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Big profits, huge risk

Posted by Deep T. in Banks on Feb 10th, 2011 | 13 comments

Previously I have posted on how the major banks recycle capital in TheCapital Rort. I want to extend that subject by showing how mortgage

‘rehypothecation’ in Australia has led to the massive expansion inliquidity available to Australian banks which is at the root of themortgage affordability issues in Australia and has put Australia’sbanking system on the unstoppable path to collapse or governmentbailout.

What is rehypothecation? From “hypothecate”- to pledge collateral.Rehypothecation is the reuse or pledging of collateral received from onetransaction in an entirely unrelated transaction. For more on thedefinition try this interview with Gary Gorton, Yale University financeeconomist.

To understand how rehypothecation applies to the Australian mortgagemarkets, I’m going to start with where the money comes from to fundour oversized mortgages and why? But to warn you, what I’m about todescribe is not pure rehypothecation because the mortgage collateral isnot directly passed to the lender but it is used to prop up the bank’sbalance sheet, the strength of which the lender relies on. So the ultimateeffect can be the same as rehypothecation.

I have updated to Dec 2010 a previous graph I’ve used comparing

residential loan, offshore borrowings and deposit growth:

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The graph represents a clear view of how offshore borrowings havefunded Australia’s growth in residential mortgages both in size andnumber. However, there seems to be a puzzling change of trend in thelast few months with deposits increasing at a greater rate and offshoreborrowings decreasing. Maybe it’s not so puzzling. The following is theRBA’s definition of Deposits and Non-Resident Liabilities:

‘Resident liabilities – deposits’ include: transaction andnon-transaction deposit accounts; and certificates of deposit.From April 2002, this item includes both Australian dollar-and foreign currency-denominated (AUD equivalent)deposits. Prior to that date foreign currency-denominated(AUD equivalent) deposits are included in ‘residentliabilities – other liabilities’. Certificates of deposit relateto both residents and non-residents. ‘Non-residentliabilities – total’ refers to total liabilities on the

Australian books of banks that are due to non-residents……

I have highlighted the relevant parts of the definition. I did a bit of adouble take when I saw this. In simple terms, loans or liabilities fromnon-residents appear in both deposits and non-resident liabilities asdefined by the RBA. I do not see this as any action that’s deliberatelytrying to deceive but rather a reflection of the poor informationproduced by the banks and reported to APRA. Does anyone really knowhow much non-residents have lent to Australian banks when non-residents in the deposit base are not identified?

My proposition based on the above graphs is that a considerable amountof what previously was properly defined non-resident liabilities havebeen transferred to deposits and that overall bank’s liabilities to non-residents continues its upward trend. This transfer is to the benefit of theoffshore lenders but at Australia’s cost and risk. I have three reasons formy proposition.

Firstly, deposit rates are at all time high rates relative to the cash rateand bank bills. Please take a look at this site which gives a goodsummary of bank deposit rates across the board. With the CBA offeringa 1 year deposit rate of 6.1%, would this tempt any non-resident

investor? Maybe Bill Gross from PIMCO, the world’s largest fundmanager, provides the definitive answer to that question when advisingthat investor’s portfolios perhaps should be:

…replaced with more attractive alternatives both from a riskand a reward standpoint. It is still possible to produce 4–5%returns from a conservatively positioned bond portfolio –you just have to do it with a different mix of global assets.

I think that’s one for the affirmative, Matilda.

Secondly, the increase in the strength of the A$ across most majorcurrencies did not come about because of current account surpluses, we

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still have deficits. Global punters have been buying A$ and lendingthose A$s to Australia. Why they are doing this is not the point. Thepoint is that if you buy A$s it must be used to buy assets or equities oras a loan or deposit. I’m betting on the later with the clear support of Mr Gross. For the moment anyway, I’m also sure that Mr Gross or anyother possible investor does not care one iota that imposing this strengthon the $A is slowly strangling Australia’s manufacturing, tourism and

overseas student education sectors.

Thirdly and by no means the least of the reasons, is the credit risk of certificates of deposit. If an Australian ADI/Bank collapses, deposits aregenerally believed to rank ahead of other wholesale lending forrepayment. That’s why deposit interest rates are considerably lower thanother types of securities issued by banks. What the actual credit rankingis very complex? See for yourself .

Regardless, in an environment where in effect the Australiangovernment has shown their willingness to step in and support our

banks come what may, as a deposit holder in a major Australian bank,your risk is as good as the Commonwealth of Australia itself. Forget theBanking Act, the market believes that the Australian Government willnot let any bank default on deposits but just may let defaults occur onwholesale funding. At over 6% for 12 months, I’m again betting that ourMr Gross thinks that’s great value “from a risk and a rewardstandpoint.”

