Feature Stories | Oct 30 2007
By Greg Peel
“There seems a good chance that the next downturn in the developed economies will be the most severe in a generation – with a non-trivial risk that it could eclipse anything seen in the post-war period.” Gerard Minack, Morgan Stanley, August 31, 2007.
“In 2007, householders in “Cabbage-ville USA” failed to make payments, triggering a global credit crisis. Markets ruminated about “a re-pricing of risk”. The faux “business as usual” calm masked the fact that the problems threaten to be the single largest credit crisis since the Savings & Loans collapse in the USA in the 1980s.” Satyajit Das, financial consultant and author of “Traders, Guns & Money”, September 5, 2007.
“For investors in commercial and investment banks, the question becomes whether there will be more bad news on write-down in fixed income assets tied to mortgages. Companies like Bank of America, Citigroup, and Merrill Lynch have already taken huge hits in earnings. And, that may only be the beginning of it.” Douglas A. McIntyre, Dow Jones, October 25, 2007.
“Over the last twenty years, the proportion of household mortgage borrowing that financed the construction of new houses [in Australia] fell from a high of 27.1% to a pitiful low of 6.7%. The household sector has borrowed, but not in general invested.” Dr Steve Keen, University of Western Sydney, October, 2007.
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A False Dawn
On October 25, Merrill Lynch – one of America’s leading investment banks – posted a third quarter loss of US$2.24 billion. This was the biggest quarterly loss in the company’s history. Most notable within the result was a write-down in the value of structured financial assets, such as mortgage-backed CDOs, of US$7.9 billion.
Merrills’ third quarter result was by far the worst among the leading US investment banks and brokerages. The bank’s US$7.9 billion compared to equivalent write-downs from Citigroup (US$3.2bn), JP Morgan (US$1.7bn), Goldman Sachs (US$1.5bn), Bank of America (US$1.4bn), Wachovia (US$1.3bn), Morgan Stanley (US$940m), Lehman Bros (US$700m), and Bear Stearns (US$700m). And the losses weren’t confined simply to the US. Globally, Switzerland’s UBS wrote down US$3.4bn and Germany’s Deutsche Bank US$3.1bn, to name but two.
At the beginnings of the credit crunch, Fed chairman Ben Bernanke suggested losses ultimately emanating in the subprime crisis could reach as much as US$50-100 billion. By the time the Fed made its historic 50 point rate cut, Bernanke was suggesting losses in excess of US$100 billion. This month the New York times has reported economists suggesting total losses could be more like US$400 billion. The figure includes losses in home values and nearly $72 billion in sub-prime foreclosures between now and the end of next year.
Why the uncertainty? Because the world still does not know what a mortgage-backed security is actually worth. A typical security used to be held to its maturity of five years without ever being re-sold. No two mortgage-backed securities are necessarily alike, and hence there is no homogeneity in the market. This also means there is no exchange trading of such securities, no transparency, and no specific register of who holds what and how many. Under US Securities Exchange Commission rules, all securities must be “marked to market” at the end of an accounting period. Under US Financial Accounting Standard Board rules, entities are permitted, in the absence of any visible market, to mark valuations to a best guess.
What makes the Merrill Lynch result even more unsettling is that as recently as October 5 Merrill’s CEO announced an expected loss figure that was ultimately one sixth of the announced result. What could happen in 20 days? Apparently Merrills went looking for buyers for some of its troubled assets, and received a bit of a shock. Stock analysts at Goldman Sachs are now advising that Merrills could yet write off another US$4.5 billion in asset values in the fourth quarter. Merrills’ guidance suggested that not only would the fourth quarter also be troublesome, but that 2008 was not generally looking all that flash either.
When Citigroup pre-announced its third quarter profit expectations at the beginning of October, management painted a much rosier picture for the fourth quarter, implying all the bad news would be exposed and dealt with in quarter three. However, when the bank released its actual result on October 15 management had withdrawn those comments. Reuters reported Citi CFO Gary Crittenden as suggesting US consumer credit should weaken this [fourth] quarter after mortgage delinquencies accelerated, and that for some fixed-income products, “we’re not optimistic that they will regain a foothold.”
