One of the key principles of Australian corporations law is the “business judgment rule”, which essentially provides that directors won’t be held liable for a company’s losses if they acted in good faith. In short: so long as directors don’t commit fraud or act for improper purposes, they can’t be sued by disgruntled investors. This is all good and well, but it can also lead to some pretty terrible decisions being made because of directors’ little, real personal interest (other than reputation) in a company’s success.

An apt example of this effect is the actions of the boards of Australia’s big banks (and this includes the CEOs, who are almost always executive directors). For while the doyens of Australian business earn millions of dollars each year running multibillion dollar financial institutions, they are exposing shareholders (and also taxpayers, due to government guarantees) to extraordinary risks through their massive use of leverage and wanton lending to home buyers. The Commonwealth Bank is the most exposed to Australia’s alleged hosing bubble, having lent $320 billion for home loans, almost 10 times its equity base of $35 billion.

You may think that a prudent business person in charge of an incredibly highly leveraged business (such as a bank) would be very concerned about the possibility of a substantial drop in the price of by far their largest asset.

You’d be wrong.

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Despite Fitch Ratings last month reporting that mortgage deliquesces are rising (30-day delinquencies increased by 5% in the December quarter while 90-day deliquesces increased by 9%), it seems that the big banks’ appetite for risk has actually increased. This comes as mounting evidence appears that the Australian housing market has peaked.

RP Data reported recently that house price rises stopped completely during the December quarter of 2010 across Australia, with Perth, Brisbane, Darwin and Canberra reporting price drops. Meanwhile, SQM Research warned housing stock levels have risen by 50% over the past year with more than 17,000 new properties coming on the market. One need not be an economist to understand that a substantial increase in available housing stock is highly likely to lead to lower prices.

With banks already massively exposed to housing, prudence dictates that bank executives should be doing everything they can to reduce their risk to one particular asset class, which appears over-priced. They’re not. In fact, they’re doing the exact opposite.

Australia’s largest mortgage broker, AFG, recently reported that “LVRs [Loan-to-Valuation Ratios] have loosened in the past month and 95% is the benchmark again. There is strong competition on price and product features, and lenders are keen to get money out the door”. In March, CBA increased the amount they would lend to 95% of the purchase price, Westpac was even more irresponsible, increasing LVRs to 97%. That means that buyers need to put only 3% of the cost of the property down (plus pay legal and admin costs).

So despite the price of the underlying security (residential property) appearing to reach a precipice, more borrowers failing to meet loan requirements and unemployment at near record lows — the big bank directors appear to think it prudent to lend more money to people buying houses, rather than less.

This brings us back to the business judgment rule. In the event of a collapse of a bank (which is certainly not out of the question, given what happened to banks in Ireland and the US after their respective property markets crashed), the ramifications for the foolish and risk-seeking directors will be non-existent.

The tens of millions of dollars in fixed pay and short-term bonus pay will certainly not be refunded by wealthy bank executives. Legal action by regulators will not be taken, as the directors, most likely relying on high-price legal advice from top-tier law firms (probably paid for by the very shareholders whose interests they failed to properly represent) will claim that they acted in good faith.

Although given the information at hand, it appears that such a notion of good faith is very thin. Bank executive directors are paid largely based on short-term profits, which have been largely generated (in recent years) by residential lending. It is in the interests of bankers to undertake risky lending to increase bank profits because they receive any upside, but shareholders (and ultimately taxpayers) bear the downside. Of course, it is possible that banks have lent so much to home buyers and investors that any significant tightening in lending standards would lead to not only a massive drop in the banks’ profitability, but also place their solvency in question.

Never before have the actions of so few put in danger an Australian economy. All the while Australia’s politicians and regulators side from the sidelines, cheering on the decade long housing boom.