In summary, because of deposit interest rates, FX strength of A$ andcredit risk, offshore funds continue to pour into Australian banks but ina different and riskier form for Australians. Whilst I don’t have enoughdata, this is a provable proposition once data becomes available.

The last point on credit risk is what links me back to the continualrehypothication of Australian mortgages by the Aussie major banks. Theoffshore investors who are pouring money into Australia on an everincreasing basis do not want to worry about credit. It’s not theirbailiwick. Absolute returns over the next year or so relative to thealternative global investment are what they are after. These money

 jockeys will plow funds into Aussie banks so long as relative returnscontinue and the perceived risk is not worth worrying about.

So for risk oversight they’re relying on APRA and for credit opinionson the rating agencies. I gotta tell you at this point my friends, I’m sureglad I’m not in either of those shoes. Relying on continual mortgagerehypothication to prop up the perceived credit risk and support capitallevels (aka haircut) of the Australian banks is a very dangerous game.

It is a truism that any financial system that can continue to increaseborrowings to meet liquidity requirements will not fail. The question iswhen or if the “continue” stops. My proposition for Australia is that it’sa “when” due to excessively aggressive mortgage rehypothication.

Don’t get me wrong, like securitization, rehypothication is a valuablefinancial tool, so how did things get out of control?

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In my post, “The Capital Rort”, I explained how the bankers wererorting the system to fill their fat wallets by reducing capital allocated toeach mortgage as property values rise. Now we need to take thatanalysis to another level, to show how they’ve actually put Australia’sfinancial system on the relentless march to either collapse or furthergovernment rescue. But don’t be concerned about our friends thebankers as they’ll continue stuffing their wallets until this occurs and if 

offshore experience is anything to go by for sometime after that as well.

For information I’m going to refer to: The RBA publication, AustralianBank Capital and the Regulatory Framework by Adam Gorajek andGrant Turner.

Confirmation of the banks using internal models to determine capital forresidential mortgages is given in words and numbers. The words:

Some banks, including the four largest, use an alternativeInternal Ratings-based approach whereby risk weights are

derived from their own estimates of each exposure’sprobability of default and loss given default.

But also from Table 2 in the paper as it relates to residential mortgages:

Exposure Average Risk-weighted assetsrisk-weight

$ billion Per cent $ billion Per cent of total

1,157 26 302 22

Under APRA’s Prudential Standard APS 112, the lowest standard riskweighting for mortgages is 35% for a standard mortgage with an LVRof 60% (Table 4). The above table produced by the RBA states that theaverage weighting across the whole ADI mortgage book is only 26%!

Clearly the internal risk models are gaining an incredible regulatorycapital advantage for those banks that use them. With risk-weightedassets allocated capital at the rate of 8% the total amount of regulatorycapital required against the total $1.157 Trillion mortgages on the banksbooks is only $24 billion a rate of a touch above 2%. Are you shocked?

Be shocked, but I have to admit that it’s not quite as bad that raw 2%figure indicates. We need to take account of mortgage insurance asapproximately half (the riskiest half) of $1.157Trn of mortgages iscovered by mortgage insurance.

Ok, so how much capital is behind the mortgage insurers? The vastmajority of mortgage insurance is provided by just 2 companies ieGenworth and QBE LMI (formerly PMI). An analysis of the accountsshould reveal the capital held against the risk of Australian mortgages.Well, be my quest. For Genworth and for QBE. I could not figure out

from these published accounts, the very simple piece of information thatis, how much capital is held against Australian mortgage risk?

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At this point, and although I cannot produce public information tosupport my case, I need to use my knowledge of the capital position of the mortgage insurers. To the nearest percent, the collective capital baseof Genworth Australia and QBE LMI against approximately $600bn of Australian mortgages is 1%.

So in simple terms the total amount of capital in Australia dedicated to

the risk on $1.157 Trillion of mortgages is approximately $30bn. Howdid this occur and how is it being allowed to continue?

It occurred because APRA allows the capital requirements of banks andinsurers to be adjusted down as the value of the collateral behindmortgages increase. For collateral, see house prices. But thoseorganizations make more and more money by writing bigger and biggermortgages. So APRA and regulation have created a system whichincentivises the lenders and insurers to take more and more risk on thebasis that bigger and more loans reduce the risk of the mortgage book.