Financial traders across the globe had initially been pleased when the first third quarter profit numbers were released by the US financial sector. They were pleasing because they were very bad – so bad that the conclusion could only be that each entity had “brought out the kitchen sink”, meaning every distressed asset had been exposed, priced, and written down. Provisions had even been made to cover anticipated losses from loans yet to turn bad. The credit crunch had, supposedly, been laid to rest in the third quarter. Financial sector stock prices had been sold down significantly, and justifiably, but now we could start again with a clean slate.
But then came Citigroup, and its warnings of more pain to be expected in the next quarter, and the next. Then came Merrill Lynch, and the world could no longer assume the credit crunch problems to be over. And we are yet to hear from many of the European banks and brokerages, where a good deal of distressed securities are assumed to lie.
Holders of distressed securities have been hoping, perhaps praying, that if they can hold on long enough a market will soon emerge. To sell at the height of the credit crunch would have been disastrous – indeed, there were simply no buyers. That is why many a hedge fund froze redemptions, which would otherwise have forced the sale of assets, and banks brought the assets of their structured investment vehicles onto their balance sheets, where they could happily mark-to model (or mark-to-myth as cynics suggest) and eventually ride out the pain.
On September 18, the Fed cut its cash rate from 5.25% to 4.75%. Many expect that on October 31 the Fed will again cut the rate, to 4.50% or even 4.25%. This drastic action was intended to unfreeze credit markets and potentially avert a credit-led US recession. US stock markets have responded with abject joy, safe in the knowledge that they can happily invest with a “Bernanke put” in place. This implies that no matter how bad things look, the Fed will come to the rescue. The same was made of the “Greenspan put” in 2001, when then Fed chairman Alan Greenspan reacted to the tech wreck and 9/11 by similarly cutting rates and reigniting the market.
A retired Greenspan is no longer happy, on reflection, with his actions. He now realises what he didn’t realise back in 2001 – that his decision would spark one of the greatest periods of global excess liquidity in history, which would subsequently lead to the subprime mortgage crisis. Greenspan is also critical of an initiative orchestrated by US Treasury secretary Hank Paulson that sees US investment banks collectively pull together some US$75 billion or more to artificially prop up the mortgage security market. The danger is that if one entity tries to sell, a panicked and devastating selling rush will follow. This fighting fund attempts to put a floor under that market. But Greenspan believes the “vultures” have an important role, and must be left to their job.
The “vultures” are those traders who are prepared to step in and buy distressed assets at a significant discount, in the hope that value will eventually return. While there is an fighting fund in place, the vultures will not enter the market, says Greenspan. Thus true market valuations will never be discovered, and uncertainty will never go away. Ironically, the vultures were hard at work buying up next to worthless Russian sovereign debt in the late nineties. One of the biggest players was Long Term Capital Management. When Russia defaulted, Greenspan had to orchestrate a bail-out of LTCM, lest the entire global financial system collapsed.
On October 26, ratings agency Moody’s announced it had downgraded US$33 billion of previously AAA-rated mortgage CDOs to “junk”. This is the most recent in a long period of asset downgrading from all ratings agencies that began earlier in 2007 and has since accelerated. It is unclear when it will end. While re-rating mortgage securities may be a step towards sensible reality, it causes all sorts of problems for holders of CDOs.
The Trojan Horse
Australian Satyajit Das has spent 25 years in the financial markets working for Commonwealth Bank of Australia, Citicorp Investment Bank, Merrill Lynch and the TNT Group. His financial commentary is respected across the globe. In his September paper entitled “Credit Crunch – The New Diet Snack for Financial Markets” he related, in his typically knockabout style, a question asked of him recently by a German banker:
“Vot does a poor American defaulting in Looneyville, West Virginia, have to do vith me?”. [And yes – there is a Looneyville in West Virginia.]
