The Labor Party has a century long and, some might say, colourful history of trying to keep Australia’s banks honest. On the basis of its animus towards “money power” (eerily like concerns about the influence of money in Washington today) it was the Labor Party that was responsible for the establishment of Australia’s first publicly owned bank, the CBA, to compete against private lenders in 1912. (The CBA eventually evolved into Australia’s first bona fide central bank as a precursor to the formation of the RBA in 1959.)
In the early 20th century, Labor’s critique of the private banks was that they were too prone to fail, engaged in profiteering, and that their lending practices were too “pro-cyclical”, with profligate credit during the good times and rationing of finance during the bad. One hundred years hence and many commentators have made similar criticisms of private banks in the US and UK.
It was the radical Chifley Labor government in 1945 that introduced the Banking Bill that tightened the regulation of private banks, formally licensed their activities, and introduced prudential supervision and controls on the provision of credit. It was also Chifley who in 1947 embarked on outright war with the private banks via his ill-fated attempt to nationalise them, which eventually cost him office.
It was the Labor Party that, much to the major banks’ horror, opened them up to foreign competition in the 1980s.
It was the union-backed industry funds that created Members Equity, the “super funds’ bank”, in 1999 to compete on a low-cost basis with the big boys.
And it has been the irrepressible Paul Keating in his post-prime ministerial life who has echoed arguments made here that the major banks bear a striking resemblance to public-private utilities.
So it has been no surprise to see Kevin Rudd’s government deliver on this rich pedigree despite the staunch advice of conservative public servants who prefer to maintain the status quo.
On Sunday Treasurer Wayne Swan announced that the Australian Office of Financial Management (AOFM) would effectively double its existing $8 billion investment in high-quality Australian home loans — known as residential mortgage-backed securities (RMBS) — to a total commitment of $16 billion.* This came less than 24 hours after the major banks has started threatening to inflict out-of-cycle interest rate hikes on businesses and home owners.
Let me be clear about one thing: this is a very bold and innovative policy initiative that has my full support. And I think the government would also have the (perhaps begrudging) backing of Shadow Treasurer Joe Hockey and Opposition leader Malcolm Turnbull, who have both advocated similar measures.
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The AOFM program builds directly on the — at the time radical — policy proposal that Professor Joshua Gans and I first developed in March 2008. We argued that in extraordinary circumstances the government needed to invest directly in the RMBS market to vouchsafe the “public good” of a minimum level of liquidity (interested readers can review the history of our efforts at this dedicated website here).
Gans and I maintained that the sudden closure of Australia’s securitisation markets in November 2007, which had previously provided up to a quarter of all the funding for Australian home loans, was a genuine case of market failure. This was in turn induced by the hard-to-fathom increase in illiquidity and risk-aversion precipitated by the onset of that exogenous shock that began life as the US sub-prime crisis. Unfortunately, the evaporation of global demand for mortgage-related investments was utterly indiscriminate and paid no heed to the quality of the underlying assets. In Australia’s case, we had developed a history of producing among the safest and lowest-risk mortgage-backed securities in the world. But it mattered not in a climate where institutions were hoarding capital in a struggle for survival.
After outlining our initial proposal in early 2008, Gans and I advocated the government use the AOFM to implement this idea. At the time, we advised Swan’s office that they should start with a commitment of $5 billion-$10 billion. The government responded with $4 billion, which was then quickly extended to $8 billion. To date, this has allowed smaller banks, non-banks, and building societies to raise a total of $10.4 billion worth of funding for home loans on economically viable terms — money that supplied a vital lifeblood of liquidity that would not have otherwise been available to them during the GFC.
It is important not to understate the historical significance of this action — there is, after all, no precedent for these measures. Furthermore, Gans and my arguments regarding the need for policymakers to inject direct liquidity into the securitisation market — in a similar vein to the way in which the government would be forced to underwrite the liquidity of the banks’ deposits and wholesale debts via taxpayer guarantees, and, more subtly, through the RBA’s own liquidity facilities — were, at the time, explicitly rejected by both the RBA and the Treasury in public and private forums.
While the spinners will try and twist the facts to the contrary, I can assure you that the Prime Minister and Treasurer were — at least initially — advised against pursuing this opportunity. So the Treasury’s emergency investments in RMBS during the GFC represent one of those rare instances where our publicly elected officials have had the courage to look beyond the sometimes narrow risk-aversion of the bureaucracy, and engineer creative and constructive policy outcomes. Of course, once you set the bureaucracy on a course it is often difficult to pull it back off it. It was no shock, then, to hear that the Treasury had grown more comfortable with its forays into the securitisation market (one example of which was that it built up a specialist RMBS investment capability inside the AOFM).
