Deep T: Australian Banking System on Unstoppable Path to Collapse or Government Bailout

Yves here. This long and informative post on the pending train wreck in the Australian financial system might seem to be too narrow a topic for most Naked Capitalism readers, but it makes for an important object lesson. Australia managed to come out of the global financial crisis largely unscathed because its banks did not swill down toxic assets from the US (chump quasi retail investors were another matter) and it benefitted from the commodities boom.

Nevertheless, one might think its bank regulators might see what happened abroad as a cautionary tale. Mortgage debt took center stage in the crisis, and Australia is in the throes of a serious housing bubble. Yet as this post describes, the regulators seem asleep at the switch as to one of its major drivers.

By Deep T., a senior banking insider who is fed up with his colleague’s reliance on public support. Cross posted from MacroBusiness.

Previously I have posted on how the major banks recycle capital in The Capital Rort. I want to extend that subject by showing how mortgage ‘rehypothecation’ in Australia has led to the massive expansion in liquidity available to Australian banks which is at the root of the mortgage affordability issues in Australia and has put Australia’s banking system on the unstoppable path to collapse or government bailout.

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

To understand how rehypothecation applies to the Australian mortgage markets, I’m going to start with where the money comes from to fund our oversized mortgages and why? But to warn you, what I’m about to describe is not pure rehypothecation because the mortgage collateral is not directly passed to the lender but it is used to prop up the bank’s balance sheet, the strength of which the lender relies on. So the ultimate effect 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:

Screen shot 2011-02-11 at 4.01.22 AM

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

‘Resident liabilities – deposits’ include: transaction and non-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 ‘resident liabilities – other liabilities’. Certificates of deposit relate to both residents and non-residents. ‘Non-resident liabilities – 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 a double take when I saw this. In simple terms, loans or liabilities from non-residents appear in both deposits and non-resident liabilities as defined by the RBA. I do not see this as any action that’s deliberately trying to deceive but rather a reflection of the poor information produced by the banks and reported to APRA. Does anyone really know how 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 amount of what previously was properly defined non-resident liabilities have been transferred to deposits and that overall bank’s liabilities to non-residents continues its upward trend. This transfer is to the benefit of the offshore lenders but at Australia’s cost and risk. I have three reasons for my proposition.

Firstly, deposit rates are at all time high rates relative to the cash rate and bank bills. Please take a look at this site which gives a good summary of bank deposit rates across the board. With the CBA offering a 1 year deposit rate of 6.1%, would this tempt any non-resident investor? Maybe Bill Gross from PIMCO, the world’s largest fund manager, provides the definitive answer to that question when advising that investor’s portfolios perhaps should be:

…replaced with more attractive alternatives both from a risk and 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 major currencies did not come about because of current account surpluses, we still have deficits. Global punters have been buying A$ and lending those A$s to Australia. Why they are doing this is not the point. The point is that if you buy A$s it must be used to buy assets or equities or as 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 any other possible investor does not care one iota that imposing this strength on 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 are generally believed to rank ahead of other wholesale lending for repayment. That’s why deposit interest rates are considerably lower than other types of securities issued by banks. What the actual credit ranking is very complex? See for yourself.

Regardless, in an environment where in effect the Australian government 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 the Banking Act, the market believes that the Australian Government will not let any bank default on deposits but just may let defaults occur on wholesale funding. At over 6% for 12 months, I’m again betting that our Mr Gross thinks that’s great value “from a risk and a reward standpoint.”

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

The last point on credit risk is what links me back to the continual rehypothication of Australian mortgages by the Aussie major banks. The offshore investors who are pouring money into Australia on an ever increasing basis do not want to worry about credit. It’s not their bailiwick. Absolute returns over the next year or so relative to the alternative global investment are what they are after. These money jockeys will plow funds into Aussie banks so long as relative returns continue and the perceived risk is not worth worrying about.

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

It is a truism that any financial system that can continue to increase borrowings to meet liquidity requirements will not fail. The question is when or if the “continue” stops. My proposition for Australia is that it’s a “when” due to excessively aggressive mortgage rehypothication. Don’t get me wrong, like securitization, rehypothication is a valuable financial tool, so how did things get out of control?

In my post, “The Capital Rort”, I explained how the bankers were rorting the system to fill their fat wallets by reducing capital allocated to each mortgage as property values rise. Now we need to take that analysis to another level, to show how they’ve actually put Australia’s financial system on the relentless march to either collapse or further government rescue. But don’t be concerned about our friends the bankers 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, Australian Bank Capital and the Regulatory Framework by Adam Gorajek and Grant Turner.

