Econoblogger and Melbourne Business School Professor Joshua Gans has been floating another new idea - Aussiemac, an Australian equivalent of the American Freddie Mac and Fannie Mae.
What would this organization do? I’ll let Gans and his colleague Christopher Joye explain it themselves:
Under our proposal, the Commonwealth would guarantee the credit worthiness of an Australian government agency, which we loosely call ‘AussieMac,’ thereby lending it Australia’s AAA credit rating. This would allow AussieMac to issue substantial volumes of very low cost bonds into the domestic and international capital markets. The funds raised through issuing these bonds could be used to acquire high-quality AAA-rated Australian home loans off the balance-sheets and warehouse facilities of lenders (including the majors). AussieMac would, therefore, serve to guarantee liquidity in the Australia home loan market in the event that other private sources of capital were to supply insufficient funding, such as is currently the case.
Historically, similar initiatives in the US, with the now privatised government sponsored enterprises, Fannie Mae and Freddie Mac, and in Canada, with the government-owned CMHC, were created with precisely the same mandate that we have in mind: ie, to “stabilize mortgage markets and protect housing during extraordinary periods when stress or turmoil in the broader financial system threaten the economy.”
But if this is such a good idea, why not have “AussieMac” just directly offer home loans to consumers? And if protecting housing finance is such a good idea, why not small business loans? Heck, plenty of otherwise sound small businesses (and big businesses, for that matter) are copping it in the neck from a global credit crunch that has essentially nothing to do with their actual soundness. In fact, why not go the whole hog and create a government-backed “people’s bank” for the purpose. We could call it, I dunno, the “Common Wealth Bank”, perhaps?
In any case, it’s fascinating to see an economist calling for the reintroduction of the government into the lending system, even if it is only behind the scenes.
Isn’t this a state bank sorta? Just sayin’.
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Where’s Andrew R. he gonna be spewin’ mate. Spewin’. Myself I’ve got no idea.
Damn, you have outed me for the socialist I am!:)
Seriously, I think that when the rationale for intervention is the government’s AAA-rating in a time when credit is being rationed, then we need only consider how to leverage that without going the whole hog. The US is protected by the legacy of FDR on this stuff but where is out protection?
And on confining it to home mortgages, the key to the plan is for it to cost the government nothing. Home mortgages are actually (current times included) the least risky investment. The problem is that when credit gets right, banks can’t simply put up interest rates as that makes those loans more risky. A government guarantee can step into the breach. In all this, I keep asking the question “why not?” and have not heard an acceptable answer. Something worth exploring.
Joshua, doesn’t this turn mortgage sellers into, essentially, sales agents for a government agency? I can see enormous cost of money advantage this offers, but I don’t see how “competition” is advanced when everybody would be ultimately selling the mortgages on to AussieMac, which would presumably offer the same terms for the same mortgages to everybody. How could a company without the government backing of Aussiemac possibly compete against it?
Furthermore, is AussieMac only going to lend to owner-occupiers or investors? If it’s just owner-occupiers, isn’t this a free kick to buyers instead of renters? If not, isn’t making cheap money selectively available for property investment going to further enhance Australia’s economy-distorting love affair with investment property?
Robert, no it doesn’t. With securitised mortgages rather than deposit-backed ones it is a very different story. We have had a credit crunch and those securitised ones are drying up (and it is that source that was responsible for all of the competitive pressure on the major banks over the last decade). The reason for that is that too many people got spooked on such investments because of the US situation that actually has little to do with our own housing market. Government guarantees can restore that confidence precisely where it is needed. The US are doing it now with Fannie Mae and Freddie Mac and last time I looked that administration wasn’t particularly left-wing.
My view is that AussieMac would mostly lend to below average cost dwellings and for home ownership and not investment purposes.
This does sound a bit like banks asking the government to take over their risks for them - ie socialise their losses, so to speak. If we need the government to be providing capital for home lending, small business lending, whatever, shouldn’t they do it directly? With a stand-off , commercial arm that is managed to lend for commercially defensible purposes?
I have no problem with a government directly controlling the credit supply (as Keynes said that good governments have to), but I do have a problem with a government bailing out the ‘big end of town’ when they get into trouble because of their own greed - which is exactly what is happening in the US today.
