Intervention back on the cards

What a difference a month or so makes. Back in August, RBA and Treasury officials paraded before the Senate and stated categorically that the markets were working as expected and the non-bank exit was but a blip and they would return forthwith or, at the very least, the expectation of their return would provide much needed competitive discipline to the major banks. And just to prove them right the banks played ball and dropped interest rates with the RBA.

But now another interest rate cut may be around the corner and with enviable profits it is not clear that the banks will follow suit. Nonetheless, I nearly fell off my chair when I heard the Treasurer, Wayne Swan, say this in Parliament yesterday:

We also, in that legislation, gave authority to the government for the AOFM to be more active in the area, should that be required. We stand ready to take further action in the mortgage market to make it more competitive so that Australian families out there get a fair deal. That is the government’s position.

This was surprising that the Treasurer all but ruled out such intervention only a few months earlier and the non-political executive branch had ruled it out as unnecessary. As it is unlikely that moral suasion will work again, I guess the Treasurer doesn’t want to face an electorate with limited bank competition.

So let me revisit the case for the intervention as I summarised it in July:

  1. Home lending is funded from two sources: deposits and securities.
  2. Thanks to the US subprime crisis, securities have dried up in Australia.
  3. The result is a contraction in supply, a rise in interest rates on mortgages, credit rationing of SME business lending and the major banks now having 90%+ of the home lending market (reversing a decade or more of competitive gains).
  4. Non-deposit taking institutions (and smaller banks) have been left out in the cold. Compared with the US and Canada that have GSEs where they are still operating competitively.
  5. An Australian GSE would bring back the securitisation channel. By using the government’s AAA-rating it would restore confidence to that market and so long as the GSE was not backing non-conforming (high risk or subprime) loans then there would be no cost to the government.
  6. The only risk would be a major housing meltdown (of the kind seen in the US recently) but in that situation the government is already carrying that risk by an implicit guarantee to the banks.
  7. There would be no moral hazard as loans backed by the GSE would have to be conforming.
  8. There would be no crowding out because supply is currently tight and the GSE could have a mandate to only ramp up activities in liquidity constrained times.
  9. At present, there is no other solution that offers to do all of this and back sustainable competition in home lending. (The spectre of re-regulation looms as a lack of a securitisation pathway removes the Wallis justification for de-regulation).
  10. And that is why we need a GSE.

The RBA and Treasury officials now appear to agree with 1-3 but don’t otherwise care. The Treasurer (and indeed the Opposition too) are now down on 4 and 5. But in the US, they have gone all the way to 10 with a nationalisation of the mortgage securisation business; the ultimate in government intervention and support and with no claims what so ever that this isn’t a market worth supporting.

When it comes down to it, Australian businesses (non-bank lenders) have failed but there has been no bail out. To be sure, this hasn’t caused a meltdown but it has left consumers with extra interest rate payments (now at a cost of almost $2.4 billion). And now Malcolm Turnbull has stepped left over the government and is calling for liquidity to address this and restore competition. It is not hard to imagine that Labor politicians are left wondering how they appear to have gotten themselves alligned with Terry McCrann and the CIS. The answer is that the advice they are getting is flawed both ideologically and factually. It is time for them to treat it just as advice and then consider their own predispositions on government intervention in failing markets.

Using the Australian Office of Financial Management was one thing that Chris Joye and I recommended as a transitional measure towards a government sponsored enterprise that did a transparent and committed job of ensuring liquidity in mortgage-backed securities. Others have called for the same thing. Right now that seems like a compelling proposition as our ‘too big to fail’ banks become even bigger. Indeed, perhaps because of that, the Treasurer should use the AOFM just to assist the non-major lenders. After all, the majors are against all that moral hazard and so assisting them would really be something they are dead against.

[Update: This post appeared in Crikey, 26th September 2008]

4 thoughts on “Intervention back on the cards”

  1. Several points:
    2: Securitisation died because housing finance turned out to be much riskier than was realised.
    4: US mortgage finance is far from healthy and there is no competition. GSEs have it all.
    5: The government can only borrow more cheaply if it assumes significant risk.
    6: Currently the government may implicitly protect bank depositors but it is shareholders who are in the front line of risk.
    8: As in the US, the end result would be nationalisation of housing finance, a terrible outcome.
    9: There is plenty of competition: it was the competitive marketplace that has killed off non-bank lenders.