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

Some banks, including the four largest, use an alternative Internal Ratings-based approach whereby risk weights are derived from their own estimates of each exposure’s probability of default and loss given default.

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

Exposure Average Risk-weighted assets

$ billion Per cent $ billion Per cent of total

1,157 26 302 22

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

Clearly the internal risk models are gaining an incredible regulatory capital advantage for those banks that use them. With risk-weighted assets allocated capital at the rate of 8% the total amount of regulatory capital required against the total $1.157 Trillion mortgages on the banks books 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 as approximately half (the riskiest half) of $1.157Trn of mortgages is covered by mortgage insurance.

Ok, so how much capital is behind the mortgage insurers? The vast majority of mortgage insurance is provided by just 2 companies ie Genworth and QBE LMI (formerly PMI). An analysis of the accounts should 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 that is, how much capital is held against Australian mortgage risk?

At this point, and although I cannot produce public information to support my case, I need to use my knowledge of the capital position of the mortgage insurers. To the nearest percent, the collective capital base of 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. How did this occur and how is it being allowed to continue?

It occurred because APRA allows the capital requirements of banks and insurers to be adjusted down as the value of the collateral behind mortgages increase. For collateral, see house prices. But those organizations make more and more money by writing bigger and bigger mortgages. So APRA and regulation have created a system which incentivises the lenders and insurers to take more and more risk on the basis 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 the while publicly espousing the quality of Australian mortgages. When all they’ve done is expose every Australian to massive systemic risk. How can we believe that in a country which has the most unaffordable housing in the world also has one of the lowest mortgage risk? If it quacks like a duck…

However, no system is sustainable without a continual money supply which is where the rehypothecation of mortgages comes to the fore. By continually revaluing the mortgage collateral to support further borrowing without needing to provide significant amounts of extra capital (hair cut, in securities rehypothecation), provides the turbo charge to excessive lending and the relentless march to systemic failure or government rescue. But this is done by piling more and more risk on every Australian, not just homeowners, not just by using the artificially created equity that may accrue in a house but also the real equity, which provides the base that spins money flow through excessive rehypothecation. This has all occurred under APRA’s reign and encouragement, 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.

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  1. PDC

    It seems to me that modern rulers of the world, being them politicians, bankers or whatever, act as they had no choice at all: doomed to follow the path of minimum resistance.

  2. Sam

    ‘Relying on continual mortgage rehypothication to prop up the perceived credit risk and support capital levels (aka haircut) of the Australian banks is a very dangerous game.’ – could someone explain that sentence to me? I don’t see how the process of diluting capital requirements with inflated asset safety has any link with a repo haircut.

  3. William

    Do you really think the Australian banking system in under-capitalised? APRA’s application of Basel requirements is one of the most stringent in the world (one can add 2-3 percentage points against Tier 1 measures when compared to UK banks for example). Of course, as time goes by LTV falls, and is obviously accelerated during property boom times. So while they may hold less risk weighted capital as a result, the buffer before bank loss starts also increases. I note that the regulator overseas both the banks and LMI – and sets their capital levels for both. Over the past decade the regulator and government has undertaken very proactive assessment of the situation, and have a history of stress testing the system, and enforcing greater capital if deemed necessary (see apra website). Due to such measure taken, current stress testing of the system, by APRA, and also independently by Fitch Ratings show that a heavy, far reaching scenario (ie gdp contraction3%, unemployment 11%, property prices down 40%, and macro econ slowdown in China) can be absorbed with manageable impact on capital (ie under the worst case Tier 1 fell 3.1% over the 3 years of stress).

    In regard the property bubble: In the short/medium term prices are underpinned by demand, the main question in regard this is why the both political parties, during their times in office over the last decade or so, have let the preferential property investment tax system fuel such a bubble?

    The politicians have already answered this: Finance minister Lindsay 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 investment framework 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 and you see the economic devastation that flows from that” – and no side of government wants this to happen on their watch.

    I also note that perhaps the movements in deposits and offshore funding is a result of the banks intentionally doing this mainly to comply with the new basel stable funding and liquidity requirements. These have been known for months, with APRA detailing their final requirements in December (hence the movement over this time). Such requirements need more stable funding (ie retail deposits-hence the domestic competition in rates), and less reliance on offshore funding sources – which is why you see recent movement in these levels.

      1. monday1929

        Yes, in Australia, the two highly respected ratings firms are Loodys and F&P. They are run by top notch men who have graduated from top MBA programs. They sit on the boards of some of the top banks, and are intimately familiar with the risk levels of those banks.
        Perhaps we can sell Australias parlament our FCIC report, to save them the expense of producing their own whitewash.