Guys,
I think the fundamental policy issue here is–as Joshua has clearly noted–that we have had a critical economic market that is responsible for providing the funding for 20% (or $50.8 billion per annum) of the $250 billion per annum Australian mortgage industry shut down. And not just for a few days or weeks. There has have not been any significant securitisations of AAA-rated Australian home loans since November 2007. Most importantly though, the closure of this market has had nothing to do with the integrity of Australian home loans or the strength of our economy. We are simply a casualty of the extreme risk aversion and illiquidity that has spawned from the US sub-prime crisis and the demise of the SIVs, CDOs and the foreign investment banks that sponsored them. To make this point clear, 30 day default rates on US sub-prime loans are over 16% (these loans account for more than 15% of the entire US market). By way of contrast, 30 day default rates on prime Australian loans are 0.84% (at Nov 07) while sub-prime mortgages make up less than 1% of our market.
The only liquidity available is via the RBA’s new short-term (ie, 90 day) repurchase agreements which it has only made available to ADIs. Under the terms of this “repo facility” the RBA will accept AAA-rated Australian home loans as collateral and lend the institution in question money. The extreme irony here is that these repo facilities are only available to ADIs (ie, banks), which the RBA has today claimed are incredibly well capitalised and not bound by significant liquidity constraints. But if the RBA is going to provide anyone with liquidity surely it should be to the segment of the mortgage market that has been most adversely affected by the illiquidity in securitisation markets: ie, the non-bank lenders. I note that the US Fed has recently extended its own repo arrangements, which the RBA has mimicked to non-ADI investment banks and brokers.
As a final comment, the RBA is already doing precisely what Gans and Joye propose AussieMac would do: ie, provide liquidity to major financial institutions when markets fail for reasons that are external to the domestic domain.
It’s been pretty dismaying watching the housing bubble collapse in the US - largely it seems due to over building and lax lending. Wouldn’t it be easier simply to re-regulate the banks? They’d all squeal, but what’s the point of opening your markets to the benefits of globalisation if you run screaming every time they turn sour? Bank de-regulation has basically failed if that’s the case.
Time for the RBA to pull its head in and set up a mortgage market that is not beholden only to the four major banks at the expense of the smaller banks and non bank lenders.
Swan needs to put the Reserve Bank of Australia on notice that if it can’t quickly deliver a fair and equitable mortgage market that is properly able to access funding to cover the liquidity needs, for all mortgage lenders in Australia, then heads need to roll at the top of the Reserve Bank.
http://www.economics.com.au/?p=1387
Steve, other than in fantasy land, how would he do that, leaving aside the farcical Q&A of your link?
And not be laughed at?
Greg M, and you don’t think that the RBA and Swan won’t be laughed at if the RBA allows the other players beside the big four banks to run short of funds or have to pay extravagant prices for their funds? I doubt whether the situation is sustainable and someone is going to look very silly if only customers of the big four banks are looked after by the RBA.
We have already seen a stockbroking firm collapse today with ASIC investigating and the RBA does have an important role to play as one of the financial market’s regulators. It would be most remiss of the RBA not to use the situation to give us the best and most secure mortgage market available.
http://www.theaustralian.news.com.au/story/0,25197,23445711-601,00.html
steve wrote:
In other words, let the private banking sector enjoy the profits, but when they screw it up, the public can carry the can. Screw that steve, let them fail and have the the government buy the mortgages for fire sale prices on behalf of the poor buggers who were silly enough to be their customers. It’s not the customers fault that the idiots who ran the bank decided to get their “cheap money” from dodgy sources.
Steve/GM:
1) If there is no problem here, and the banks are so incredibly well capitalised, and not subject to liquidity constraints (which is what Glen Stevens said yesterday), why is a major government agency, the RBA, being forced to supply unprecedented levels of liquidity, on unprecedented terms and conditions, to those same liquid and well-capitalised institutions (eg, its overnight repo facility has now been extended to 3 months and the fact that it is accepting for the first time ever AAA home loans as collateral against which it will lend to the banks)?
2) Stepping back from the question of the stability of Australia’s banking system (which is the RBA’s real focus in providing liquidity), why is a major government agency, the RBA, supplying liquidity to offset the adverse effects of the closure of the $50 billion per annum mortgage securitisation markets, which funded 20% of the entire home loan market, to the institutions that the RBA claims least need that liquidity—ie the banks? Put differently, why is the RBA discriminating in its provision of liquidity and why should government make the same liquidity services available to all lenders (including the non-banks)? AussieMac would do exactly what the RBA is doing but simply make the liquidity service accessible to all lenders that satisfy AussieMac’s “prime” credit quality requirements (ie, the loans need to be low-risk AAA assets).
