Former Prime Minister Paul Keating spoke this morning with the ABC radio’s Ali Moore (listen to the audio here ):

ALI MOORE: Can I start by asking you the question that is on everyone’s lips, do you think that we’ll get half a per cent rate cut today but mortgage holders will only see a bit of it?

PAUL KEATING: Oh I think so, probably. I think we probably will get the half from the – from the central bank. But I think our banks, the four banks will probably pass on – we’ll just see whether it’s uniform, whether what they pass on is equal across the four of them or whether they vary in some way. But I doubt it would be the full 0.5.

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MOORE: What do you make of what’s happened overnight? Do you think that it’ll eventually work its way through the system or that the $700 billion record – rescue package is being looked at fundamentally as not up to the job?

KEATING: Well the great problem in the United States is the level of – the level of housing debt which is about $13 trillion from memory and where – where valuations are. And there’s a gap between the valuations and the debt. And that gap is greater, of course, than the size of the package provided by the Congress.

It’s a bit like, I think, it’s a bit like lending a car owner, you can imagine a car having been jacked, you pull the jack out and it falls quickly and violently. But if you can ratchet it down you can move a big weight down.

I think basically the $700 billion is ratchet money. It’s – it’s not to solve the problem absolutely, because the problem can only be solved when we have an equalisation of – of debt and equity in the United States across its housing market.

MOORE: Isn’t part of the problem though, also, that as this car’s being ratcheted down it’s sort of knocking a whole lot of other cars that are parked around it? Because if you look at what’s happening in Europe and indeed here, I mean, well certainly not the banking sector here, but we’ve seen the collapses in the banking sector spread.

KEATING: Well that’s right. Because what happened, you see, the ratings agencies, Moody’s and Standard & Poors were out there taking fees from issuers of debt which they gave – this is a sub-prime debt, housing debt – which they gave investment grade status to. And it was that investment grade status that allowed the big investment banks, with the enormous muscular horsepower they had to basically sell those – sell those securities into every nook and cranny of the market.

Now, you know, part of the problem in the United States is that the rating agencies were compromised by this process. These are the very same rating agencies who are out there telling the Australian States what they should and shouldn’t be spending. I mean they’re quite disgraceful in their behaviour and they have, you know, granted investment grade status to these things and then they’ve been sliced and diced by the institutions into these collateralised debt obligations or CDOs. So you actually buy a piece of … a decimal point of some security and it may be a very big security so the decimal point is a very large amount of money, but there’s no direct access or call on the asset. The asset is kind of collateralised.

So it was a very big — a very big thing. And it was done by the big investment banks who went out of their traditional area of lending to business and advising business who then decided to get into the sort of money-making caper of selling these mortgages to the investment fund industry round the world after they’d been given investment grade status by the rating agencies.

MOORE: And indeed, as you say, it’s around the world. You talk there about the collateralised debt obligations and what was packaged up and sold around the world. In that context and given people’s wariness now of financial engineering, how do you see your proposal working, of superannuation money going into mortgage funding, which on the face of it would seem to make a lot of sense? But people are obviously going to be wary given this whole thing started with sub-prime debt in the US.

KEATING: Well exactly and that’s, that’s – you see at the moment, Ali, we have a thousand, a thousand billion in superannuation assets and – and, you know, the key to all wealth is about asset allocation. So fund managers and trustees of those superannuation funds would determine that so much of that went to equities, so much went to property so much went to cash … For property they’ve mostly invested in real estate investments trusts because they’ve been liquid. So you can pick up the phone to a broker and you can sell units in a real estate investment trust and – and have cash overnight.

So super funds have found them a sort – for the property component of their allocation, they’ve found them a useful thing to do.

The problem is they’ve fallen now, except for Westfield and Stockland, the rest have fallen, on average, 74 per cent in the last six months. And they’ve fallen because they themselves are very highly geared. And so the market is walking away from highly geared institutions even if they nominally have good solid assets underneath them. But they’re good solid assets that are – that are heavily geared. So REITS as the call them, real estate investment trusts, have taken a huge knock.

MOORE: So how do you get the money directly into mortgages because you can’t obviously do one on one deals?

KEATING: No, what you do is basically this, that the industry has got to be encouraged, that is that’s the funds management and trustee’s structure, have got to be encouraged not simply to invest in the more liquid real estate investment trust unit but the – but the more – the more illiquid but nevertheless solid prime mortgages of Australia.

I mean what you need to do in things like superannuation is you’ve got long term liabilities of somebody’s superannuation in retirement, so you need to match them off with long term investments and long – long term assets on the other side of the ledger. That – the perfect ones here, well to give an example, at the moment of course a mortgage is eight and half per cent. So if you have your super fund, wouldn’t you rather have eight and a half per cent coming from a high quality mortgage in Australia than you would minus five or minus six which is the outcome for this year in super funds?