Yet with the passage of time the government’s strategy of buttressing the liquidity of the RMBS market was directly undermined by its subsequent decision to offer the Commonwealth’s AAA credit rating to guarantee less highly rated bank debts. This was one of those unanticipated consequences of the government guarantees, which also wreaked havoc on the commercial paper and mortgage trust sectors.
Regular readers will recall that I have repeatedly drawn attention to the fact that the guarantees were hindering the efficacy of the AOFM initiative (see, for example, here , here and here ). Whereas in the past RMBS had been one of the few AAA-rated investment classes available to institutions alongside government debt, the government’s transformation of much riskier AA-rated, A-rated and BBB-rated bank debt into AAA-rated (and “sovereign backed”) securities massively boosted — by about $145 billion it turned out — the universe of assets competing with RMBS.
Following the government’s announcement that it would offer to guarantee all bank liabilities, the demand for RMBS diminished with the consequence that spreads (or the cost of RMBS funding) rose significantly from about 130 basis points over the swap rate to about 200 basis points over. Before the GFC, “economically viable” pricing — that is, the maximum price issuers could afford to pay to undertake new lending — was believed to be about 100 basis points over in comparison to the historical spread of about 25 basis points during the decade preceding the crisis.
This is not to say that the government’s action was not warranted. In an extreme emergency one would always prioritise the safety and security of the core deposit-taking system over second-order competitive considerations such as the liquidity of RMBS (although, as Gans and I predicted, the closure of the securitisation markets posed systematic stability risks, and had knock-on effects, such as the rationing of credit to businesses as the major banks reallocated capital away from riskier business lending to the comparatively safe residential mortgage market).
While some commentators are prone to making glib remarks about the systemic risks triggered by the illiquidity in the RMBS market, it is sobering to recall that it was the closure of the UK securitisation market that triggered the first run on a UK bank — Northern Rock — since 1866 and the eventual nationalisation of the UK banking system. Informed observers know that Australia narrowly avoided the same fate.
After the announcement of the guarantees we posited that one potentially elegant solution to the above mentioned problem would be for the government to temporarily guarantee the intrinsically safer assets of the institutions — namely AAA-rated RMBS and CMBS — as opposed to the companies themselves (as it does when it guarantees their liabilities). This option had also been anticipated in our original work, and in 2009 was canvassed by smaller lenders such as Challenger.
A guarantee of RMBS would have the added benefit of immediately creating a level playing field among all lenders since the cost of the guarantee would be independent of the institution, which is not currently the case (i.e. the price paid by banks for the guarantees is based on their credit rating and thus makes it far more expensive for smaller competitors, such as Bendigo & Adelaide Bank and Bank of Queensland). The application of an asset-level guarantee to CMBS could also serve as a cheaper and more effective surrogate for the failed RuddBank initiative that was targeted at improving the availability of finance to commercial property investors.**
Almost directly following my first posting on this subject, the UK government announced that it would start offering guarantees of RMBS. This actually raises an independent policy question: one of the problems originators of Australian RMBS may face is that they are competing with Canadian and UK securities that benefit from sovereign guarantees that are not afforded to their Antipodean cousins (ie, an analog to the challenges confronted by our banks when raising wholesale debt in global markets).
Notwithstanding my concerns about the impact of the guarantees, I have also repeatedly observed that as the issuance of guaranteed bank debt dried up once credit markets stabilised, the need for mitigating guarantees of RMBS should also diminish in lockstep. Put differently, the AOFM solution comes back into play since it is not being undermined by an artificial pipeline of competing AAA-rated assets.
Taking a step back, the over-arching strategic challenge we put to policymakers was that they had to engineer a long-term remedy to the current asymmetry in the manner in which governments subsidise the liquidity of the three primary sources of funding available to lenders: deposits, wholesale debt and securitisation.
The most stealthy and subtle form of these subsidies is the RBA’s liquidity facilities, which, as both we and Dominic Stevens, the CEO of Challenger, have highlighted, synthetically reduce the cost of funding available to deposit-taking institutions to below-market levels in times of crisis, which puts their competitors at a comparative disadvantage. Naturally, the deposit-taking institutions pay a price for this liquidity service — tighter regulation. But this in turn implies that the regulatory architecture needs to be broadened to more formally address and protect the new financial intermediaries, and the capital sources, such as securitisation, that they rely on, which have emerged over the past two decades (and will, presumably, continue to emerge in future decades).
