Memo to Australian journalists: For the sake of your credibility, the big four banks did not save Australia from the global financial crisis. Bank executives are not oracles with some sort of divine ability to allocate capital (in fact, the contrary is more accurate). Over the past three years the banks skirted the global crisis and continued to make record billion-dollar profits because they have continued to prop up the over-valued collateral on their bloated balance sheets, and because the Australian taxpayer continue to guarantee their funding sources.
One could conclude that Australian banks have become a walking embodiment of moral hazard — privatised profits and, should the need arise, socialised losses. Meanwhile, the esteemed heads of these organisations receive remuneration in the millions or tens of millions, headed by Ralph “the $16 million dollar man” Norris.
In fact it is Norris’ Commonwealth Bank that has placed Australian taxpayer dollars most at risk, as the briefest of looks at the bank’s balance sheet confirms.
The CBA has total assets of $646 billion (which means its return on assets is a paltry 0.92%). These assets largely consist of loans made by the CBA to its customers. For example, if you have a mortgage with the CBA, the amount that you owe to the bank would appear on the bank’s balance sheet as an asset and on your personal balance sheet (if you were to construct one) as a liability. In CBA’s case, about half of its assets ($314 billion) are loans made on residential property. It has about $20 billion in personal loans (usually unsecured) and another $155 billion in business loans. While the CBA reduced its business loan book by $5 billion in 2010, it continued to grow its home loan book by $34 billion or 12%.
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The CBA then has about $610 billion in liabilities, of which $365 billion comes from depositors and the rest it borrowed from various places. That leaves about $35 billion in “net assets” or equity — this is shareholders’ funds.
The CBA therefore grew its loan book in 2010 by about the same amount it has as equity. This shows just how risky investing in a bank is.
When making a loan for a dwelling, banks such as the CBA will lend up to 95% of the value of the property (with an insurer covering the risk above 80%). The CBA is incentivised to keep growing its loan book because so long as mortgagees make their interest payments, the CBA is able to grow its profits. This was shown last year, when the CBA was able to grow home loan income by $700 million or 38%. This was largely due to strong volume growth (the bank made more loans).
If you think this could be a risky way to improve profits, you’d be right.
It is even riskier when deeper analysis is made into how banks “value” properties when extending loans.
Banks aren’t completely reckless — they don’t simply lend money to anyone. For example, if someone wants to buy a two-bedroom property in Frankston, the bank won’t lend the buyer $2 million. Instead, the banks will usually get a “valuation” done on the property. The problem is, most house valuations don’t value the asset on the present value of future cash flows, but rather, the valuation will generally involve a study of “comparable sales”.
That is, if the three-bedroom house next door sold for $800,000, and the house they are valuing is the same size, they will generally attribute a near identical value. The problem is, the house next door may very well be vastly over-priced (possibly, because another bank lent the owner of that property a sum based on a similarly overly optimistic valuation). This creates a “faux-positive feedback” loop.
Let’s consider a specific example.
Say the Commonwealth Bank agrees to lend a purchaser enough money to cover 90% of the cost of a property that the person wishes to buy (we will call this Property A). The purchaser ends up paying $500,000 for the property.
A few months later, a property down the street (Property B) that is quite similar to Property A is bought by a cashed up investor who has seen the property market appreciate and doesn’t want to miss out on the potential gains. The buyer of Property B has cash so didn’t need to borrow from the bank. Because the buyer of Property B has heard that property never goes down, and Property A was sold a while ago for $500,000, the buyer of Property B pays $550,000 for the asset. His rental yield is low (far less than what he would get putting the money in the bank), but it doesn’t matter — he will make a lot more money if the price of the asset continues to rise at 10%.
Later in the year, another house (Property C) also in the same street, is for sale. This time, the potential purchasers need to borrow from the bank and can contribute about 10% of the purchase price. Before the bank will lend the buyers any money, they get another valuation done. This time, the valuer (who is paid per job, so doesn’t spend too much time and doesn’t really care for the accuracy of the valuation) sees that Property B sold recently in the same street for $550,000. Property B and Property C are similar, so the valuer deems that property C is worth $570,000 because the market seems a bit stronger since Property B was sold. During that time, the rental yields for Properties A, B and C have not increased at all, so in reality, their respective value would not have changed.
Based on that information, the CBA is happy to lend the buyers of Property C about $510,000.
What has just happened?
In a short time, the price of Property C (and Property A) has increased from $500,000 to $570,000. This is not because of any fundamental shift in the value of the properties (as noted, rents didn’t rise), but rather, because the bank was willing to lend the borrower more money. (The difference in equity between the buyer of Property A and Property C is only $7,000, so the buyer of Property C doesn’t even really notice the price rise).
In the short term, the result is a positive one for the lender. That is because the buyer of Property C would be paying greater interest on their borrowing than had the price of the property remained the same. Perversely, the value of the “asset” on the bank’s balance sheet has also increased.
The increased profits made by the bank (or back to real life, made by the CBA in 2010) flow not only through to the bank’s bottom line, but also to its executive team’s hip pockets. This is because the CBA’s Group Leadership Share Plan is based directly on how much profit is generated by the bank. The more loans the bank makes, the more profits is generated, the more executives are paid.
Unsurprisingly, the remuneration paid to the CBA’s top 10 executive sky-rocketed, from $33.8 million in 2009 to $56.7 million in 2010 — an increase of 68%.
There you have it — a quick example of how the banks have been a leading cause (albeit not the only cause) of Australia’s property bubble, and have created an almighty risk for not only property owners, but also taxpayers. Meanwhile, those very risk-taking executives are handsomely rewarded for the privilege.
Should Australia’s residential property market tumble, and the value of the $320-odd billion on CBA’s balance sheet be written down, it will be the taxpayers footing the bill — not the executives.