3) Perhaps most importantly, is a minimum level of liquidity in major economic markets increasingly becoming a “public good”? This is exactly what Gans & Joye are saying in their report, and it is a point that is being explicitly acknowledged by Central Banks (including the RBA) around the world by virtue of their own actions. Importantly, you could easily structure AussieMac to avoid the “disintermediation” and “moral hazard” risks that the RBA/Treasury will claim undermine its purpose (ignoring for the moment that the Central Bank’s own actions introduce exactly the same risks). These controls would be straightforward to achieve with the key focus of AussieMac really being the provision of liquidity to all qualifying Australian lenders (ie, not just the banks) during periods of extreme market duress when liquidity for all intents and purposes disappears for extended periods of time.
During the ordinary course of market operations you could limit AussieMac’s role to providing, say, a maximum of 10% of the market’s liquidity at any given point in time (with the benefits justified as supporting the government bond market, which has been shrinking and is in dire need of a boost).
David Rubie, I doubt that it was the customers fault that the stockbroker went broke either but it will be the customers that do their money as usual not the banks. The customers accounts have already been frozen and I am not sure that I would like to see that happen to mortgage holders with the smaller banks or non bank mortgage customers. We’ve seen it before but it is never a pretty sight and is probably avoidable, I’d have thought.
steve, I’m going to be very annoyed if the upper management of our failing financial institutions are allowed to walk away with $90 mill like that Bear Stearns guy. Failed bank upper management should really be facing jail time. It’ll be interesting to see how it plays out here (I suspect I’m going to be annoyed).
David, in my time I have seen two Building Societies collapse under the Bjelke Petersen regime one was called Metropolitan (and I forget the name of the other) and the assets were taken over by the then Government owned precursor of Suncorp, the State Government Insurance Office with relatively little pain to the customers.
Southern States had the pyramid debacle, another called Tri Continental or some such name and a big South Australian Bank go belly up at great cost to the customers and accompanied by much wailing and gnashing of teeth.
This is an interesting article too.
http://www.smh.com.au/news/banking/guarantee-no-savings-grace/2007/10/02/1191091073147.html
All I can say is that if the Reserve Bank’s oversight of the Mortgage Market is as thorough and workable as the ASX in regard to protecting the assets of people with money invested in Superannuation funds and licensed stockbrokers then God help us. The Financial Markets in this country are riddled with poor management and dodgy practices for which there is little or no consumer protection.
http://www.theaustralian.news.com.au/story/0,25197,23448339-5012439,00.html
Freddie Mac’s homepage is here it seems a much saner way to run the system than what is presently available in Australia.
http://www.freddiemac.com/
If we have to have a backup mortgage system, I think the first thing to be done is fix the name. Both “Aussie” and “Mac” are already over used in Australia, so in the interests of imparting the same impression as the American ones, I propose the following name:
Fanny Flo.
More fun and games from the banks.
http://www.abc.net.au/news/stories/2008/03/31/2203069.htm
An underlying assumption of this proposal seems to be that credit is an unalloyed good. Similarly, it doesn’t appear to consider the inherent problems with securitisation that have become all too apparent in the last year.
Since June 2001, housing credit has grown from $353 billion to $930 billion (an increase of about $27000 for every man, women and child) and, despite its recent relative slowdown and the tremendous acceleration in business credit, still represents 52% of all credit from a starting point of 46%. Over that same period, securitised housing credit went form $53 billion to $218 billion (off a high in August last year of $229 billion). It’s surely no coincidence that during this time net foreign indebtedness grew from $302.5 billion to $610 billion. (all figures ex RBA)
Of course some of this was devoted to the construction of new dwellings and the improvement of old but much of it simply resulted in a disproportionate increase in housing prices: against income, against GDP, against rental returns, against pretty much anything one cares to name. I fail to see how this has advantaged anyone other than the relatively canny or lucky few who geared up early and have already taken the exit or are edging towards it. Certainly, the boom in housing prices significantly increased consumption and so ensured that our current account deficit would remain nigh on intractable.
To argue that at the first hiccups after such a binge the government should step in to underpin the mortgage market seems to me extreme, particularly when what is being suggested is an entirely new institution which would inevitably in time take on a life of its own. Surely there’s already quite enough moral hazard to go around.