        Oh, and the Australian crash was, I mean is, UNFORESEEABLE.

    1. monday1929

      Can I ask you one question? Did you believe in 2007 that the subprime crises would be “contained”?
      Thank you for any reply.

  4. Hmmm

    Australia’s situation is very dire. The credit/housing bubble is huge. However this article is sloppy. 1) it ignores the fact that all Australian mortgages are full recourse; the capital held against residential home loans includes the future garnished wages of borrowers; 2) it ignores the fact that >90% of borrowers are on variable interest rate contracts, so the capital held against residential home loans includes future juiced up interest rate margins; 3) it ignores reinsurance by the LMIs.

    My impression is that most of the risks of the credit/housing bubble rest on the laps of the borrowers themselves, to a much greater extent than in the US, and the reinsurers of the LMIs (probably foreign). The main problem facing the banks is that the risk models that allowed them to reduce the risk weighting of their home loan books as house prices rose (and LVRs fell) will force them to raise the risk weighting when prices fall. However, there is a limit here: 100% risk weighting. If the current average risk weighting is 26%, we are talking at most of a tripling of capital, an additional $75 billion. Most of this could probably be built up by increasing interest rate margins(hence point, 2 above) and the banks have already built up a bit of a buffer: Tier 1 capital stood at 9.6% as at September 2010, against the required 8$

    1. monday1929

      I hope those LMI’s are solid (whatever they are). Genworth was a $1-2 dollar stock during the long ago Crash of 2008, meaning it is insolvent.
      How much support for the economy will wage-garnished, underwater (not literally I hope) Australians provde?

      Looks like EWA provides a good way to wager (and what else is there to do now?) on a commodity and housing bubble burst, without the annoying foreign reserve surplus that China has.

    2. eleanor rigby

      Just so you know, BaselII allows a minimum LGD of 10% in advanced internal risk models for residential mortgages. APRA decided to set a higher minimum of 20%. So even the “advanced” banks have to hold more capital against residential mortgages than Basel II requires. And boy do the local banks complain about them. They would have loved US FSA’s laxer just-the-Basel-minimum approach. APRA also raised the LMIs’ capital requirements after their 2005 stress test. it is all on their web site.

      I am pretty sure the original poster (Deep T) has no idea what they are talking about and cannot read a balance sheet. They are getting all het up about non-resident holdings of CDs — of course you can’t tell who holds a tradeable security from the balance sheet of the issuer. But this is from the Australian books, not the consolidated books, which is surely what tells you about total foreign liabilities. And anyway, did it occur to Deep T to find out how important CD’s are? Answer is in table D3 on the RBA’s web site.

      Have you actually, you know, tried to persuade APRA or RBA of your concerns?

      1. eleanor rigby

        I meant UK FSA, of course.
        Anyway, for anyone who doesn’t know how to find statistics on RBA’s web site, the answer is that TOTAL CDs on issue by the Australian banks is around $170 billion, and this is down from the peak in 2007 of $200bn. So I don’t see how it can be that non-residents are buying up all the CDs and replacing offshore bond issuance. At least not in big enough quantities to be fuelling a big bubble.
        Also, I went at looked at APRA’s web site. The relevant page is:
        There is a form 320.0 which gives the domestic books numbers, and this must be what the RBA uses to produce its statistics. If you scroll down to row 350 or so, you can see
        12.1. Australian ADI operations: Total amount due to non-residents (excluding intra-company transactions)
        12.1.2. of which: Deposit liabilities due to non-residents (excluding intra-company transactions)
        So the RBA obviously doesn’t publish every last detail, but it sounds like they know exactly how much the banks owe offshore.

      2. wtf

        If Basel II did nothing to protect the banks during the GFC, why would Basel III (+ a bit) be that much different?

  5. Glen

    Don’t forget Canada. Despite being heralded as the Poster Child of good banking and fiscal responsibility, Canada is going to have its own crisis. A look at the recent comments and actions of one of Canada’s largest banks may by enlightening.

    Ed Clarke, CEO of TD Canada Trust, has been pleading with the the Federal Government on change the maximum amortization period of Canadian Mortgages from 35 to 25 years.

    In December, the TD’s Ed Clark was prominent among bankers calling for such tightening. He seemed to be pleading, “Stop us before we lend again,” but his message was really that when government insures mortgages, bankers can’t afford not to extend them. Government policy creates a classic “prisoners’ dilemma,” where bankers are led to make decisions that are individually rational but systemically suboptimal, even downright dangerous.

    Read more:

  6. Doc Holiday

    General Blankfein’s Loot to be Frozen soon?