MOORE: You’d want to know that your high quality mortgage was indeed high quality and not just what Standard & Poor’s have told you was high quality a year ago.

KEATING: Well that’s why we don’t need those donkeys in the United States, rating agencies, telling us what we should be doing. I mean, fundamentally APRA, the Australian Prudential Management Authority and the Reserve Bank and the government and the banking industry can – could agree on what, and they already have let me say, on what is a AAA based mortgage, it can be 50 per cent equity or 50 per cent debt.

Now nobody is going to let their property go if they’ve got 50 per cent equity in it or 60 per cent equity or whatever, because they’re going to let the mortgage default. So the default rate in mortgages of this quality is sort of as a decimal point, you know, 0.00 something, it’s virtually nil.

So therefore — therefore if we had, let’s make it simple, 100 million of mortgages which have got a bond on the top and that bond is traded and that bond’s invested in via super fund, well of course that’s — that’s a solid, that’s a truly solid asset.

The problem is there’s no liquid market for them. So the super funds stay away from them and my — part of my proposal is, and when I say proposal, it’s a – it’s thinking off the top of my head, but then when I started with super I started virtually with nothing, back in the middle-’80s. So you’ve got to imagine things to be better.

That is if the central bank, the Reserve Bank, were to take mortgage, Australian mortgage bonds into its repurchasing operations as part of the official repo process to fund – to fund the cash in the economy.

MOORE: They’d then be considered a more secure and liquid investment wouldn’t they?

KEATING: Well it means that the super funds could turn them, back them if they feel, you know, worried about them. In other words, once they become an official asset they start moving. Now you say, oh well that, you know, why hasn’t that happened now? Well it could happen, but central banks mostly – mostly discount treasury bonds.

But of course Australia technically has no – now – no budget debt. So while we still have bonds outstanding, we’ve kept them outstanding to create a bond market so we do have the value of knowing, the value of a 10-year bond. In other words it’s a sort of – it’s the high watermark of the Australian financial system and you can’t get the watermark without a bond market.

So we decided to keep the bond market which we would have otherwise paid out. And in place of that we have what’s called the Future Fund sitting beside it with 20 billion of cash which would have otherwise paid out the bond market.

Now just — just take, let me ask you this question or let your listeners understand this question. If the Reserve Bank did not have treasury bonds to discount each day in its repurchasing operations, what would it take? Well, the answer is it would corporate bonds, it would take local government securities, but it would be mostly taking private assets.

So therefore why — if we’re going to be driven to this in the long run, why not in the shorter run start taking private assets now.

MOORE: Take mortgage bonds?

KEATING: Take mortgage bonds.

MOORE: Can I ask you just one other question: what we’re seeing overseas is a lot of countries, Germany, Ireland, now Denmark and Sweden all being forced to give blanket government guarantees to private bank deposits. And in this country we don’t have any explicit government guarantee of bank deposits, depositors rank ahead of all other creditors if a bank collapses, but there’s no explicit guarantee. Are we getting to a point where we have to think about that?

KEATING: Well I – I don’t think in Australia we are but what we do have is a bank which is regulated and comes within the regulation of the Reserve Bank and – and the Australian prudential authority enjoys lender-of-last-resort facilities in the event they have a liquidity problem. In other words, if they’re short of liquidity, the Reserve Bank will basically advance them the money or lend them the money.

The problem we have in the world problem – the world financial community at the moment, and especially the United States, is – is not a liquidity problem per se, it’s a solvency problem. It’s not that there’s a shortage of funds in the market, rather there’s a shortage of value in the market and nobody quite knows who’s got value. And this is why the inter bank rate has risen.

MOORE: But you don’t see a need for deposits in this country, you don’t see a risk in this country? I just get a lot of text messages I should say, Paul Keating, saying are my deposits safe?

KEATING: Yes, the answer to the deposits of course they’re safe. They’re safe because we have deposited — our banks are involved in depositor insurance and — and as well as that, the central bank stands behind them. But more particularly, Ali, our banks are properly capitalised.

One of the things I did in the 1980s was when I gave banks for the first time the ability to bid for deposits at their price, and then lend them free of quantitative restrictions at their price. In other words, giving banks the ability to create credit instead of being rationers of credit. I then backed that structure up with a legal structure of prudential supervision which – which we established what we call reserve asset ratios. This has now been changed to the prime asset ratio; it went from the RAR to PAR.

MOORE: And this is why the Prime Minister and – and the Treasurer today can say that the banks are well capitalised?

KEATING: They can say they’re well capitalised because I said to the four banks back in the ’80s, I’m giving you blokes more ability to lend for housing, for commercial things and not have us looking over your shoulder as in the old days. That’s – so you’re going to be much more freer to lend, but you’re not going to be freer to operate your balance sheet without our supervision.

And so that supervisory structure or prudential prudent structure was established at that time. And that’s fundamentally why things are better here than not.

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