This is absurd. But every participant has their snout in the trough, all thewhile publicly espousing the quality of Australian mortgages. When allthey’ve done is expose every Australian to massive systemic risk. Howcan we believe that in a country which has the most unaffordablehousing in the world also has one of the lowest mortgage risk? If itquacks like a duck…

However, no system is sustainable without a continual money supplywhich is where the rehypothecation of mortgages comes to the fore. Bycontinually revaluing the mortgage collateral to support furtherborrowing without needing to provide significant amounts of extracapital (hair cut, in securities rehypothecation), provides the turbocharge to excessive lending and the relentless march to systemic failureor government rescue. But this is done by piling more and more risk onevery Australian, not just homeowners, not just by using the artificiallycreated equity that may accrue in a house but also the real equity, whichprovides the base that spins money flow through excessiverehypothecation. This has all occurred under APRA’s reign andencouragement, so much for reliance on public institutional oversight.

So when will the money wheel stop and the gangs take over the

highways? I have a few ideas on that but it’s certain that it’s not never.

 Deep T. is a senior banking insider who is fed up with his colleague’sreliance on public support.

13 Responses to “ “Big profits, huge risk”

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1. PeterJB says:February 10, 2011 at 9:19 am

This is a huge risk: I must say that I thank you for for validatingmy instincts here which essentially is at full obligation of the Oz

 – no doubt at all.

But I ‘smell’ that there are actually (perhaps) x3 re-hypothecations going on in this chain (keyword: smell):1: As you point out above (deposits/f. liability)2. Securitized mortgages RMBS3. Purchase of these RMBS by the taxpayers agent, theGovernment

At 7% over 30 years the buyer is paying x3 times the “set price”of his home and that is inflation corrected.

Most interesting article – thank you

PeterJB

Reply

2. PeterJB says:February 10, 2011 at 9:33 am

Apologies but I just had a flash; It has always worried me that theOZ govt debt is low where the worrying point it that ourgovernment does not fund the future of Australians ie it focuseson Marxism disguised as Social democratic practices of fundingonly current comforts (so as maintain the longevity of officemodel running (for themselves)).

And, where it is actually Australia’s private debt that fundsAustralia’s insipid future growth. Damn: this process is – must be

 – appears as, Policy (Classified).

This answers a powerful lot of questions and besides, it is a huge/massive drain on Australian’s wealth cum productive capacity –

 just to fill some pockets.

PeterJB

Reply

3. True Blue Perspective says:February 10, 2011 at 11:38 am

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Thanks Deep T. Your insight to our failing banking system isawesome. There are massive problems with the system and itlooks like either the gangs will rule the highways or thegovernment will bail them out. We need some Solutions andAction!

Reply

4. Sean says:February 10, 2011 at 11:40 am

My concern is that our Govt will do the same thing as Ireland’sand take over the banks’ bad books (also happened with the SAgovt and State Bank of SA in the 90ʹs) forcing taxpayers to pickup the tab. If the banks actually do succeed in crashing theeconomy on the back of this engineered Ponzi scheme we call

housing then perhaps we should seriously consider Ben Chifley’sidea of nationalising domestic banking or at least stiff regulationagainst residential property speculation.

Reply

5. FrankieFourFingers says:February 10, 2011 at 1:01 pm

We have the bank executives whose primary objective is to gettheir big bonuses, and we have the politicians whose primaryobjective is to get elected. In order to meet those objectives, it isin the interest of both bank executives and politicians to keephouse prices rising any which way. The financial stability of ournation is of secondary concern.

Reply

6. 787 Dudliner says:

February 10, 2011 at 2:28 pm

Don’t sell if you don’t have to. At -10% negative equity switch toRexona Sports as the fear stench may upset your co-workers

http://www.smh.com.au/business/property/if-you-dont-need-to-sell-dont-20110209-1amn5.html

Reply

7. Stewart says:February 10, 2011 at 4:42 pm

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I must say: though i’m skeptical of banking “security” in general,i DID think that, at least we did things a bit more sensibly here inAustralia, that our banking system really was one of the more“robust” in the world.

Now, i guess that is indeed possible, but it really comes out like

this: that we’re the best amongst an array of the bad – which isnot really that good after all, is it??

Quite concerning and sobering, really.

Thanks Deep T.

Please keep it up…

Stewart

Reply

8. graham.tomlin says:February 11, 2011 at 12:20 am

In a nutshell this is credit default swaps by another name–thinkBear-Sternes/Lehman Bros

Reply

9.  JR86 says:February 11, 2011 at 5:01 am

You might even be high estimating the amount of capital at themortgage insurers. Genworth claims to have 1.4 billion in capitalsupporting it’s Australian mortgage insurance book which insuresover 283 billion in mortgages. Talk about a lack of oversight.200x leverage? On an average LTV of over 65%? Someone needsto shake the regulators silly.

