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The Foreign Debt Bomb

At this point in the debate over the resource super profits tax, Wayne Swan must be praying for a European banking crisis. It would be a welcome external whipping boy for a local share market sell-off. And it developed into a full blown sovereign debt and liquidity crisis, it would give the government a convenient excuse to shelve the tax altogether until after the election.

The challenge of today’s Daily Reckoning is two-fold, then. First, what the heck is actually going on in Europe? Second, is the super profits tax really just a gimmick that allows the government to claim it’s putting the budget back into surplus ahead of schedule, while avoiding any of the tough “austerity” measures that European governments are forced to make?

But first, to Spain! Markets in Europe and America tanked overnight again and the euro weakened against the dollar. Investors still aren’t sure – or have no idea – if the EU $1 trillion rescue package actually solves the big debt problems in Europe, or merely kicks the can down the road. A little can kicking can buy you some time, though, so it’s not entirely a bad thing.

In Spain, a bank in Cordoba owned by the Catholic Church – CajaSur – was seized by Spain’s central bank after refusing a merger. Standard and Poor’s estimates it will take €35 billion to rescue Spain’s banking sector from a decade-long binge on housing lending. According to Bloomberg, housing loans account for half the assets of the Spanish banking sector.

Hey! That sounds familiar. Over half of Australian banks’ local lending is to the housing market. But of course, Spain had an irrational boom in property prices driven by credit and bank lending. Australia has a genuine property boom, singular in the world in that it’s been driven by immigration, a housing shortage, a cultural preference for owing large sums of money to banks for long periods of time.

By the way, the above comments were ironic. You know how we feel about the housing market here, built as it is on bedrock of debt. But if you want to read something truly surreal that borders on the Kafkaesque, check this out.

If you don’t have time to read the story, it’s about a new interest-only-and-forever mortgage product from ING Direct. The loans, in theory, would have no fixed term and absolutely zero requirement that you ever pay down the principal. In theory, according to ING CEO Don Koch (who wants to become your mortgage partner for life), the loans are a great idea for Australia. Why?

“People are needlessly being denied the chance to buy a property while prices spiral rapidly out of their reach,” Koch says. “There is an urgent need to provide more affordable options and borrowers should be able to choose whether they want to repay the capital, or not… It has worked fantastically in Europe as a way for people to get home ownership and build wealth throughout their lives. It just requires a change in mindset about how you live with debt…Some won’t like carrying a mortgage for so long but, for a lot, this will make home ownership cheaper.”

But is it really home ownership…if you don’t’ actually own anything?

It sounds like this is just out and out speculation on higher house prices. You borrow big from the bank because you reckon you can sell and bank a capital gain in a short period of time. You get all of the benefits of home ownership without actually owning a home. And you get all of the capital gains associated with rising house prices without having to make a large down payment or pay any principal.

Let’s just throw this out there as a question…isn’t this sort of product designed for people who want to speculate on house prices? And doesn’t it leave the borrower with a large liability to the bank, in perpetuity? And could you think of a better way to destroy a bank’s balance sheet over time than loading it up with these kinds of loans?

Don’t worry! With the help of you, the Australian tax payer, the Australian Office of Financial Management is happy to keep buying the mortgage-backed bonds sold by Australia’s non-bank lenders. The AOFM has funded nearly $8.7 billion in various mortgage backed securities issued by non-traditional lenders in the name of keeping smaller lenders competitive in the mortgage market.

Right.

But back to the problem banks in Spain. “Many of them are half bankrupt,” Rafael Pampillon tells Bloomberg. He’s the chief of economic analysis at the IE Business School in Madrid. He says the problem Spanish banks, “have loans to property developers and mortgages that have turned toxic.” European and Spanish authorities are hoping that more solvent banks with deposits as assets can take over the toxic banks and “dilute” the risk.

There is a fine line between inoculating yourself against a virus…and introducing it into your system so it can kill you, isn’t there? That said, we’re not biologist…nor are we a Spanish banking authority. Gracias a dios!

The bigger picture is that distrust among European financial institutions over solvency seems to be growing, not dissolving. Three month Libor rates rose. And in plainer terms, risk aversion is the new black. Everyone’s doing…or not doing it actually.

For a country with a large foreign net debt and which is historically an importer of capital to finance, say, major mining projects, the prospect of another crisis in capital markets would be a worry. But not here. She’ll be right mate!

To be fair, and utterly serious, there is no evidence we have seen yet of Australian banks getting squeezed by a higher cost of foreign capital, much less cut off. But as mentioned yesterday, with over $150 billion in debt to roll over, there’s a lot of borrowing to do. And if it’s at higher costs than expected, it could crimp economic growth.