This question sums up an awful lot about the global credit crunch and its origins in the US subprime crisis. Its answer could be a text book case study in chaos theory. But in order to begin to understand the answer, let’s start with two simple facts: (1) At the end of 2006 there were US$485 trillion worth of outstanding financial derivative positions held across the globe (the total global GDP was around US$60 trillion); (2) most people in the world, including those who sell, buy, and rate financial derivatives, don’t always understand them.
Take mortgage-backed collateralised debt obligations (CDOs) for example. One might say that at the end of 2006 the number of people in the world who honestly understood CDOs could arguably have all met in a small university theatrette. It would be an apt location, because the CDO is the epitome of what twenty-first century financial derivatives have become – highly complex instruments that could never have come about but for the marriage of highly complex mathematical algorithms, twenty-first century computing power, and money. CDO holdings have nevertheless sprung up in locations across the globe – from the US to Europe, Asia and Australia – just like some new strain of globally transported influenza virus.
If we needed any proof of the assertion that very few people understood the CDOs they were trading in, we need only look at our German friend’s comment above, or indeed the news that Moody’s is now re-rating AAA securities to junk.
While CDOs might be the creation of mathematical PHDs, it helps to at least appreciate the crucial elements. Satyajit Das provides a simplified example which has been adapted here. One must first appreciate that while once upon a time banks took in deposits and then offered loans to customers, in this day and age banks package up their loans and on-sell them to investors.
Take a $100 million loan portfolio made up of 100 loans of $1 million each. Assume that if any one loan defaults, the investor loses 60% of that loan, or $600,000. An investor buys a share in the portfolio worth $2 million, or 2% of the portfolio.
If the investor’s share represented 2% of the entire portfolio, and 3 loans defaulted, the investor would lose 2% of $600,000 times 3, or $36,000. Banks work on a basis that in any given portfolio of loans, a small percentage will default. But that’s okay when you are diversified across 100 loans.
A mortgage CDO, however, does not work like that. Rather than offer investment across the whole portfolio, the bank splits up the portfolio into three tranches, allowing investors to specifically invest in one of the three tranches. In a mortgage CDO, those tranches represent “senior debt” made up of prime, high-deposit, full documentation loans; “mezzanine debt”, made up of lesser deposit, less documentation loans; and “equity”, made up of no deposit, no documentation subprime loans. A typical CDO might contain 78% of the senior tranche, 15% of the mezzanine tranche, and 2% of the equity tranche.
Under this arrangement, tranche holders only lose when a loan in their tranche defaults. They are protected from losses in other tranches. But as logic would dictate, the subprime loans are most likely to default, followed by the mezzanine. Prime loans are not very likely to default.
Let’s now say the same 3 loans defaulted (as above). No surprises that they are all subprime. More than 2 defaults is enough to wipe out the equity tranche, so the equity investors blow their money. Instead of losing $36,000 the investor has lost $2 million. That’s nearly 56 times the amount of loss. The mezzanine investor is still in the game, as only 1 of the 15 loans has defaulted. The senior investors are not concerned.
Why invest in the equity tranche if you can be blown away so easily? Well the simple answer is that that particular tranche offers a higher rate of return than the others to compensate for the risk. The mezzanine level return is less, and the senior return is the least. But it gets more complicated than that.
While you may only be investing in one tranche, your ultimate investment is in part of the entire portfolio. Because the tranches represent three differing levels of return, the bank can tweak those returns so that they are slightly more evenly distributed. In other words, the senior debt investor can receive a better return than other comparable assets are paying. The subprime loans, or equity tranche, would be rated as “junk” by a ratings agency, while mezzanine might attract an A or AA. The senior tranche would be straight AAA.
Because the CDO offers a higher return than comparable assets for the AAA tranche, the creator of the CDO created the first ever high-yielding AAA security. Suffice to say, investors across the globe just could not get enough of them.
But whenever something looks too good, there is always a catch. One market commentator has described CDOs as “hookers in nine inch stilettos”, another as “pigs with lipstick”. The catch comes in the form of the collateral.