As for securitisation, recent events have shown all too clearly that enabling loan originators to divorce themselves from the ongoing performance of those loans is a recipe for disaster. The incentive structure over time becomes grossly distorted, loans are in due course produced with almost no concern for their viability and, if this process is allowed to continue for long enough as it was in the US, the whole financial system can be threatened. Thankfully, it seems we haven’t proceeded anything like as far down this track but I see no reason whatsoever to encourage any continuation.
As an aside, much is made of Fannie and Freddie in these sorts of discussions. It’s kind of amusing to contrast the current hopes that they will help to save the system with the serious concerns expressed only months ago that they represent a systemic risk. Which in my view they do. Were they not backed by an implicit government guarantee, they would quite possibly already have gone the way of Bear Stearns.
Anyway, it seems to me the only truly critical tasks for the RBA in a crisis are to ensure that depositors in the banking system are fully protected and that the finanical system itself is enabled to continue functioning. The example of Norway in the early 1990s provides an interesting and possibly instructive template. Two thirds of the banking system was affected and the Norwegian government ended up nationalising the 3 largest banks (these were subsequently progressively privatised after the crisis has passed, for a small profit as it happens). A research paper from Norges Bank (their central bank) sums up their approach:
- Private solutions were explored before the government intervened.
- Share capital was written down to zero before committing public funds.
- The government acted swiftly to limit contagion, but did not provide a blanket guarantee.
- Liquidity support was given to illiquid, but solvent institutions.
- The government did not use an asset management company - as the other Nordic countries did later on.
For anyone interested in these matters, the paper not only reviews what did happen but also considers what could have been done differently and perhaps better.
http://www.norges-bank.no/Pages/Article____13822.aspx
I will drop my pseudonym (ie, Jack Stilgitz) and respond to the post above directly.
The author, “Mr Ingolf”, appears to have wholly misunderstood, and in turn mischaracterized, the fundamental tenet of the “AussieMac” policy paper that I recently published with Joshua Gans. He also mistakenly draws on the Norwegian Banking Crisis of the early 1990s as support for his arguments. While I will expand on this point later, it suffices to say that the Norwegian incident shares no commonalities whatsoever with the challenges facing Australian institutions who are—as the RBA itself has noted—very profitable, well capitalized, and in no way facing a sub-prime or non-performing (ie, high arrears) loan crisis. Simply put, the Australian financial system has been the subject of a global liquidity shock that has afflicted many other developed economies and which is entirely exogenous (ie, external) to our economy and the households and institutions that populate it. In this regard, one need not belabour the point that domestic economic growth is so strong that our Central Bank has raised interest rates in 3 of its last 4 meetings and allowed a further, “de-facto”, rate hike to be imposed on households by private lending institutions.
The critical assumption of our AussieMac paper is in no way that credit it an “unalloyed good”, as Mr Ingolf would have us believe. On the contrary, our central proposition is that a basic level of liquidity in key economic markets is a “public good”. This argument is clearly supported by the major governments around the world whose Central Banks have acted to supply large volumes of liquidity to banks and, importantly, non deposit-taking financial institutions, where the “market” has failed to provide such liquidity with potentially catastrophic consequences. The policy imperative here is in part reinforced by the fact that severe market dislocations, such as the credit crunch that we are presently observing, are becoming increasingly common and more quickly transmitted in today’s highly integrated world. The presence and apparently regularity of these extreme events is consistent with recent academic innovations in the behavioural finance and extreme value theory literatures.
In standard finance theory, academics, and the commercial practitioners that follow their prescriptions, have all too often made the erroneous assumption (for analytical purposes) that asset returns are “normal” (ie, virtually never subject to events like the 1987 stock market crash or the 2001 tech wreck) and that financial markets are “frictionless”—ie, participants always benefit from perfect liquidity and price-discovery. These are, by way of example, some of the essential assumptions underpinning the “Capital Asset Pricing Model” (CAPM), which is widely used in the finance sector. Up until recently, perfect liquidity and return normality were condition precedents in almost all models used in conventional financial economics.