This is but one of the motivations for the ‘Son of Wallis’ inquiry into the financial system that five prominent economists and I proposed earlier this year, which now looks to be getting the belated backing of leading media commentators (all of the major non-government political parties lent their immediate support while Lindsay Tanner also appeared to like the idea ).
One of the main concerns here is that Australia’s system of prudential regulation failed the first serious test it faced, as the authors of the Wallis Inquiry report, such as Professor Ian Harper, acknowledge. Wallis was explicitly predicated on the rejection of any form of public guarantee of private institutions, no matter the extremity of the crisis, for fear of the permanent moral hazard risks that such action would stimulate.
It bemuses me that there is all this talk of “rolling back the guarantees”, which completely misses the point. The real policy questions here are:
(a) given that financial markets will now operate on the basis that guarantees will, in fact, be available in times of crisis, how do we minimise the ensuing moral hazard risks; and
(b) what strategic policy framework, and specific rules and regulations, will govern how these unprecedented guarantees can be deployed by politicians in future emergencies?
In fact, I would have thought that taxpayers deserve dedicated legislation that carefully addresses these questions.
The significance of the government’s extension of its AOFM investments is that it clearly communicates to the market that policymakers are committed to vouchsafing a minimum level of RMBS liquidity during times of crisis. The offer to consider manufacturing a “liquidity facility” under which investors facing liquidity risks can sell RMBS assets back to the AOFM further underlines this point.
With the demise of the SIVs and CDOs, the long-term suppliers of capital to fund RMBS and CMBS will increasingly become Australia’s super funds. As I have noted on many occasions (see, for example, here and here ), these funds’ asset-allocation strategies are way overweight local and international equities. About 50-60% of the $1 trillion-plus of workers’ savings invested in super are tied up in highly volatile Australian and international shares (with a circa 50:50 split between them).
There are two fundamental problems with this. First, given the extraordinarily strong correlations between Australian and international equities there is little-to-no benefit investing in both. In short, trustees are just parlaying up members’ risks. This is practically borne out in the near 1:1 co-movements in Australian and international sharemarkets during the 1987 crash and the 2007-09 GFC.
The second issue is that it is almost impossible to justify a 50-60% portfolio weight to Australian or international shares (or a combination of both) based on the past 30 years of data because of both their extreme volatility — 15-20% per annum — and their high correlations. Standard portfolio optimisation analysis shows that the idealised weight to global equities over the past 30 years would have been just 20% given a target nominal return of about 10% per annum. This fits much more closely with the Future Fund’s intended portfolio weight to global equities and global private equity of just 35% (i.e. close to half the typical super fund’s exposure when you add in private equity).
The chief casualty of Australian super funds’ love affair with the casino that is shares has been fixed-income investments such as RMBS and CMBS. The equity obsession itself is presumably explained by the establishment of our superannuation system in 1992 at the coincidental commencement of what would prove to be a very long bull market in shares. Another oft-neglected topic here is the impact that the $500 billion-plus worth of superannuation capital has had on equity market pricing over this period. Folks are fond of talking about over-investment in housing. But you rarely hear the same question posed of shares.
Most highly rated fixed-income investments have outperformed international equities on a raw return basis with about half the risk during the past three decades. If one risk-adjusts the historical asset-class performance, debt securities smash Australian and overseas shares.
So one of the long-term answers to the funding of AAA-rated RMBS and CMBS involves educating trustees and their advisers about the need to boost their portfolio weights to fixed income assets that afford members superior risk-return tradeoffs. Of course, anyone making this case is likely to annoy those with vested interests in equities (think most analysts, strategists, fund managers and investment bankers).
* Since the government will be investing in AAA-rated assets, there will be no increase in net debt.
** Asset-level guarantees have a powerful precedent in Canada, where the government-owned CMHC has offered arm’s-length guarantees of qualifying RMBS for more than a decade. This has enabled more than $240 billion worth of Canadian home loans to be successfully securitised throughout the GFC in contrast to Australia where there was virtually no private issuance. The availability of this finance has in turn allowed smaller Canadian lenders to survive and prevented the mass consolidation that we have witnessed here (cf. the merger or acquisition of Aussie, RAMS, Wizard, Challenger, St. George, BankWest and so on).