A ratings agency will provide a AAA rating as long as the collateral is sufficient against the loan. If that collateral falls in value, so should the rating. The offsetting factor about a collateralised debt obligation is that while the returns and risks may be divided into tranches, the collateral is not. As soon as any loan in the portfolio defaults, the value of the collateral of the entire CDO diminishes. If 17 out of 100 loans in this portfolio defaulted, the senior investor is still protected, but the collateral has reduced considerably. A ratings agency can thus no longer ascribe a AAA rating.
If a security is downgrading in rating, it immediately falls in price. While most hedge funds can be relatively fluid with their investment decisions, investors such as pension funds set strict limits on investments of differing grades. If an asset is downgraded, then a pension fund may be obliged under its own rules to divest. In this case, not only has the asset fallen in price, it must also now be sold, thus putting more pressure on the price.
But the hedge fund will likely have a bigger problem. In order to invest in the CDO, the hedge fund would have put up some cash as its own collateral with a bank, and the bank could well have lent the fund six, seven, perhaps ten times that deposit. This is the dreaded “leverage”. Mind you, what is a mortgage if not the ultimate leveraged loan? So now the hedge fund, in our example, is no longer looking at simply blowing $2 million in cash. It might be looking at having to pay the bank back $1.8 million it doesn’t have. The irony is, in many cases it would be the same bank that created the CDO in the first place.
And many who invested in the supposedly AAA tranches are highly leveraged as well. Why wouldn’t you be? A CDO allows you to borrow money at AAA rates and invest in another AAA security paying a higher return. It was money for jam. And by 2004, Greenspan had lowered the US cash rate to 1%. Money was virtually free.
But a hedge fund holding CDOs in 2007 that have been downgraded in value must also sell to pay the bank. That hedge fund may be located in New York, Berlin, Tokyo or Sydney. If no one wants to buy, the hedge fund is in trouble. The bank is also in trouble. That is why our German banker has been ultimately caught out by the default of a subprime mortgage in Looneyville, West Virginia. It is chaos theory at its best.
While anyone in the world might have reasonable assumed the US property boom must one day come to an end, there were clearly very few in the world that realised what effect a US housing downturn might ultimately have on the value of their asset-backed security portfolios, or indeed on the value of their entire balance sheets. Those few clearly did not include, for example, the global CEO of Merrill Lynch. As Satyajit Das suggests: “A feature of credit investing was that the complexity and risk of structures was inversely related to the understanding of the investor being sold it”.
Supply-side Economics
Economic theory could arguably be divided into two camps – “demand-side”, or “build a better mouse trap and the world will beat a path to your door”, and “supply-side”, or “if you build it they will come”. Take potatoes for instance. The world “needs” potatoes so if you grow and sell potatoes you are satisfying a “demand”. The world, however, does not “need” French Fries but if you “supply” French Fries then you will create a demand.
In the good old days, as now, people needed a house. But the only way they were ever going to buy one was to get a mortgage. Banks satisfied this demand by offering mortgage loans. In the twenty-first century, there has been such a supply of money that banks needed a way to recycle that into profits. Hence non-banks and mortgage brokers got into the act, and eventually banks as well, supplying cheap and easy mortgages that were just too tempting for those who knew they shouldn’t. Financial French Fries.
Only this week in Australia, the Financial Sector Union is railing against the latest practice of banks linking their sales employees remuneration to the number of credit products they can sell. This is exactly the sort of system that caused the US subprime crisis.
So abundant has liquidity been in the twenty-first century that banks and other financial institutions have been at pains to come up with ways to compete with each other and turn a profit. One way is to create more and more variations of investment instruments which have become more and more complex. The CDO is a classic example. While most new derivative products take a while to catch on, CDOs were “the bomb”. Volumes went from nothing to massive overnight. But while the supply of CDOs had created its own demand, soon demand for CDOs outpaced supply. At the end of the day, most people do not buy a house more than once or twice in a lifetime.