The larger issue is that nearly half of Australia’s net foreign debt – the total level of near 60% of GDP – is owned by institutions in the UK and the US. And $581 billion of Australia’s foreign debt is owned by private sector financial corporations (see the bottom of page 60.) Worse still, nearly $500 billion in foreign debt has a maturity of 90 days or less, meaning any large and sustained disruption to global credit markets would require some kind of local solution.

Local solution? That would again mean government guarantees of big bank borrowing. And if there is a phase two of the credit crisis and it’s worse than phase one, one wonders if you’d see debt monetisation right here in Australia. Would the central bank be forced to print money to buy corporate or housing debt for which there was no international market? Hmm.

What would that do to the Aussie gold price?

Finally, in the midst of all these theoretical questions about how Australia will fare in a future credit crisis, there is the second question we began the day with: was the Resource Super Profits Tax just a gimmick to paper over a big hole in the government’s budget and “pay” for increased super and a corporate tax cut?

Who knows at this point? But it’s clear that some elements of the tax policy were designed by people who have never run a mining company. Not that we have either, mind you. But we’ve been around them for awhile and understand something of the private sector. And in the private sector, you generally don’t invest in projects that you expect to fail. Nor do creditors lend you money on the basis that you might fail.

The government’s offer to subsidize 40% of losses on marginal projects is supposed to make marginal projects more economic. The government argues that these projects will be taxed at a lower level thanks to the ability to offset losses, and thus will encourage mining investment in marginal projects.

Just what we need! More marginal, low-profit resource projects!

A miner – indeed no entrepreneur – goes into business to make a marginal profit. He goes into business to make a big profit, knowing full well that everything is against him. The marketplace abhors a huge profit margin the way nature abhors a vacuum. Profits are a signal to other competitors to come in and provide a good or service at a cheaper price or in a better way.

The innovative entrepreneur captures big initial profits by taking big initial risks. His risk ends up benefitting everyone by luring other producers in. The end result for consumers is an industry or goods and services that didn’t exist before. That is a social benefit which does not accrue to a corporate bottom line.

In any event, in a world where public sector salaries are higher, the only real reason to stay in the private sector is that you have a business you want to be in and believe you can make more doing in that way. There are other more ethical and philosophical reasons too, of course. But the government inviting itself to be your partner in business is like a stranger inviting himself into your marriage bed.

He says it will subsidise your love-making on nights where you have poor performance, saving your marriage from trouble. And on magical nights, he’s …uh…just along for the ride. Because your marriage bed is in his jurisdiction, he’s entitled to his fair share of your marital bliss. And please scoot over would you? You’re hogging the doona.

Granted, there is a difference between a spouse and a non-renewable natural resource. Although now that we type that, we are less sure about it than when we first thought about it. But in our metaphor above, where the government intrudes into a pre-existing, consensual, private relationship, it’s pretty clear who’s getting.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning is the Editor-in-Chief of The Daily Reckoning Australia and the author of 2005’s best-selling The Bull Hunter (John Wiley & Sons). He began his financial publishing career in 1997 as a small-cap analyst. From 2000 to 2005 he was the managing editor of Strategic Investment, where he recommended gold and warned of the US housing bubble. Dan has covered financial markets from Baltimore, Paris, London and, beginning in 2005, Melbourne Australia, where he is the Publisher of Port Phillip Publishing. To follow Dan's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.

1 Comment

  1. Ross says:

    In Dan’s last statement is an implicit recognition of the status quo. But that status quo has the state with an existing rent/taxation interest. I agree with him that Henry’s measure is a grab. I agree with him that the GST process method is flawed. I am an investor in Ridley and they own Cheetham Salt and that will be a nightmare by my reckoning due the low value resource and the value adding. I haven’t heard from them yet on the issue but GPG are in there on the register and it shouldn’t be long. But I also believe in sovereign equity arrangements if a proper process can be found. On a large scale project basis in-country equity defined by a single foreign subsidiary’s activity the equity involvement is achievable as it has been with mid east oil except when Bush (HW & GW) mates refuse to “make nice”. But going across all sorts of resource commodities and mixes of projects and size of business is a fruit cake socialist plan. The bit about trickle down economics though ? Sheesh … hand Dan a calculator. His mate Ron Manners on the “no tax” for gold producers 20 years ago all over again, and the AU gold industry did what? And have a look at the Volcker/Reagan US gross national debt curve in the 80′s and you see it as steeper the Greenspan and even Bernanke’s. Reagan’s trickle down off Soviet busting military spending did what? Trickle down from a syringe into the sucker taxpayer you mean.

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