Reply

10. PhilBest says:February 11, 2011 at 8:14 am

As Michael Lewis pointed out recently in his article on the Irishcrash, it actually is not necessary to have layers of complexity inthe form of CDO’s and CDS’s and derivatives, to engineer a

massively over-leveraged property bubble. The Irish bubble wasquite simple; it was based on Irishmen selling bits of Ireland toeach other at ever-inflating prices, with money borrowed mostly

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offshore.

Alan Moran and Bob Day and Hugh Pavletich can tell you aboutthe connection between land regulations and the Irish bubble too.It is THE common ingredient everywhere these bubbles havehappened. In fact, it is easier to look for where the bubblesHAVEN’T happened, and note the ABSENCE of a land supply

racket enabled by the local “planning” authorities.

The reason that this is a truly international phenomenon, is thatglobal warming mania and its love child, anti-sprawl mania, is atruly international phenomenon.

“Sean” above (11.40AM Feb 10) is absolutely right (Irish name,Sean?). It is sickening to see taxpayers now on the hook fordecades, while investors who are supposed to have been exposedto risk, get paid out. The international opportunists that “Deep T.In Banks” identifies absolutely should NOT be bailed out by the

Australian taxpayer. If an international investor has not learnedenough by NOW to do due diligence on the fundamentals, he/shemost definitely deserves to lose their shirt. They are little morethan international bubble-chasers.

Reply

 Sean says:February 13, 2011 at 6:10 am

Actually Phil my mother just happened to love SeanConnery – I’m from Melbourne. And I’m 100% with you,shareholders have to lose out by definition. Pyramid wasanother taxpayer bailout disaster worth mentioning but wecan thank Jim Kennan (then Vic treasurer) for that ball andchain…

Reply11.  Deep T: Australian Banking System on Unstoppable Path to

Collapse or Government Bailout « naked capitalism says:

February 11, 2011 at 8:07 pm

[...] By Deep T., a senior banking insider who is fed up with hiscolleague’s reliance on public support. Cross posted fromMacroBusiness. [...]

Reply

12. William says:

February 12, 2011 at 1:54 am

Do you really think the Australian banking system in under-

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capitalised? APRA’s application of Basel requirements is one of the most stringent in the world (one can add 2-3 percentage pointsagainst Tier 1 measures when compared to UK banks forexample). Of course, as time goes by LTV falls, and is obviouslyaccelerated during property boom times. So while they may holdless risk weighted capital as a result, the buffer before bank lossstarts also increases. I note that the regulator overseas both the

banks and LMI – and sets their capital levels for both. Over thepast decade the regulator and government has undertaken veryproactive assessment of the situation, and have a history of stresstesting the system, and enforcing greater capital if deemednecessary (see apra website). Due to such measure taken, currentstress testing of the system, by APRA, and also independently byFitch Ratings show that a heavy, far reaching scenario (ie gdpcontraction3%, unemployment 11%, property prices down 40%,and macro econ slowdown in China) can be absorbed withmanageable impact on capital (ie under the worst case Tier 1 fell3.1% over the 3 years of stress).

In regard the property bubble: In the short/medium term prices areunderpinned by demand, the main question in regard this is whythe both political parties, during their times in office over the lastdecade or so, have let the preferential property investment taxsystem fuel such a bubble?

The politicians have already answered this: Finance ministerLindsay Tanner April 2010 “The key reason why governments of both persuasions have not interfered with negative gearing is of course that that any dramatic change in the overall investmentframework could lead to a stampede of people out of property,which could lead therefore to dramatic drops in prices which of course you’re seeing in other economies around the world andyou see the economic devastation that flows from that” – and noside of government wants this to happen on their watch.

I also note that perhaps the movements in deposits and offshorefunding is a result of the banks intentionally doing this mainly tocomply with the new basel stable funding and liquidityrequirements. These have been known for months, with APRA

detailing their final requirements in December (hence themovement over this time). Such requirements need more stablefunding (ie retail deposits-hence the domestic competition inrates), and less reliance on offshore funding sources – which iswhy you see recent movement in these levels.

Reply

13.  Non-Resident says:

February 12, 2011 at 5:15 am

“Does anyone really know how much non-residents have lent to

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Australian banks when non-residents in the deposit base are notidentified?”

It is perhaps just a minor point, but this could be the reason forthe abiblity to identify the holders:http://www.ato.gov.au/businesses/content.asp?doc=/content/50240.htm&page=43&H43

Reply

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