    It’s a dead duck. Fortunately the government has more sense.

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  2. Joshua and I have argued long and hard in our assorted papers and submissions about the quite orthodox rationale for governments to temporarily intervene in key economic markets when they collapse. As it would happen, we are seeing this all around us today with central banks and governments intervening in different capital markets on a daily basis in order to safeguard our collective welfare. The inherent contradiction between these otherwise warmly embraced actions and the criticisms tendered in response to our proposal are typically ignored by those that do not support our work.

    One example closer to home is that a major Australian government institution–the RBA–has lent many billions of dollars to the banks in order to prevent them from being adversely affected by the illiquidity in global capital markets and exposed to the risk of a run on their deposits. Of course, another key economic market–namely, the market for high quality â??primeâ?? mortgage-backed securities (ie, the so-called â??securitizationâ?? market), which up until recently provided roughly 20-25% of the funding for all Australian home loans–has been economically closed to non-bank lenders, building societies and banks for the last 11 months (ie, lenders have not been able to securitise for less than 100 basis points over bank bills, which is the minimum break-even point to support new lending according to the RBA (who confirmed analysis previously published in one of our papers)).

    The RBA and Treasury have posited asinine arguments as to why the government should not inject some much needed liquidity into this market along the lines that we proposed–which almost everyone agrees, including the RBA, is economically closed for quite irrational reasons (we were, in fact, the first to suggest the use of the Treasuryâ??s AOFM, which would be a neat near-term solution). Yet in response to our proposal, the only critique they have offered is that the illiquidity in this market is â??cyclicalâ??. This is complete crap–there has never been any such cycle before, and you would be hard pressed to find a sane economist anywhere in the world who would describe the current capital market calamity as cyclical in the ordinary sense of the term.

    Rory Robertson, who is Macquarie Bankâ??s interest rate strategist and one of the RBAâ??s staunchest defenders, has not historically been a supporter of Joshua and my proposal. Yet yesterday he sent out a note to his clients with the comments that I have enclosed below. This is basically a verbatim replica of the explanations that Joshua and I have regularly offered up for the need for the government to intervene in Australiaâ??s RMBS market. Of course, Rory is using it to justify the US interventions. The irony is particularly rich given that some of the examples Rory uses to buttress his points are taken from the RBA itself–eg, the RBA enjoys being able to intervene unilaterally in the foreign exchange market, but it does not wish to afford the same luxuries to the Commonwealth in the context of a market that funded a quarter of all Australian home loans! Go figure.

    I took Rory up today on this apparent contradiction between his critique of our work and the mirror image rationalisation he has outlined below for government intervention elsewhere and he appears, to his credit, to acknowledge that there was some substance to what we were saying–or in his paraphrased words, â??what I wrote was morphing towards what you guys were sayingâ??. Enjoyâ?¦

    Rory Robertson, Macquarie Bank, writes at Wed 24/09/2008 5:19 PM:

    Krishna Guha in Washington on FT.com reports that Fed Chairman Bernanke yesterday explained to the US Congress the logic the urgent plan to buy up to $700b worth of “troubled” – mostly mortgage-related – assets from US financial intermediaries. He told members that each security can be thought of as having two different prices â?? a â??firesale priceâ?? and a â??hold-to-maturity priceâ??.

    Like both the BIS and the RBA (see links below), the Fed reckons ongoing market turmoil generally has forced the former well below the latter: â??today the firesale price may be much less than the hold-to-maturity priceâ??. That is, the “hold-to-maturity” price reflects the value of – damaged but still-substantial – expected future cash flows while the latter reflects the distressed prices observed recently as banks and other leveraged holders have been forced to sell in a hurry in the face of intense liquidity stresses. It is these distressed-sale prices that are doing so much damage to finance-sector balance sheets, via “fair value” accounting.

