THE DISTILLERY: Avalanche-proofing ANZ

A week or so ago, Jeremy Grantham, the GMO maestro, appeared on the Financial Times website to describe his research into the history of bubbles. Out of 34 identified historical bubbles he acknowledged only two which had not yet returned to long-term trend-lines of income multiples – the UK and Australian housing markets. He put their resilience down to floating rate mortgages. This column agrees. However, before we celebrate by buying another house, there is another source of vulnerability that the internal fail-safe of floating mortgages cannot fully insure – external shocks. For Australia it might be one of two that pricks the housing bubble: a repeat of the seizure in global credit markets that prevents the banks from rolling over their huge international debts, or a dive in commodity prices which leads to a more particular financial crisis. Commentary today around the ANZ result and the Henry Review shows too little awareness these possibilities.

Leading us off on ANZ is Stephen Bartholomeusz of Business Spectator, who is the only one playing on the right ballpark. Bartholomeusz argues that "... the banks are as well prepared as they could be for another global credit market shock, which is, given events in Europe, highly possible, or the introduction of tougher capital and liquidity requirements that are working their way slowly through the global regulatory pipeline ... ANZ is carrying a Tier 1 capital adequacy ratio of 10.4 per cent, which would be equivalent to 15.4 per cent if the UK Financial Service Authority's approach to calculating capital adequacy were used. It has already raised about 70 per cent of its 2010 wholesale funding requirement and is holding prime liquid assets of more than $63 billion.”

In an exclusive interview with this column, veteran bank analyst Brian Johnson of CLSA sees this as evidence that APRA is winning the political battle to rid Australia of its external funding vulnerability. According to Johnson, bank Tier 1 capital more traditionally sat at 7 per cent. He notes, however, that working against APRA's efforts are privileges the banks continue to enjoy in their ability to 'repo' just about anything with the RBA, and confirms a point made by this column repeatedly, that if another crisis erupts, the government guarantee will be deployed pronto.

Commentary needs to focus on just how much more capable the ANZ and the other banks are of withstanding an offshore credit crunch. So long as we cannot definitively answer that question, neither the ANZ, nor the other three major banks, is a private entity.

In a second piece, Bartholomeusz also reckons that "...within the Australia region the bank has a $159.3 billion mortgage portfolio. At the point of origination, the average size of a loan is $218,000. If there is stress within that portfolio, it isn't evident. A year ago the individual provision loss rate was 0.03 per cent. Today it is 0.02 per cent, which is negligible and compares with the overall loss rate of 0.62 per cent experienced by the bank. The average loan-to-valuation ratio at origination for ANZ's mortgage portfolio is a perhaps surprisingly low 62.2 per cent and the average 'dynamic' LVR for the portfolio is only 47 per cent. Less than 2 per cent of the portfolio is in 'low-doc' loans and those loans, which ANZ has stopped originating, have LVRs at origination of 80 per cent. There are no sub-prime loans in the portfolio. ANZ says that 76 per cent of its borrowers are ahead on their repayments.”

Impressive certainly. But this column must point out that externally funded bubbles rarely show stress during their inflation. Stress comes in a shocking avalanche later, when the bank itself is forced to withdraw credit as the crunch hits its offshore liabilities first. Asset deflation is the effect as credit shrivels and unemployment, as well as defaults, rocket.

Other commentary on ANZ today ranges from the rhetorical, with John Durie and Matthew Stevens of The Australian praising CEO Mike Smith for political savvy, to the effort by Elizabeth Knight of The Sydney Morning Herald, who makes the farcical claim that "...there is probably more competition in the Australian banking market now than we have seen in the past 10 years” even as ANZ further increased its net margins. This column suggests she read the analysis by the Milind Sathye, Deputy General Manager of the Reserve Bank of India, published in The Age earlier this month, making a mockery of such claims. The new Chanticleer, Robert Guy, does little better with the inane observation that Smith "needs to remain focused on execution to ensure the promise of Asia is delivered.” What about some thought on how ANZ's increased cross-border activity affects its funding and asset quality profiles, not to mention mismatches?

