Australia's mission critical

In part one of this series, we argued that Australia had been lucky to skate through the GFC with only minor collateral damage to its financial system. We also showed that despite the contrasting outcomes, there appears to be few differences between Australia and Britain's banking and finance sectors aside from relative maturity.

The fact is Australia was fortunate to be three to five years behind the UK apropos the development of its mortgage market. As a result, we had lower levels of non-conforming, low-documentation, low-to-no deposit and non-bank lending. Our major institutions were also less dependent on securitisation as a source of funding. We were nonetheless happily sitting in the slipstream of our UK cousins, with at least one Australian bank explicitly modelling itself on Northern Rock. Our contention is that had the global financial storm hit our shores in five years' time, Australia may have faced much more dire consequences: bank failure(s) and the partial nationalisation of our financial system.

The key take-away here is that policymakers need to consider fundamental reforms to the financial system that address the previously unknown and potentially catastrophic risks that have been unearthed by this crisis. The financial world that we see today is radically different to that which existed two years ago, and new approaches will be required to manage it.

One strength of the centre-left Rudd government is that it has been comfortable taking decisive action to remedy perceived market failures (conservative politicians have a habit of tying themselves up in ideological knots when it comes to defining the role of government).

Yet as Kevin Rudd and Wayne Swan have discovered, there are unexpected side-effects associated with these interventions – throw the stone across the pond and it impacts both its targets and, indirectly, every other point in the pond. And so we had the 'run' on mortgage trusts when the government guaranteed bank deposits. We also saw the cost of funding in both the commercial paper and securitised mortgage markets skyrocket when the government offered its AAA rating to guarantee bank debts. (It has been a concern for some that this latter initiative benefited the major banks most, with many of the smaller and more vulnerable institutions choosing not to avail themselves of it.)

The principal problem here is that the Rudd government needs to formulate an overarching policy strategy to guide its actions. All of its interventions – the deposit guarantees, bank debt guarantees, RuddBank and the $8 billion investment in the residential mortgage-backed securities (RMBS) market, amongst others – have been understandably reactionary responses to the unfolding chaos. Put differently, Rudd and Swan have been scrambling to apply bandaids to the symptoms of the underlying cataclysm in an attempt to shore up the system. But they must now design and implement more fundamental protections that will help mitigate the risk of future calamities. That being said, they've had little choice – this was more a matter of cauterise the wounds today and think about the surgery tomorrow.

As conditions start to stabilise, the prime minister and treasurer will need to step back from the fray and contemplate the new financial order – a world in which the probability of economic Armageddon is higher than anyone ever realised. Understanding this also requires one to appreciate that the origin of the next catastrophe may have nothing to do with local circumstances. This is the downside to globalisation; the cost of sharing our risks with the rest of the world is that we occasionally get financial pandemics.

Taking stock of what we know today, it is hard not to conclude that Australia's financial architecture needs to be re-engineered. It's as if we have found out that the enemy possesses radar-guided missiles that necessitate a radical new fighter design that minimises its radar cross-section.

Many profound policy questions remain unanswered, such as:

- Should the RBA be allowed to 'lean against' incipient asset-price booms (there is unusually high-profile dissent within the RBA on this matter, with the second-in-command at Treasury, David Gruen, last week lending weight to Guy Debelle's controversial arguments against the Phil Lowe-Glenn Stevens position in favour of cautiously 'leaning against the wind')?;

- Should APRA impose 'automatic stablisers' that require banks to accumulate capital in good times to serve as insurance against the bad?;

- After investing $8 billion to underwrite the liquidity of the RMBS market, what will be the government's long-term policy approach to supporting securitisation, which has been unregulated since its Australian inception in the mid 1990s?;

- When will the deposit and/or wholesale funding guarantees be phased out and what new set of policy guidelines will explain how they might be redeployed in future force majeures?;

- What new regulations will govern executive compensation at banks and securities firms to mitigate the 'call-option', like payoffs that have tainted these arrangements in the past (eg. higher risk-weightings for firms that have short-termist structures and/or claw-backs on remuneration for executive negligence)?; and

- Has this crisis reminded policymakers that Australia's major banks fulfil a unique community role akin to public-private utilities that warrant special controls to guard against system stability risks?

On this final point, it is rather incongruous that we've been repeatedly told that our major banks were lucky not to have had substantial overseas exposures while they are concurrently rushing offshore to obtain exactly this (cf. ANZ in Asia).