    By buying the illiquid assets at prices above distressed levels – closer to their estimated cash-flow based value – the US Treasury would create a new observed market price for these assets that is higher than the current firesale prices: “This would cap mark-to-market losses on these securities for banks and might indeed result in some writebacks of capital for companies that had written down their assets to the prevailing firesale prices. That would set in train a virtuous rather than a vicious cycle. In effect, the US government would fix the problem of procyclicality embedded in the mark-to-market accounting regime by the back door. It would use its own purchases to establish new prices to which banks would mark their portfolios â?? prices based on expected cash flow rather than the prices private sector buyers would be willing to pay in the absence of the government scheme”.

    “…In normal times these transactions would take place between private parties. However, the price at which private sector buyers are willing to purchase is influenced by the prevailing price of risk along a number of dimensions, including liquidity risk. In current circumstances â?? when the price of risk is very high â?? this means buying at firesale prices only. According to this line of thinking, only a government buyer can establish a new and higher set of observed prices close to the cashflow-based value, because only the government remains risk-neutral and is immune to the big increase in the liquidity risk premium.”;

    **The latter reference is from the RBA’s March Financial Stability Review. Back then, the RBA observed that:

    The sharp falls in the prices of the ABX.HE indices over the past year or so have …played a part in the large credit writedowns that some financial institutions have recently been reporting. There is, however, a growing concern that the prices of the ABX.HE indices, particularly the â??AAAâ?? sub-indices, may be giving an unrealistic signal of the losses likely to be sustained on the underlying RMBS, which is prompting some to question the use of these indices in valuation models. According to one estimate, the recent prices of the ABX.HE indices imply cumulative losses of about one third on the constituent RMBS. One way this could occur would be if two thirds of mortgage holders defaulted, and the average recovery rate was only half of the mortgage values. This would be many times worse than historical experience and implies a very significant fall in US house prices. Those questioning the use of ABX.HE indices in valuation models have also focused on the fact that the indices capture only a very narrow slice of the market â?? 20 underlying RMBS versus the 50â??100 that were typical in ABS CDOs produced in recent years â?? and that the prices may be prone to distortion given the relatively thin trading seen recently. (See RBA link above, Box B on page 20 of 73)

    **The problems caused by panic-period pricing of US mortgage-related assets have only got bigger since March, to an important extent driving the failure of several big-name US financial institutions over recent weeks. The RBA – in its September Financial Stability Review due tomorrow, at 11.30am – no doubt will again highlight the inefficient and damaging pricing behaviour in US mortgage markets.

    **To help put current developments into their proper context, recall that the RBA was pretty well the only buyer in the world of the Australian dollar when it collapsed below 50 US cents in the early 2000s (the low-point was 47.7 US cents). Sustained RBA intervention ultimately put a floor under the A$, and the RBA ended up making a fortune from its A$ purchases as it headed towards “parity” over the next five of six years.

    **The RBA has justified its occasionally aggressive interventions in currency markets as follows:

    …over the past couple of decades, the academic literature has come to acknowledge that financial markets can overshoot â?? i.e. asset prices can move to levels that do not seem reasonable in the context of a range of economic and financial developments. There is an extensive literature, for example, on speculative bubbles, herding, fads, and other behaviour which can drive market prices away from their equilibrium values, even in a market which is deep and liquid. When such overshooting occurs, intervention may help in limiting the move or returning the exchange rate towards its equilibrium level, thus obviating the need for costly adjustment by the real economy to the incorrect signals which the exchange rate would otherwise give.

    (See 6. Why Does the Reserve Bank Intervene in the Foreign Exchange Market at http://www.rba.gov.au/MarketOperations/International/ex_rate_rba_role_fxm.html#six )

    **Sure, the US mortgage market is much bigger and important than our little old A$ market. But – and correct me if I am wrong – the approach the RBA takes periodically in the A$ market – buying aggressively when the A$ breaks sharply below levels the RBA regards as justified by fundamentals, to avoid painful macroeconomic damage – is exactly the approach the Fed is taking in proposing that the US Treasury buy up to US$700b worth of mortgage-related and other securities; simply, the Fed judges that these securities are trading way below their fundamental values, and that current “firesale” prices reflect a massive market failure, a failure that is causing painful and unnecessary damage to the global finance system and the global economy.

