Explicit vs implicit in the AFR

Christopher Joye and I have a piece in today’s Australian Financial Review on the political risks associated with not doing something about the reduction in competition in home lending [over the fold].

‘AussieMac’ for emergencies makes sense
by Joshua Gans and Christopher Joye
Australian Financial Review, 19th July, 2008, p.62.

The US government’s intervention on Fannie Mae and Freddie Mac has a clear lesson for Australia. In the US, those institutions were set up to provide a backstop of liquidity for the home lending sector in times of crisis. That decades old goal remains but in the meantime, Fannie and Freddie were privatised and the guarantee that the US government provided them with explicitly became implicit.

In Australia, our current methods of dealing with the evaporation of the primary securitisation market has been a set of responses that amount to implicit guarantees. The RBA has intervened in the market. But they have not done so in a way that has preserved past competition in home lending. The main beneficiaries have been larger institutions. Instead, it is crisis management and insurance and without any premium being paid. The political risk is that this will end up lining bank profits and will not smooth out bumps sufficiently to restore competition when the crisis abates.

We have proposed an explicit method of intervening that would have mitigated the current wash-on instability being felt in Australia and that would not fall into the pitfalls we have seen in the US from implicit guarantees. This would involve the government setting up a new publicly-owned agency that would issue low-cost government bonds and use these funds to purchase very high quality, low risk “prime” home loans from Australian lenders (including the bigger banks) that are temporarily unable to access securitised funding. Importantly, we have made it clear that this institution should only be an emergency liquidity supplier to Australian lenders when securitised funding for high quality home loans evaporates as a result of external shocks, as has been the case in Australian since November 2007. Our “AussieMac” proposal has received widespread support from smaller banks, building societies and non-bank lenders for the government to establish a more permanent infrastructure that guarantees that all Australian lenders–and not just the bigger banks–have access to minimum levels of funding during extreme market crises.

Australia’s central banking system supplies exactly this sort of liquidity support to deposit-taking institutions (ie, the banks). Yet when the central banking system was set up, securitisation did not exist: it is a more recent innovation that emerged in Australia in the early to mid 1990s. Since that time our financial system has evolved to the point where prior to the credit crisis around 23% of all funding for Australian home loans came from securitisation, which enabled smaller banks, building societies and non-bank lenders to compete with the major banks. Unfortunately, our regulatory system has not changed to reflect these capital market innovations.

Almost all participants agree that the primary securitisation market has failed for reasons almost entirely unrelated to Australia. Australia does not in effect have a sub-prime market (less than 1% of our home loans can be classified as such) while the RBA and others have frequently noted that Australian default rates are a fraction of their US equivalents. When critical markets fail, economists accept that governments have a responsibility to intervene to provide the “public goods” of a minimum level of liquidity and price discovery. This is exactly what we have seen central banks and governments around the world do since the second half of 2007, including the RBA: the problem in Australia is that the RBA’s liquidity services only benefit “deposit-taking” institutions and afford no security to smaller institutions and non-bank lenders that have been most severely affected by the crisis.

There are those who oppose intervention on the grounds that markets will shortly return to normalcy. What has happened since we first published out paper in March 2008? First, there has not been a single public securitisation of AAA-rated home loans on what would be considered “economically viable” terms (ie, terms that support profitable new lending). Consequently, a market that has provided 20% plus of all funding for Australian home loans remains in effect shut. This has caused many smaller yet still significant lenders to stop lending altogether (eg, Macquarie Bank) or to severely ration credit (eg, Adelaide Bank, Challenger Financial Services and Credit Union Australia). The market share of the Big-5 banks has continued to rise with Fujitsu Consulting estimating that they now represent around 90% of all new home loans (up from 75% prior to the crisis). The major banks keep on passing on rate increases over and above the official RBA changes with a total of 50 basis points so far. And, as we predicted, we are seeing extensive credit rationing by the major banks in the small business and corporate lending markets as they re-allocate capital away from this more expensive, 100% risk- weighted sector to the 35% risk-weighted home loan market. The bottom line is that the primary securitisation markets are still not a source of viable economic funding for Australian lenders with significant adverse consequences for both competition and the cost of housing finance.

Australia needs a debate about having explicit and widely accessible guarantees as opposed to implicit limited ones. What is at stake is not only the structure of competition in retail lending but also insurance against moves that might mean a return to highly regulated retail banking as a quid pro quo for implicit guarantee. Such regulation would handicap our financial sector. In this respect, long- term competition is an opportunity to those with a stake in the sector and not a threat.

Joshua Gans is an economics professor at Melbourne Business School and Christopher Joye is CEO is Rismark; a non-bank provider of equity financed mortgages. They have made a submission to the Senate Economics Committee Inquiry on banking competition.

One thought on “Explicit vs implicit in the AFR”

  1. Competition is good, but credit is a drug. There is no excuse for trying to sustain the model that got us to where we are.

    Securitisation generates massive fees for the finance sector and encourages misallocation of capital into residential property and asset growth, while transferring unknown risk to unsuspecting downstream parties. Good riddance I say.

    Substituting government bonds is nearly as bad. It’s a bad use of government debt, will privatise the profits but socialise the losses, and will prolong the unsustainable housing boom.

    In my view the critical factors are (1) credit only to the creditworthy and (2) transparent regulated wholesale funds origination such as covered bonds. In this context, creditworthy means 80/20 mortgages, payments limited to 36% of income and an end to low-doc and other aberrations. Home ownership is a privilege not a right.


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