In line with the aspirations of the latest G20 summit in London, we would propose a thorough, Wallis-style review of the entire financial system led by the likes of Bernie Fraser, who would be well-placed to oversee such an exercise. Bernie is the only person to have been both Governor of the RBA and Secretary of the Treasury. He is also a director of one of the smaller banks, Members Equity, which has been impacted by crisis. And his involvement with the superannuation industry affords him a solid feel for capital markets. Finally, we would venture that the centre-left side of politics should be sympathetic to his skills (he was appointed Governor of the RBA by Paul Keating and has close ties to the industry funds movement). Of course, there are other possible candidates, such as Ian Macfarlane.

A final and more specific word on the policy options available to government to boost competition. There is mounting speculation that they will announce a new initiative to improve competition in the banking and finance sectors, which Graeme Samuel has described as barely workable. In April, Christopher Joye argued that they should consider arms-length guarantees of AAA-rated commercial and residential property loans. A week later, Gordon Brown's government announced that they were doing exactly that. The Weekend Australian and the Australian Financial Review have also recently run features on this idea. The proposal has several appealing attributes:

-- By guaranteeing the underlying assets and not the institutions, one can create a level playing field amongst all lenders, not just the big banks, since the cost of the guarantee would be independent of the institution's size (and note that it is safer for taxpayers to guarantee AAA-rated assets than AA, A, or BBB-rated banks over which they have limited control);

-- There is a pricing precedent with the Commonwealth guaranteeing AAA-rated state government debt, which costs 30 basis points. Industry liaison suggests that this measure, which is supported by the likes of Bendigo & Adelaide Bank, Challenger and Members Equity, could reduce RMBS spreads back to economically viable levels of circa 100 basis points or less;

-- There is a successful and long-standing benchmark in the form of the Canadian Housing and Mortgage Corporation (CMHC). The CMHC guarantees have allowed Canada's securitisation markets to remain functional throughout the GFC. Canadian home loans also have among the lowest default rates in the world (lower than even Australia's, according to the RBA);

-- Moral hazard risks could be minimised by requiring securitisers to furnish a 'first-loss' equity piece to the government-guaranteed pools, so that the originator of the assets always takes the first hit in the event of default (this is precisely what the CMHC does and may be one reason for Canada's low default rates);

-- The guarantees would be 'off balance sheet' and would not, therefore, directly increase public debt (although they would raise our contingent liabilities);

-- They would be revenue positive for taxpayers; and

-- A guarantee of AAA-rated commercial property loans or 'CMBS' could provide support to the struggling commercial property sector and serve as a surrogate for RuddBank to the extent that this was still deemed desirable.

The other option is to expand the government's existing $8 billion commitment to investing in securitised home loans via the AOFM. We know a fair bit about this since Christopher Joye and Joshua Gans were the original authors of the idea in March 2008. The issues here are threefold:

(1) The AOFM's efforts are being directly undermined by the government guarantees of bank debt, which has created an alternative super-class of AAA-rated securities (since they have the sovereign's backing) that has reduced demand for RMBS. So while the existing $8 billion has been effective in injecting an important lifeblood of liquidity into smaller lenders, it has had no impact on the overall cost of funding. Indeed, following the government's announcement of the bank guarantees, RMBS spreads increased to unprecedented levels, where they remain today;

(2) The government is unlikely to want to do anything that raises public debt beyond the levels outlined in the latest budget; and

(3) Given its reactionary nature, the AOFM measure needs to be contextualised within an overarching policy strategy.

We would have preferred to have seen the government announce that it was making an enduring commitment to support the liquidity of Australia's RMBS market, which had until the advent of this crisis supplied funding for up to one quarter of all Australian home loans. The government need not have disclosed the dollar quantum of their commitment, or the timing of any interventions. In this way, they would have retained the flexibility to participate privately in the RMBS market alongside other investors to influence pricing during periods of extreme duress. This is exactly what the RBA does in the foreign exchange market when it judges that the price of the Australian dollar has materially departed from fair value. To quote the RBA:

"Financial markets can overshoot – ie. 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…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.”

The same rationale could be employed by the government to justify irregular interventions to influence the liquidity of (and hence pricing in) the securitisation market. But it needs to define a coherent policy framework before doing so. And this should in turn be embedded within a broader recalibration of Australia's financial and regulatory architecture. Bernie Fraser sounds like the just the man to undertake such a review.

As a final consideration, this exercise could present the prime minister and treasurer with the perfect vehicle through which they can make a lasting and politically valuable contribution to the complexion and regulation of Australia's financial system.


For an update on this proposal click here to read Christopher Joye's post today.

Christopher Joye writes Business Spectator's property blog and is managing director of research group Rismark International which produces the RP Data-Rismark Hedonic House Price Indices. Rismark operates a series of investment funds, but is not involved in the securitisation markets.

Sharan Burrow is President of the Australian Council of Trade Unions. She is also the current president of the International Centre for Trade Union Rights (ICTUR) as well as the International Confederation of Free Trade Unions (ICFTU).