    **”According to this line of thinking, only a government buyer can establish a new and higher set of observed prices close to the cashflow-based value, because only the government remains risk-neutral and is immune to the big increase in the liquidity risk premium”. Ideally, the US Treasury’s unusual purchases of mortgage-related assets will turn out to be as profitable as the RBA’s occasional heavy purchases of A$. The hope is that the US Treasury will put a floor under prices, sparking purchases by value-conscious long-term private investors, and ultimately generating a series of “write-backs” on banks’ balance sheets, bolstering bank capital and limiting the damage increasingly flowing from the global credit crunch. We’ll see. First, the $700b package needs to be given a tick this week by the cranky US Congress.

    “IASB calls credit crunch meeting” (September 24, 2008): The International Accounting Standards Board next week will hold an urgent – previously unscheduled – board meeting to discuss topics including â??fair valueâ?? and off-balance sheet accounting. The FT reports that it is the first time the IASB has held an extraordinary meeting of this sort. Many banks and insurers have “complained that the extreme market moves of the past year have caused them to write down billions in terms of ‘fair value’, leading in many cases to reported losses, even though they have no intention of selling the holdings and believe that prices will recover”; http://www.ft.com/cms/s/0/886e4a40-898e-11dd-8371-0000779fd18c.html

    **Comments, criticisms and corrections welcome.

    Rory Robertson
    Interest-Rate Strategist
    Macquarie Debt Markets Division (Sydney)

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  3. There is another solution to the house asset bubble crisis that will encourage the building of houses and be non inflationary. The financial crisis we are told has happened because there have been too many loans given to people who could not repay the money and for houses that were worth less than the loan. Money is a measure that represents the value of something. Another way of putting it is that we have created more money than there is value and the amount of money in the system is out of kilter with the assets it is meant to represent.

    Assuming this is the problem then how do we now get rid of the excess loans and with it the excess money?

    A solution is to turn the loans we have into low interest loans and to require the money from the loans to create a new asset of some value. Perhaps if we could get enough people to put up their hands and say – I want to keep my money and I do not want it to go away but I am happy to hold it – have low interest paid on it while I am holding it – and I promise to spend it on creating a new asset. This would work – but of course is impractical to do it for existing loans.

    However, what if we did it for some – not all – new house loans? Let the US (Australian?) government give new loans money to some people who want to build a new house or buy an existing house. The government would do it as they do now but by giving the money to ANY lending institution at zero interest. Those institutions could lend the money at their marginal rate of interest. However the money from these loans can only be spent on housing. When a person uses the money to buy a house then the person selling the house gets money that still has these restrictions. There is no interest on the money they receive and it can still only be used for housing. When it is used to build a new house then the restriction on the money goes away and it can be used for any other purpose.

    If enough of these loans are issued it will isolate house assets from the rest of the economy. You can still buy houses with cash and with regular loans. What will happen will be that the money with low interest will have a lower value than their face value until the money is spent creating a new house. This will increase the rate at which new houses will be built and it will drop the price of houses back to their “true value” as expressed by the income we can earn from the house as a rental property.

    It will not be inflationary to the general economy as it does not matter how much money is created as house loans as that will only drop the value of house money relative to other assets. This would be remarkably simple to introduce and would have an immediate effect. All those people who had taken out loans for speculative purposes on houses would have difficulty realising their house bubble gains. All those people with existing loans for houses they wanted to live in would be clamouring to pay them off and would not be worse off. They could sell their house to someone with a low interest loan and go buy another house at a lower price.

    So rather than the US putting more money into the system to buy up existing mortgages the US government could give the money as low interest loans for housing and not disadvantage the people who wanted loans for housing rather than speculation. The political question is to whom to give the loans? Perhaps any person who had never previously owned a house – the proverbial first home buyer. That is politically an easier decision than giving lots of money to bankers who loaned excessively in the first place.

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