    Mubarak’s Swiss Assets Frozen

    Bern decided to freeze Mr. Mubarak’s money in case the funds came from illicit means and to prevent Mr. Mubarak from accessing them until the source of the money is clarified. The Justice Ministry had no immediate comment as to whether the move came as a result of a request from authorities in Cairo. Reliable estimates of Mr. Mubarak’s wealth, or how much of it is held in Switzerland, are scarce.

    1. Paul Repstock

      OMG! Gutless little Swiss slime sucking banksters…Where the hell did they think the money came from yesterday???

      Blow them when they are up, kick them when they are down..

  7. monday1929

    The Steve Keen link provides the closest thing to time travel someone without a Delorean can hope to achieve. Th3e parabolic rise, and the justifications given by the usual (Australian) suspects are priceless- including using the homeless population in their housing demand calculations. If you recall, demand by “illegal” aliens was used in the USA as one factor to justify our bubble pricing. Japan offered 100 year mortgages near the end of their bubble.
    I am willing to bet that when the first cracks appear in the low end of the Australian housing market, the central bank will assure the populace that “it will be contained”.

    I hereby pledge 10% of all profits gained from this bubbles collapse toward a bounty fund which will pay anyone providing information leading to the indictment of any senior bankers, raters, or “regulators” in the USA.

    One obvious (??!?)trade is long commodities and short selected Australian sectors.

  8. KnotRP

    Poor Steve Keen…got suckered into a bet on “when”, instead of “if”….entirely correct on everything EXCEPT for his estimation of the depravity and corruption governments would engage in just to “turn the machines back on in the austrailian housing market” (Trading Places) for a little while longer.

    Keensandra has truly been cursed with such knowledge…

  9. Skippy


    Massive speculative RE/CRE bubble blow whilst wages were stagnate (Bonsai’s work reform cough neo-liberal agenda) save for exec comp and mining sector increases (See Gillard’s hasty retreat from Rudd’s election promises under business pressure/international investor concern).

    Mobile work force induced real estate expansion see Queensland and Perth et al via labor chasing returns (selling over valued assent in a total inflationary environment to find better quality of life issues).

    All under a massive media blitz, insisting the herd join the game before its too late (last sucker in the door is a sukie na na).

    Government life line to crappy sub-prime MBS/CMBS (same rubbish as USA) tapped out, bailout of a bailout soon?.

    Chinese/Singaporean hot money (elite newly minted industry owners/capitalists) looking for a place to park it down under as a hedge (+ expansion of influence) the US/Euro markets, propping up leaning tower.

    Massive reduction in mining royalties (now near a half billion in one state alone), AG/livestock cash flow/expectations/profits loss (um 6 months to turn around[?] in some sectors), infrastructure damage (energy, energy, energy and road/rail), lag time at ports, all due to an La Nina pointed directly at the northern Australian coast, its not all history yet).

    Clean up in one state alone nearing, to date, of half a billion, legacy issues with toxins, land and water (my kids rugby field is being tested, near CBD), Brisbane CBD was inundated (some projects will bust projections at near completion…sorry…Leighton/Petie, 60 odd thousand residences in one state with out power for months?

    All this on the back of states selling utility’s to fund their budgets…what is the debt weighting going to be like down the road, where is the cash flow to off set these future funding needs, inflation[!], inter/national consumption[?].

    In ending I know of mostly of a few types now days, the bail-ers or the over leveraged and the short horns (clue-less/treading water), yet here we stand debating capital limits % of exposure…right


  10. David Collyer

    Deep T’s bank-of-envelope calculations suggest our banks back $1.157 trillion in mortgages with a mere $30 billion in shareholders’ funds and the capital of mortgage insurers Genworth and QBE.

    If his calculation is even roughly proximate, our banks will be trashed by even a modest downtick in prices.

    We have been looking out for the needle that pricks The Great Australian Land Bubble. I think this is it. Unless the arguments Deep T raises are immediately contested and proven to be incorrect by the RBA, a run by overseas depositors and short selling of our banks will begin 9 am Monday.

    1. eleanor rigby

      Why the f*** would the RBA sit around responding to anonymous bloggers?
      I just googled your name and apparently you are a political candidate for the Australian Democrats party. Why don’t you write them? Heck, why don’t you call them and ask to speak the head of Financial Stability there? I just looked up who that was. I’m guessing she is pretty busy, but you aren’t helping anyone just posting to blogs.
      And I presume if you are willing to make the prediction in the first sentence, you are willing to short the banks’ stocks. Let’s see if you are more than just talk.
      PS: ASX doesn’t start trading till 10am, so I’d like to see the short-selling start before that.

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