In the real world, however, participants are finding that they are increasingly faced with periods of profound illiquidity, extremely poor price discovery, and, in certain cases, complete market failure. In the financial market history of the last two decades, there are numerous examples of this illiquidity problem and governments acting to remedy it. In 1998 the massive hedge fund LTCM confronted severe illiquidity for its securities when the Russian government defaulted on its debt obligations, losing some US$4.6 billion in less than four months (LTCM was also hit by a sudden convergence in the “correlations” of all of the assets it held, which it had previously assumed to be uncorrelated and hence well-diversified). Of course, at that time the US Fed acted to facilitate a bail-out of LTCM by a consortium of investment banks.
In the past 8 months, major banks and investment institutions around the world have been subject to the specter of extreme illiquidity in the market for many of their debt securities, which has in turn made price discovery near impossible (ie, how do you value assets for which there are virtually no prices and when prices do exist almost all participants—including the regulators and government—agree that they represent dramatic deviations from any understanding of fair market value). One of the principal issues here is that academics, practitioners, and regulators have discovered that financial markets are not always “efficient” (in the “Chicago-school” or “semi-strong form” Fama (1965) sense). This is in turn because the investors that inhabit our markets are not the perfectly rational “agents” that economists used to have us believe. Fama’s “efficient market hypothesis”, under which asset prices reflect fair value almost all of the time (and, for example, active fund managers cannot consistently exploit pricing inefficiencies), is crucially predicated on the assumption of “rational expectations” developed by the likes of Lucas (1976). In short, this hypothesis supposes that investors in aggregate behave rationally almost all of the time and does not accommodate any traditional interpretations of systematic irrationality.
More recently, though, pioneering academics such as Kahneman and Tversky (1979) have documented that in reality people behave in a manner that can deviate strikingly from the predictions of the “neo-classical” economic theory (and rational expectations in particular). For example, Barberis, Shleifer, and Vishny (1998) and Daniel, Hirshleifer, and Subrahmanyam (1998) have, amongst many others, demonstrated that there can be major mispricings, non-rational decision making, and return anomalies in financial markets due to the behavioural biases of investors. In particular, the tendency of fallible humans to identify fictitious “patterns” in otherwise random return sequences and to be consistently “over-confident” in their assessment of their own forecasting abilities can result in significant market over- and underreactions (eg, consider the tech boom in the late 1990s and the subsequent tech wreck in 2001). Behavioural economists have also found evidence of the anecdotally well-known market phenomenon of “herding” and “groupthink” whereby strongly anomalous market-wide effects can materialize where there is collective fear and greed (again consider the enormous and seemingly irrational—at least judging by the actions of Central banks—global risk-aversion induced by the US sub-prime crisis).
It is now accepted by many economists that these behavioural biases that plague human decision-making under uncertainty can cause extreme asset pricing bubbles and subsequent crashes. In parallel with such innovations in the field of “behavioural finance”, academics have also started to accept that capital market returns are not “normally distributed”, but rather characterized by “fat-tails” (see Mandelbrot (1963)). The presence of these fait-tails in asset returns, which suggests that extreme events (such as the 1987 crash or the current credit crunch) can occur with far greater regularity than the predictions of a normal distribution, is also consistent with the tendency of investors to irrationally “herd” in one positive or negative direction, which perpetuates the clusterings of extremely positive or negative outcomes, such as that which we are observing today.
Unfortunately, it would appear that recent regulatory changes that require institutions to “mark to market” securities that they would previously hold to “term” only serves to further exacerbate these liquidity crises and entrench the associated market failures (since the institutions are forced to report losses and raise equity to supplement their capital on the basis of inaccurate prices that are purely an artifact of irrational investor risk-aversion and the consequent unwillingness to trade). In the presence of highly uncertain prices, institutions are reluctant to lend to one another as they do not have sufficient visibility on the value of the collateral that they will use as security. This propagates potentially enormous problems for the financial system at large as transactions that were previously considered to be nearly risk-free are subject to perceptions of “counterparty risk”. This is precisely what happened with Bear Stearns, which in on 10 March 2008 reportedly still had US$17 billion in cash. A few days later, the leading US investment bank Goldman Sachs announced to the world that it would no longer serve as a counterparty in Bear Stearns’ transactions. Goldman’s actions shattered confidence in Bear Stearn’s ability to service its obligations and meant that it could no longer raise any short-term debt funding to underwrite its working capital requirements. Once again, the Federal Reserve (the NY Federal Reserve in fact) was forced to step in and inject liquidity into a market that had failed: in particular, the Fed took Bear Stearns’ otherwise illiquid and unpriceable assets as security and lent JP Morgan the $30 billion that it needed to buy Bear Stearns.
