WEEKEND ECONOMIST: Snip, snip

Markets continue to overestimate the likely response from the Reserve Bank to the current liquidity crisis. Recent market pricing has an 85 per cent probability of a 50 basis point cut on October 7 with a 90 per cent probability of another 25 basis point in November (even if there is a 50 in October).

We have consistently argued that the RBA will cut rates by 25 basis points on October 7 and follow with another 25 basis points by year's end. A Bloomberg Survey on September 5 showed that of the top ten banks and investment banks only four (including Westpac) expected a 25 basis point move in October (none expected a 50 basis point) and only three (including Westpac) expected rates to be down by 50 basis points by December. Banks may be revising their views on October following the recent extreme tightening of liquidity but we would be surprised if banks go along with markets in anticipating a 50 basis point cut in October.

The reason for the market's extreme pricing undoubtedly relates to the concerns about bank funding costs and the potential for banks to actually raise mortgage rates if the RBA does not ease rates in October. That is a respectable argument but does not automatically follow that the preferred policy would be 50 basis points.

The global capital markets are certainly pressuring bank funding costs. Major Australian banks currently fund themselves with around 50 per cent customer deposits (largely retail) and 50 per cent wholesale deposits. Around 60 per cent of wholesale deposits are sourced offshore in normal periods and 40 per cent from the domestic market. Within the wholesale category, around 30 per cent (15 per cent of total deposits) are term funding (defined as longer than 12 months maturity), 15 per cent intermediate funding (six-12 months maturity) and 55 per cent short term funding.



The pressures on bank funding at the moment are widespread. In the retail space it is very difficult to obtain a reliable data history to detect trends. The RBA produces average rates for each maturity but banks tend to offer 'specials' in varying maturities so averages do not really capture real trends. We consider the three
year term deposit rate which shows a substantial narrowing in the margin with the three year swap but only a small proportion of retail deposits are in the three year maturity. However the three year 'story' is certainly consistent with anecdotal evidence which suggests that retail margins have contracted as all banks see retail deposits as an attractive funding avenue.

Australia's four majors are rated AA (only 14 of the top 100 banks are rated AA or better) and have regular access to global capital markets but the regional banks are rated well below the majors and therefore have found the global markets essentially closed. As a consequence retail deposits have become a very attractive source of funding and an increasingly competitive 'battle ground'. However, it is pressure in the wholesale markets where bank funding costs are most stressed.

Liquidity issues also affect term funding. The graph below shows the margin between swap and a AA three year bond.



While term markets are effectively closed that margin is imputed at around 120 basis points compared to 10 basis points before the crisis began and around 100 basis points in early September when the banks last cut mortgage rates.

The next graph hows the current spread between the bank bill rate and the OIS rate (the market's estimate of the RBA cash rate curve).



Banks' short term borrowings are at the bank bill rate and as the margin with the RBA rate increases so it becomes more expensive for banks to adjust asset rates (floating rate mortgages represent about 40 per cent of total assets) to RBA rates. Prior to the credit crisis, which began in August last year, this margin was around 10 basis points. It has averaged around 45 basis points over the past six months but has recently blown to 80-90 basis points. When the banks cut variable rate mortgages by 25 basis points following the RBA's cut of 25 basis points on September 1 that spread had contracted to around 30 basis points. The spread is directly driven by global liquidity issues.

A pertinent comparison is where these wholesale spreads stood not only in early September when the banks accommodated the RBA's cut, but where they stood in early July when the banks raised the variable mortgage rate by around 15 basis points despite no lead from the RBA. The bank bill/RBA spread was around 40 basis points (compared to 80-90 today). The term spread was around 90-100 basis points compared to an 'expected' 120 basis points today.

That comparison will be very disturbing for the RBA. Recall that the Westpac Consumer Sentiment Index reached a 17-year low in July as consumers responded to an independent rate hike. We expect that despite a 17 per cent jump in Consumer Sentiment partly related to the RBA successfully engineering an across the board cut in the variable mortgage rate, consumers are still decidedly anxious. The Index is still 8 per cent below the point where optimists outnumber pessimists and has been in this 'sombre territory' for the most consecutive months since the recession in early 1990's.

As the RBA pointed out in its Financial Stability Review yesterday, housing credit growth is now at its lowest level since the mid 1980's and anecdotal evidence suggests there is no relief in sight.

The RBA will not want to risk a repeat of early July. In its Financial Stability Review the RBA referred to a period of household balance sheet consolidation – that is not a bad thing after years of excessive credit growth but we suspect that the RBA would like to see the recent sharp slowdown in housing credit growth arrested.

Mortgage rates cannot be allowed to rise given our recent experience with the impact of such a development on a fragile consumer. Just as the credit crisis will persist for probably the remainder of 2008 and most of 2009 so these stresses on bank funding costs are also likely to remain. That will represent a constant ongoing challenge for the RBA to take pressure off mortgage rates. Better to do that with a consistent 'drip' of 25 basis points rather than the big 50 basis points that the markets are currently anticipating.

The announcement of the $US700 billion rescue package for US banks is likely to provide significant liquidity relief for the US financial system which in turn will relieve some of the pressure on the bank bill /risk free spread in Australia as well as the US. While markets by their pricing of relentless rate cuts out to next March are assuming little relief, we disagree. Indeed this relief will probably be sufficient to avoid three 25 basis point cuts by the RBA this year (we expect only two).

However, more broadly this initiative will not provide the solution for the US economy. Economic recovery will only come when the banking system has sufficient capital to finance recovery. This graph shows that to date banks have been unable even to replace the writedowns which have already occurred.


Back in May, the IMF forecast total bank writedowns of $US1 trillion compared to only $US500 billion that have been recorded so far. Further write downs from the toxic waste CDO's will now be limited directly by the Paulson plan but some banks may have to take further losses in order to meet the government's price when disposing of their assets. It is generally accepted that commercial banks have not written down equivalent assets by identical amounts.

The next stage in write downs will come from the weakening in credit quality resulting from economic recession – commercial property; prime mortgages; credit card assets; and other commercial loans. Some new capital may be provided from the rescue package if banks can manage to sell assets at above marked down value and take profits, but that is unlikely to be in the spirit of the package.

Private sector capital may also be forthcoming if investors perceive balance sheets to be in good shape. The market may get unrealistically encouraged by the $US5 billion investment by Berkshire Hathaway in Goldman – the most opportunistic investor and the "best" investment bank might be a misleading indicator of a trend.

It is likely that the eventual solution will be the public sector needing to directly subscribe capital to a much restructured US banking system. Some may come from the current scheme by buying assets above marked down value but a new approach under a new US president will probably be required. In the meantime, the RBA is likely to continue easing, but at a more conservative pace than currently expected by the market.

Bill Evans is chief economist at Westpac Banking Corporation