The Second Coming of Subprime

The Second Coming of Subprime

Do you remember when subprime loans were a small problem in an obscure part of the US mortgage market?

Next thing, all hell broke loose…

Well, today we investigate a similar scenario.

At first, it appears to be a small problem in an obscure part of the Australian mortgage market. The only problem is that it’s not small.

In fact, Australia’s banks have the potential to trigger a global contagion thanks to their reliance on overseas funding.

I’ll explain…

The Truth behind Australia’s Trillion Dollar ‘Debt Bomb’…

...and the Hidden Opportunity

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We’re at record levels in this country.

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The basic idea is that Australian banks ignore lending standards.

If you lack the income needed to buy a house in Australia, your mortgage broker may just stick a ‘1’ in front of your income on the paperwork. You can then afford your dream home with the additional $100,000 in income, at least as far as the bank is concerned. Sometimes they’ll even use a different coloured pen when they make their amendments.

The loan application form will then be sent to the bank, where people who don’t speak English verify everything is in order. As part of the Royal Commission into banking, one lender has confirmed it didn’t verify mortgage broker claims because it would be ‘too complex, time consuming, and costly’.

They didn’t think of hiring cheap foreign labour like their competitors — that would be too honest.

If the borrower still didn’t qualify for the loan after the mortgage broker’s adjustments, the banker would call up the broker to request further ‘amendments’ to the paperwork. They would then question why the mortgage broker hadn’t manipulated the statement as they were trained to do by the bank in the first place.

Adding in a spouse’s imaginary income and signing off for them was a possible follow-up solution. Or the bankers would just do it all themselves.

One banker charged $2,800 for the service of providing false documentation, which is ironic given how much banks rely on such information. This particular bribery scheme was operating across multiple bank branches. It was also probably unnecessary given the lack of verification the back office performed. What a rip-off!

And now, hilariously, the banks plan on tightening in-house lending standards that they openly ignore. This is like closing the barn door on a stall that doesn’t have any walls.

Dodgy loans creates global market panic

The key question here is how common this practice is. But consider how hard that’d be to establish.

Imagine going back through the loan application documentation of a borrower a few years ago and trying to compare it to their financial position at the time. It’d take hours for each person, presuming the bank deigned to provide the information — which they tend to resist in surprisingly creative ways.

Over in the US, an analysis comparing tax filings with loan application forms found a huge divergence between income. But the same study hasn’t been done in Australia.

So the estimates for how bad the problem is rely on surveys. And those vary wildly.

Personally, I think the problem is big enough to cause a major crash in Australia’s financial system — one that goes global.

A crash that goes global.

It’s not just lending standards that are iffy. After 26 years without a recession, Australia’s economy doesn’t really know what a downturn is any more. Our lending habits reflect that.

One academic at a top Australian university recently pointed out that Australian banks lend 25% more than US banks to comparable customers, often using falsified and inaccurate information.

Interest-only loans reach as high as 40% of loans for some major banks. And in the next three years, a huge portion of those interest-only loans reset to higher interest rates. That’s what snapped the US mortgage market in 2006.

The contagion effect is pretty straightforward. Australian banks rely on offshore funding. This is a double-edged sword.

First, it means any trouble in the Aussie banking system spreads overseas.

Second, overseas sources of capital could dry up at the slightest sign of trouble, dramatically worsening the situation.

Put the spiralling effect of the two together and you realise that Australia and its financiers overseas are in deep trouble.

The power of rising house prices

Why on Earth do Australian lenders behave in such awful ways? Well, as long as house prices rise, it’s a win-win-win scenario.

The lender has a rising collateral value, which de-risks the lending proposition. They don’t mind if the borrower defaults if they can claim a house that’s going to be worth more than the mortgage.

Clueless borrowers actually make a profit out of unaffordable lending. By the time they sell or get foreclosed upon, the increase in the house price is a windfall gain.

And mortgage brokers’ sins remain hidden because their dodgy practices are never uncovered at any stage of this process.

It’s only when house prices fall that the whole story reverts.

Suddenly, lending risk is determined by default risk, not collateral risk. The probability of default is what matters when the value of your collateral is declining.

Borrowers find themselves underwater, owing money even after selling the house.

And mortgage brokers’ manipulations are exposed.

But here’s the kicker…something that makes Australia unique…and uniquely risky for the global financial system.

If a borrower can prove they’re a victim of these practices, they can often cancel the loan and keep the house. Yes, a free house.

That also means the bank has to write off the entire loan, which is a huge loss. This was not how things unfolded in the US, where borrowers took the loss.

The problem facing Australia’s banks is therefore orders of magnitude bigger than what US banks faced in 2008.

Once the markets realise this, they’ll react very badly to any signs of housing price drops in Australia.

And those signs just hit the newsreels, with the major cities seeing house prices drop.

The world is about to discover who has been swimming naked in the Australian housing market. And it could unleash panic that goes global.

Until next time,

Nick Hubble Signature

Nick Hubble,
For The Daily Reckoning Australia