THE DISTILLERY: Securitisation breakdown

We pick up today where we left off yesterday, with financial services. According to Adele Ferguson of The Age "... there's speculation the decision by the Rudd government to withdraw its guarantee scheme for banks will be followed up with the introduction of new legislation designed to stimulate competition...It is understood that fierce lobbying is going on behind the scenes by smaller banks and non-bank lenders to convince Treasury and the government to introduce legislation that allows the creation of a multi-billion-dollar covered bond market, which are bonds backed by AAA residential mortgages.” Ferguson concludes that "...with competition all but wiped out” the government "needs to act fast and beef up the securitisation markets, facilitate a covered bonds market and back a new AAA-rated mortgage bond.”

Regular readers will know that this column is an enthusiastic supporter of new measures to boost competition with the banks. It supports the notion of a covered bond market for mid-tier banks. Such securities have been operating effectively in Europe for centuries, not least because covered bonds, unlike securitisation products, remain on bank balance sheets, keeping them wedded to credit standards and capital reserves. However, in this column's view, Ferguson's support for a revival of securitisation is more questionable. Non-bank lenders have no regulator and no rules outside of regular trade practices and corporate law. Nor do they hold any of their own mortgages to maturity. They led the decline in Australian credit standards in the last cycle by introducing first 'low-doc' loans in 1997, then 'no-doc' loans by 1999. Later it was subprime or 'non-conforming' loans, which were growing very fast when the GFC happily intervened. In our drive to revive competition, we should not forget these lessons. For those that think securitisation can be revived safely with a few rule changes, this column suggests reading nakedcapitalism.

Ian Verrender also addresses financial services, continuing his recent pacing of the AXA saga. The entire piece is rehash, with the exception of one rumour worth repeating. "There has been a history of rivalry between AMP and National Mutual stretching back decades and mirroring the intense competition between Sydney and Melbourne. And there are suggestions that ancient animosity resurfaced when AMP teamed with AXA last year to take out the Australian subsidiary. There has been some talk that Rick Allert outfoxed Dunn, extracting a ''final'' offer and then walking across the road to the Melbourne-based NAB to get a sweeter deal, thereby locking out its Sydney rival.” Not that it matters terribly.

Before departing the hallowed ground of Australian banking, this column must also cast its eye over an op-ed by Mark Johnson and Geoff Weir of the Australian Financial Centre Forum in The Australian Financial Review. In defending their report aimed at converting Australia into a global financial hub, the pair reckon that they are not arguing for "major tax concessions and a 'light touch' regulatory approach” to "entice” financial services firms to headquarter in Australia. Though they admit they are arguing for cuts to "... state taxes and charges relating to the insurance sector; and also the abolition of withholding tax on offshore borrowings by banks” because "... the first contributes to private underinsurance... while the latter adds to the cost to Australia of financing our current account deficit.”

It is touching that the pair is concerned about these issues, but what are they doing in the report if they're not about encouraging financial investment? They go on. "There was nothing, other than generally good governance practices and improved corporate risk management systems, that would have prevented Australian banks...from having much larger exposures to many of the 'toxic waste' structured financial products leading up to the crisis...what is of relevance with respect to risk management of both cross-border and domestic transactions of Australian financial institutions is the quality of our regulatory framework and the regulators themselves; and the quality of the risk management systems and of senior management within our financial institutions.”

Let this column remind the reader that this is Mark Johnson, former chairman of Macquarie Bank. It is a moot question whether or not that August institution would have survived the GFC without extensive government support. But there is no doubt about the extent of the intervention. Macquarie relied too heavily on short-term capital market debt to fund long term assets. When investors woke up to themselves during the GFC, the model collapsed. Likewise for the big four and their over-reliance on short-term capital market debt to fund long term assets like mortgages. This is the same dynamic that drove the crisis in overseas banks. Australian banks illustrate differences of degree, not kind. Likewise, the bailout may have been less expensive than elsewhere but it was still a bailout. Seen in this context, the very existence of the AFCF highlights how little responsibility is being taken by the banks for the actions that brought them so close to calamity during GFC.

Still on financial markets, two commentaries follow yesterday's release by the ASX of research into algorithmic trading. Matthew Stevens of The Australian and Stephen Bartholomeusz of Business Spectator explain that the ASX is conflicted in its review because algorithmic trading is most effective when multiple exchanges provide minuscule pricing differentials that can be exploited by millisecond sensitive computer trading systems. The ASX is therefore potentially using risks in algorithmic trading to protect its monopoly against moves to introduce competing exchanges. Nonetheless, both also describe a litany of problems with 'algos'. Not least is the allegation that high frequency trading potentially undermines "the transparency of markets, adding to their volatility, introducing new sources of risk, increasing the potential for market manipulation, exacerbating inequities and changing the nature of markets from facilitating efficient capital formation and risk transfers to forums for pure short-term trading”, as Bartholomeusz puts it.

Unfortunately, neither commentator reaches a conclusion on the subject. But Bartholomeusz at least finishes with a statement that makes it obvious to this column what the outcome should be. "Another way of looking at that question would be to ask whose interests, if there were a potential conflict between the interests of market participants, should the authorities prioritise – traders or investors.”

Lastly today, John Durie of The Australian and Alan Jurie of The Australian Financial Review cover the "key-man risk” in the departure of Richard Uechtritiz from JB Hi-Fi. Durie sees this as a part of JB's transition from start-up to corporate player. "The retailer's culture seems to serve as a barrier to potential predators, who fear that JB Hi-Fi will lose its unique style if it becomes part of a massive retailer.” And puts a negative spin on Uechtritiz three year consulting contract. "If new JB Hi-Fi boss Terry Smart is so good, why does Richard Uechtritz need to hang around on the board and as a paid consultant?" Jury is similarly negative, pointing out that JB powerbrokers have played their "succession cards too close to their chest. Virtually all investor contact since the company listed in 2003 has been with Uechtritz, and this has led to the development of too-close an identification of the company with the man.”