenty of loans made to people who will struggle to repay them or service them if prices fall and rates rise. It might not be as egregious as U.S. subprime, but just you wait.

And even if you concede (which we don’t) that there was no reckless lending boom by the banks, they definitely went on a borrowing boom. This is what John Boyd called progress; confusion at a higher level. The Aussie banks financed the local property boom by going bonkers in the global wholesale funding market when the global cost of capital was cheap. Now, they will have to refinance that boom in a more capital competitive world.

But she’ll be right!

All of which brings us back to gold. It’s the canary in the financial coal mine. If it holds its highs even as equities power along, you’ll know that the world’s banking system is not as well capitalised as you’ve been led to believe. You’ll also know that many of the subterranean rumblings of the last few months may be ready to break loose. Until Monday!

Dan Denning
for The 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.
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