Of course we should all be hyper-aware of the danger that most commentary effectively avoids, given it is the fate we dodged in the GFC, not only through floating mortgages, but crucially, the government guarantee to wholesale debt. Which brings us to two other comments on the Henry Review attempts to boost bank deposit savings rates and hence mitigate their dependence on offshore wholesale funding. Karen Maley of Business Spectator reckons "... a tax break on savings could see an estimated $130 billion flowing into bank and building society deposit accounts, giving them a reliable and relatively low-cost source of funding.” By this column's calculations, that would boost the ratio of bank funding to somewhere around 52 per cent – a considerable improvement – and a position the nation's financial system has not enjoyed since the late 1990s. Maley goes on to argue that this money is more likely to be shifted from other savings sources like superannuation than be additional, which may not be ideal, but it's still an improvement and the super pool can sure afford it. Maley also points out that Swan will likely lift "...the tax rate on super contributions from 15 per cent, to as high as 30 per cent on Sunday ... Canberra will be much better off. The current tax breaks on super cost are estimated to cost the government about $12 billion a year in lost revenue. In contrast, it's estimated that introducing a tax break on bank savings would likely cost the government at most $1 billion.” This column is pragmatic enough to have no problem with this, either. When another external crisis comes, the federal balance sheet will need to be in significant surplus to support a renewed wholesale guarantee.

Commentary may have failed to answer the question of whether or not stimulating bank deposits will cure us of our external vulnerability, but it has thrown up some interesting questions about further dangers related to the measures. As Sam Wylie, Senior Fellow at Melbourne Business School, pointed out in an Australian Financial Review op-ed yesterday, the banks may simply lend the money out again. In that event we would be trading an externally funded bubble for an internally funded one. This column will point out that that is why we should not ignore the bank-provisioning rules emanating from the G20. Bank lending should be contained with higher capital and liquidity ratios. Further insurance is also in the floating rate mortgages, which work on the upside to contain credit growth so long as the RBA has the cohones to pull the trigger.

Wylie makes three other objections to stimulating increased deposits which are worth considering: first, that the tax breaks are likely to only apply to five and ten year term deposits, which he says makes them more like bonds. This column will counter that bonds are information sensitive and their capital value rises and falls as they trade. Deposits suffer from neither, which is why they are a "sticky” form of funding. Second, he says increased deposit-funding will increase big bank dominance. Surely not, this column will counter, given the big banks credit-rating advantage does not apply to deposits. Third, Wylie argues we'll lose productivity because less super funds will mean higher a cost of equity capital for companies. Perhaps, this column will muse, but not by much, given the huge super pool and that the greater competition arising from smaller banks might reduce debt funding costs. Anyway, the boost to financial stability is worth the trade off.

Our other related external vulnerability is commodity prices and how reliant we should allow ourselves to become upon them. Jessica Irvine of The Sydney Morning Herald asks this question in addressing whether or not tax incentives should be restructured to encourage young people to move to the boom mining states. She frames the issue in terms familiar to this column: "The greatest risk is that the boom turns out to be temporary but while it lasts hurts other industries, a condition known as 'Dutch disease', coined by The Economist to describe the decline of the manufacturing sector in the Netherlands after the discovery of a large natural gas field. According to Swan: 'It is very much on our mind because our aspiration for this economy and for this society is to have an economy which is as broadly based as possible.' What if it's not temporary? If the mining boom is a permanent feature of the next decade, it makes a lot of sense to assist human resources - you and me - to flow to where they can most productively be used.”

This column will only observe again, just as Grantham has, that all booms are temporary. It may be that the boom ends in a crash or, as Karl Marx observed, that the intrinsic mechanisms of capitalism get to work on crimping excess profits through the creation of new capacity. Either way, the boom always ends. This column thinks Swan is right to seek a more mixed economy. It continues to wonder, however, just how he will actually deliver it.