In a prescient 2005 Bank of England paper by economists Cifuentes, Ferrucci and Hyun Song Shin, entitled “Liquidity risk and contagion”, the authors argue:
“When the market’s demand for illiquid assets is less than perfectly elastic, sales by distressed institutions depress the market prices of such assets. Marking to market of the asset book can induce a further round of endogenously generated sales of assets, depressing prices further and inducing further sales. Contagious failures can result from small shocks… At times of market turbulence the remedial actions prescribed by these regulations may have perverse effects on systemic stability. Forced sales of assets may feed back on market volatility and produce a downward spiral in asset prices, which in turn may affect adversely other financial institutions…In this way, the combination of mark-to-market accounting and solvency constraints has the potential to induce an endogenous response that far outweighs the initial shock.”
It should be clear that market failures and the absence of price discovery suggest that the provision of a minimum level of liquidity can be construed as a “public good”. While in practice it is hard for any good to unconditionally satisfy the two key conditions of a public good—namely “non-rivalness” and “non-excludability”—many come close to approximating them (eg, the light from a lighthouse, clean air, and market infrastructures). It is well known that markets can fail to produce sufficient quantities of such goods, which is referred to as the “public good problem”. As a technical aside, there may be an argument that market liquidity is “rival” but “non-excludable”, in which case it may be more appropriately classified as a “common pool resource”. In any event, you have similar problems to those found with public goods, albeit that in this case they are known as the “tragedy of the commons”.
The argument that market liquidity has public good characteristics is an increasingly well-understood feature of the academic literature. Schwartz and Francioni (2004) note that a number of different “exchange goods” have public good qualities. They nominate “price discovery” in financial markets, wherein transaction prices are like the beam from a lighthouse. The quality of these prices in turn relies on the effectiveness of the market’s infrastructure, systems, procedures and protocols, which takes the bids and offers and transforms them into market-clearing trades that give rise to prices. Price discovery is also dependent on how the exchange discharges its self-regulatory obligations. Schwartz and Francioni (2004) assert that an exchange’s self-regulatory obligations and the provision of supplementary liquidity are other examples of “exchange-produced” public goods.
Along similar lines, Holmström and Tirole address the question of whether “the state has a role in creating liquidity and regulating it either through adjustments in the stock of government securities or by other means?” in their 1998 Journal of Political Economy article, entitled “Private and Public Supply of Liquidity”. Holmström and Tirole conclude that when there are liquidity shocks and “aggregate uncertainty” the private sector “…cannot satisfy its own liquidity needs. The government can improve welfare by issuing bonds that commit future consumer income…The government should manage debt so that liquidity is loosened (the value of bonds is high) when the aggregate liquidity shock is high and is tightened when the liquidity shock is low. The paper thus suggests a rationale both for government-supplied liquidity and for its active management.”
In situations of extreme market stress, there may be difficulties discovering prices with any reasonable degree of accuracy, as we have seen in the AAA Australian mortgage securitisation markets. A market that accounted for $284 billion worth of transactions since 2002 (and nearly $51 billion per annum since 2003) has more-or-less disappeared. With virtually no liquidity in either the primary or secondary market, observed prices for AAA-rated prime Australian home loans with mortgage insurance in place have blown out 20 times from 15-20 basis points over bank bills to more than 300 basis points over.
The provision of supplementary liquidity and price stabilization services by a government agency, such as we are seeing today with the RBA (on a limited and discriminatory basis to banks only), the Federal Reserve, the Bank of England, the CHMC in Canada, or, perhaps in the future, AussiMac, is clearly consistent with the supply of the public good of liquidity and price discovery. In short, these interventions are needed because the production of sufficient liquidity and accurate price discovery are not forthcoming in a pure market environment that is gripped for considerable periods of time by irrational investor behaviour—that is, by the complete closure of otherwise incredibly low-risk markets, such as the market for primary AAA Australian mortgage-backed securities. Importantly, the supply of liquidity and price discovery by these government agencies conveys non-rival and non-excludable benefits to all market participants.