The only way to supply CDOs with mortgages was to create more mortgages, and the only way to create more mortgages was to start relaxing some of the previously strict credit record and income requirements. The industry saw the rise of the mortgage broker, who could run around selling a financial institution’s mortgages and receive a commission. The more mortgages they sold, the more commission they would earn. These mortgages would then be warehoused by a security “originator” such as a bank or non-bank lender, and reconstituted into CDOs. As competition became more and more fierce, the US saw the advent of the NINJA mortgage – no income, no job or assets. Creditworthiness had reached rock bottom. NINJA loans were basically fraudulent, because a lending institution required the homebuyer to at least have a job. Stories are now emerging that mortgage brokers were submitting applications to lenders with fictitious jobs pencilled in, and that the homebuyer knew nothing about it.
For the real dregs of uncreditworthy homebuyers, there was really nothing to be concerned about. You got to own your own house. You tried to make some payments but if you couldn’t, you didn’t. It takes 90 days of delinquency before a loan can move to default, and then another period of time after that before the bank can actually evict you. At that point, having paid nothing, you simply walk away. You never worry about your credit record because you never had one in the first place.
But for many lower income Americans it was not just about getting something for nothing. There are plenty of well-intentioned homebuyers who simply did not understand what they were getting themselves into, but who were lured by teaser rates of as low as 1% interest for 18 months or so. When these rates reset, they can reset up to 10% or more, and we haven’t yet hit the peak of mortgage resetting. What’s more, many of these loans were also “neg-am”, or “negative amortisation”. Normally a mortgage payment will pay off interest and part of the principal. The amount of principal paid off accelerates towards the end of the loan. However with neg-am, mortgage sellers compensated for teaser rates by reversing the principal reduction – the principal actually grows as you move into time. Higher rate + more principal = ultimate default, but well intentioned buyers were simply ignorant of such things. And could sellers care? More sales – more commissions.
None of these dodgy mortgage products would have been much of a problem if US housing prices had simply kept going up. If you fell into delinquency you could always just sell the house for a profit. But US housing prices were being pushed up not just by simple demand, but by demand created by the supply of cheap mortgages. This could not last forever, and it hasn’t. When the US housing market began its inevitable pullback, the first defaults came in. But the structure of dodgy mortgage finance has started a mad rush to get out. The US housing slump is now the worst seen since the depression and, if anything, it is getting worse still.
Many US mortgage brokers are now gone. Many writers of mortgages, originators of mortgage securities and traders of CDOs are now gone. The CEO of Merrill Lynch will soon be gone. All were caught up in a typical financial market bubble, one fuelled by the usual greed. A low income American who wanted a McMansion would go to a mortgage broker who would provide the mortgage and then on-sell it to a mortgage originator, such as a bank, for a profit. The bank would package up the mortgages into a CDO and then sell them off to hedge funds for a profit. The hedge fund would borrow money from the same bank to leverage up its investment and make a profit. Somewhere in the world an individual was invested in that hedge fund – from Looneyville to you.
But another little complication, that many didn’t realise, was that when the mortgage broker sold a mortgage to a bank the broker still retained the risk on that mortgage. That is why mortgage brokers in the US, who were only really playing a margin, have been decimated. And that is why the value of CDOs began to collapse. But still we have the problem of no one knowing for sure where these CDOs are.
But banks know where they are – or at least where their own holdings are. For banks (which have already been involved twice in the “flow chart” above), were also investors in CDOs. Banks have access to cheaper funds than independent hedge funds, so why let hedge funds make all the money? Banks invested in CDOs by first creating entities known as “structured investment vehicles” (SIV) or “conduits”. Within these constructs banks could buy AAA CDOs funded with the issuance of their own short term corporate paper. But in order to avoid capital adequacy complications, these entities were moved off balance sheet. That’s another reason one knows who has what, because holdings do not appear in public financials statements.
It is because no one knew who had what that the global credit market completely froze in August. Who could you trust? As Satyajit Das put it: “In the new money game, banks increased loan volumes, reduced capital available to absorb risk and lowered the credit quality of their loans all at the same time”.
The US corporate paper market is currently worth (or was worth) some US$2.2 trillion. Of that, 53% is asset-backed paper (as opposed to traditional borrowing over corporate cashflow). Of that 53%, half are mortgage assets.
But mortgage assets were not the only form of CDO. There have been CDOs created over all sorts of different types of loans. Once again, supply created demand but then demand created supply. But there is another, quite amazing, story of derivatives that are just plain “wrong”. That is an instrument known as the credit default swap (CDS).