Unfortunately for Mr Ingolf, the Norwegian Banking Crisis to which he refers was not brought about by an exogenous liquidity shock that resulted in the closure of key markets liquidity in turn causing major havoc for domestic institutions, as is the case with the credit crunch that Australian lenders face today. As is noted in the paper to which Mr Ingolf refers, the Norwegian Banking Crisis was a “classic boom-bust crisis” wherein the economy was hit by a cyclical economic downturn (ie, a recession) wherein “loan losses and non-performing loans soared, wiping out the capital of many banks.” None of these attributes apply to Australia in the context of the current credit crisis. Firstly, we are not facing a severe recession—indeed the RBA has been furiously raising interest rates and doing everything within its power to attenuate GDP growth that it considers to be too strong. Secondly, the market failures Australian institutions are subject to have nothing to do with loan losses or non-performing assets in the domestic environment. On the contrary, despite the RBA raising interest rates 12 times in the last 5 years mortgage default rates (at November 2007) were no greater than the historical averages. As Joshua and I clearly state in our paper, the Australian financial system is being dislocated by a global liquidity crisis has been brought about by the US sub-prime calamity and the consequent extreme risk-aversion of major institutional investors who had exposures to the SIVs and CDOs that had invested in sub-prime assets.
The failure of the primary AAA mortgage securitisaiton market in Australia begs two further questions:
(1) If there is in fact no market failure here, and the banks are so incredibly well capitalised, and not subject to liquidity constraints (which is what Glen Stevens effectively said last Thursday), why is a major government agency, the RBA, being forced to supply unprecedented levels of liquidity, on unprecedented terms and conditions, to those same liquid and well-capitalised institutions (eg, its overnight repo facility has now been extended to 3 months and the fact that it is accepting for the first time ever AAA home loans as collateral against which it will lend to the banks)?
(2) Stepping back from the question of the stability of Australia’s banking system (which is the RBA’s real focus in providing liquidity), why is a major government agency, the RBA, supplying liquidity to offset the adverse effects of the closure of the $50 billion per annum mortgage securitisation markets to the institutions that the RBA claims least need that liquidity–ie the banks? Put differently, why is the RBA discriminating in its provision of liquidity and why should government make the same liquidity services available to all lenders (including the non-banks)? AussieMac would do exactly what the RBA is doing but simply make the liquidity service accessible to all lenders that satisfy AussieMac’s “prime” credit quality requirements (ie, the loans need to be low-risk AAA assets).
It has been recently alleged that the presence of AussieMac will increase moral hazard by encouraging more relaxed lending standards.
Any objective analysis will show that there is no reason why this should be a risk.
As we outline in our paper, AussieMac would be limited by its charter to only purchasing very low-risk, high credit quality “prime” home loans from Australian lenders (ie, either off the balance-sheets of banks or out of the warehouse facilities provided by non-bank lenders). Unless these lenders originate assets that comply with AussieMac’s rigid credit criteria, the assets would not be eligible for purchase. As discussed below, there is a wealth of highly reliable information to facilitate detailed credit risk analysis on Australian home loans. Consequently, so long as AussieMac imposes its credit requirements, there will be no deterioration in lending standards.
Note also that AussieMac would not be “guaranteeing” Australian home loans. It would be purchasing conforming, low-risk mortgages on its own balance-sheet using funds raised with its AAA sovereign-backed credit rating.
It would be straightforward for AussieMac to set its credit criteria much like any other lender. In Australia, there is exceptionally detailed mortgage and mortgage default data available for the trillions of dollars of Australian home loans that have been originated by Australian banks and non-bank lenders over the last 40+ years.
Mortgage insurers, such as PMI Mortgage Insurance and Genworth, have been insuring the mortgage default risk underpinning Australian home loans since 1965. The AAA-rated or AA-rated mortgage insurers have access to all of this default information, which AussieMac could easily use alongside other credit data (such as that provided by VedaAdvantage, which is the key Australian credit bureau) to set its required credit criteria. (Much of this data is also published publicly by the major ratings agencies, such as Standard & Poors.)
One of the reasons that Australia has one of the lowest rates of mortgage default of any country in the world is because of the strict credit standards imposed by lenders. For example, the mortgage insurance claims frequency on insured Australian home loans has averaged less than 0.7% since 1965 (ie, this is the proportion of loans that the insurers actually have to pay out on). The latest S&P scheduled payment 30 days or more arrears estimate on prime Australian RMBS was just 0.84%, which is a fraction of the nearly 4% 30 days arrears on prime US home loans and the 16% plus arrears rates on US sub-prime.
Importantly, AussieMac could also “mortgage insure” away all of the default risk underpinning any prime home loans that it acquired at relatively low cost. This is standard practice in the Australian mortgage and RMBS securitisation markets, and could be easily facilitated by either PMI and Genworth, who currently mortgage insure more than $400 billion worth of prime Australian home loans. AussieMac could achieve this in one of two complementary ways: (1) it could insist that all home loans with LVRs greater than 80% of the value of the property are mortgage-insured at the cost of the borrower, which is standard industry practice; and (2) it could then take out “portfolio-wide” insurance which would be a supplementary cost that it would pay to PMI or Genworth. Note that PMI and Genworth are regulated by APRA and capitalized independently from their parent entities with AA and AAA credit ratings, respectively.
Thanks for such a comprehensive and informative reponse, Christopher. By the way, Ingolf is my christian name, something you couldn’t of course have known. While it doesn’t much matter on the net it did feel a little odd (as no doubt it would for you to be addressed as Mr. Christopher).
I have no argument with the bulk of your post. Like you, I harbour no illusions that the markets are necessarily particularly rational and entirely accept that bubbles and crashes come with the territory. I also accept that liquidity, or more precisely lack of liquidity, is at times a pressing problem. Someone once summed it up very nicely by suggesting that “Liquidity is a coward. It’s never there when you really need it.”
From the tenor of your post, I’m pretty sure you agree that despite these quite serious flaws, markets are still our best means of price discovery, information transmittal and resource allocation. The core problem, as I see it, is that to endure, adapt and prosper it’s essential that such complex, largely self organising systems have constant real world feedback. In the case of the current financial architecture, that loop has for decades been clogged and distorted (more so of course in some nations than in others). Implicit central bank guarantees and various government support and protection schemes and instrumentalities have over time fundamentally altered the perception of risk. This, in turn, together of course with central bank monetary accommodation and the phenomenal growth in the last decade or so of what some call the “shadow banking system” has enabled credit growth to far exceed all historical parameters. In the US, Fannie and Freddie, together with securitisation, played a critical role in this exuberant expansion.
Still, it’s clear from your response that I didn’t explain myself anywhere well enough. In my initial post, I was primarily concerned with very long term, structural issues in the financial system and the potential dangers of establishing a new institution which, once established, would be most unlikely to go away in any hurry and which in due course might well play a distorting role whenever market memory fades sufficiently for the next credit boom to unfold. It seemed to me that creating an AussieMac was a very large step indeed in order to simply alleviate current liquidity problems. It further seemed that the underlying assumption that it’s always best to rapidly alleviate such problems deserved closer scrutiny.
Put in simple, indeed somewhat crass terms, my view is as follows. If the financial system is to be deregulated (which I certainly favour) then participants must not be unduly saved from their own foolishness. If, on the other hand, the political decision is made that widespread protection is to be provided, then fairly stringent regulations ought to be enforced. I fear that what we’ve wrought in the last couple of decades may just be the worst of both worlds, where markets are allowed, indeed encouraged, to innovate and expand with little hindrance but where the harsh discipline of the marketplace (which unhindered tends through fear and uncertainty to enforce its own rough constraints long before matters reach anything like the present level of excess) is to a large degree excluded through a plethora of well meaning but often ultimately destructive initiatives.
I entirely accept that this is a philosophical point of view on which reasonable people can (and do!) disagree and that the answers are by no means simple. I also appreciate that the resolution of this continual conundrum will always be a compromise, and often a messy one. Still, it seems to me these underlying principles deserve as much scrutiny and discussion as possible and that’s what I had intended to briefly touch on in my post.
The Norge’s Bank example, by the way, was not brought in because I think Australia as yet bears any relation to the situation then prevailing but because it was, I thought, a particularly fascinating (and relatively recent) example of how systemic risk can be dealt with whilst trying to ensure that moral hazard is not unduly heightened in the process. Right now, as you say, Australia’s liquidity problems are almost entirely a form of collateral damage from the larger global crisis. Whether Australia might face systemic risk issues more of its own making in the coming couple of years is a separate discussion. For my part, I don’t think it’s at all out of the question. When gearing attains current heights, a debt deflation dyamic is, I fear, an ever present danger. That we also suffer from a large and seemingly quite intractable external imbalance certainly does nothing to reduce that risk.
Anyway, thanks again for the response. Hopefully I’ve managed to make myself slightly better understood this time around.