In another case of supplying the market with something it will then demand, the credit default swap was created to give holders of corporate bonds (ie “lenders” to companies, such as a bank) protection against that company defaulting. An investor could “sell” the lender protection by charging a fee and then taking on the default risk. But like any good derivative, only a proportion of the face value needed to be put up. This allowed, once again, leverage. But what it also meant was there were more CDS instruments out there than actual bonds. General Motors has US$130 million in debt, but the amount of swaps on that debt in the marketplace amounts to some six to ten times that amount.
Which begs the question, what would happen if the General defaulted? (This is not beyond the realms). There would be more claims of protection on the debt than the debt itself, and not enough actual bonds to deliver. And the CDS market has also grown enormously.
This is the sort of market madness we have found ourselves immersed in in the twenty-first century. It all started with cheap money. And now, as the US faces the prospect of suffering for its greed, stupidity and fraudulence, the Federal reserve has cut the cash rate once, and will likely do so again.
The Debt Addiction
“The new liquidity factory is self-perpetuating. If you bought assets with borrowings then as the asset went up in price you borrowed more money against it. In an accelerating spiral, asset prices rise as debt fuels demand for the asset. higher prices decrease the returns forcing investors to borrow more to increase returns. Bankers become adept at stripping money out of existing assets that had appreciated in price, such as homes. In the USA, UK and Australia – the ‘fast debt’ nations – home equity borrowing funded a frantic debt addiction.” Satyajit Das
The home equity loan is a classic excess liquidity invention. You have a mortgage on your home, the value of your home has gone up, so why not borrow more against that (unrealised) value? Why not “leverage up” in the good times?
“On almost all the measures I know, private sector leverage is at generational, or all-time highs”, noted Morgan Stanley’s Gerard Minack is his Downunder Daily at the end of August. He points out that the US debt-to-GDP ratio now exceeds the peak that preceded the Great Depression. Australian debt is likewise at unprecedented levels.
One simple reason that debt levels have risen so high is that interest rates have fallen so low. This is Reserve Bank of Australia Glenn Stevens’ argument – high debt levels are not as risky when interest rates are low, because the interest payments are roughly the same as they were when rates were high but debt was low. But debt service levels in both countries have also risen (that is, the proportion of income needed to service debt). This means that the increase in leverage has actually exceeded the decline in rates.
While this may somewhat put paid to Stevens’ argument, his deputy Ric Battellino noted in an address recently that apart from a few problem areas such as Sydney’s western suburbs, the excessive debt in the housing market is being held by wealthier middle class investors who have the sort of job security to be well covered. In other words – nothing to worry about. From the wider perspective, economists can argue that Australia’s historically low unemployment rate means not only job security but rising wages, which again means the capacity to service additional debt. And the economy continues to boom.
This is all okay as long as nothing turns up to upset the economic conditions. But the truth is that existence of excess leverage in the market is less of a problem, as Minack suggests, when interest rates are high, not low. If the economy gets itself into trouble when rates are high, then there’s plenty of scope to short-circuit the problem by cutting rates. But rates are still currently around historically low levels.
Minack notes that over the past 25 years in the US, each successive interest rate peak has been lower than the one before. If we have now seen the latest cycle peak in US rates, it will be the lowest since 1959. This means long rates – those on which US mortgage rates are based – are also historically low. Indeed, long rates are trading in the range seen in the 1920s. If US mortgage holders get themselves into trouble, then high long rates provide scope for refinancing that will prevent spiralling disaster. But when rates are low there is very little room to move. As Minack puts it, “the bullets that the Fed fired in the last cycle have not been reloaded”.
Then throw in the unsettling reality that US households have no savings. Current household sector cashflows are negative. Thus the only way to avoid taking on more debt is to cut spending, and the only way to reduce debt is to cut spending sharply. And add in that the US is now an external creditor – it has a large current account deficit. When the US has suffered hard economic landings in the past it has been an external creditor. Once again, flexibility in the face of a credit crunch is reduced. The US GDP is 75% reliant on consumer spending.
Minack believes the next downturn in developed economies will eclipse anything seen in the post-war period. He doesn’t, however, believe the downturn will happen tomorrow, or indeed, “I don’t think it’s a story for this year”. Currently, Gerard Minack is bullish.
Australian Immunity?
“Australia’s level of irresponsible lending isn’t as high as that which brought on the US subprime crisis, but because of our rate of increase in debt is so much higher, the impact of any slowdown will be more severe here – and the pain will be much more widely spread” Dr Steve Keen; “Deeper in Debt – Australia’s Addiction to Borrowed Money”; September 2007.
Dr Steve Keen of the University of Western Sydney notes Australia’s private debt to GDP ratio has now reached 156%. Before the 1930s Great Depression that ratio reached around 80%. Before the significant depression of the 1890s it peaked at 100%. Last year, the increase in national private debt accounted for a full 16% of GDP. As a result, Australian households are now poorer after interest payments than they were in 2002. One side of politics is suggesting Australians have “never had it so good”. Many Australians are wondering just what this “good” is.
As interest rates have risen, the number of mortgage defaults in Australia has begun to rise. The country has undergone an unprecedented housing boom. House prices have more than doubled in the last 20 years, far outstripping real wages or rental returns. While the housing boom has now come off the boil in many areas, Australia has not suffered anything like the slump in prices now being witnessed in the US. One reason for this is that Australia did not sink to the same murky depths of subprime lending.
But the housing “boom” in Australia actually created very few houses. Nor did it create very many new homeowners. Dr Keen notes that 20 years ago the proportion of mortgage borrowing that financed the construction of new homes was 27.1%, but today that figure has fallen to 6.7%. What this means is that the spectacular rise in house prices is not related purely to a greater demand for houses. It is mostly related to existing homeowners moving up the scale, and investors buying more than one property. The capacity to do so has been provided by easy access to finance. It is the supply of money that has created the demand for houses, thus pushing up prices. As debt levels amongst homeowners has increased dramatically, net equity in housing has actually fallen.
“Rising house prices do not in themselves create wealth”, suggests Dr Keen. There have been many who have profited from playing the market – buying cheaply and then riding the boom to then sell again. But for most Australians its been about borrowing big to buy someone else’s house as their place of residence, or as their investment nest egg. “And we’ve blown a large chunk of our record borrowings on speculation”.
RBA deputy governor Battellino has called the availability of cheap money “the democratisation of finance”. He does not believe such democratisation has yet run its course. Eventually, household debt will reach a point where it is in some form of equilibrium relative to GDP or income, said Batteliino, but the evidence suggests that this point is higher than current levels. In other words, there is a point at which Australians cannot stray beyond in terms of the extent of their borrowings, for they will not be able to pay the interest and still feed themselves.
Dr Keen notes that we have not yet reached the point of the “crushing” interest payment burden of 1990 (when the cash rate was 17% and mortgage rates 20%), but if debt levels keep growing at the current rate we’ll be there in 18 months. The fallout from 1990 debt levels was a severe recession. Back then it was corporate Australia that went to the wall – Bond, Bell, FAI and Quintex to name but a handful. It was corporate Australia that had overstretched its debt capacity, and corporate Australia has since learnt its lesson. But in the twenty-first century, it is the turn of the household sector to be up to its neck in debt, with increasingly less room to move.
One way to alleviate Australia’s debt burden is to lower interest rates. At present, however, with underlying inflation running at close to 3%, and energy and food prices going through the roof, the RBA is expected to raise rates more than once by the first quarter of 2008. The RBA last raised rates in August, for the first time in nine months. typically a rate rise takes some time to filter through the system, although variable rate mortgage holders are immediate hit with a payment increase. But mortgage rates have also risen independently of the official cash rate – by as little as 5 basis points for the big banks and up to 30 basis points for non-bank lenders. These increases have come about simply because of the widening of global credit spreads – a result of the credit crunch precipitated from Looneyville, West Virginia.
And evidence is now mounting that the credit crunch is far from over.