The coming Australian debt crisis?

My article in Thursday’s Fin is over the fold. At this stage the US mortgage/CDO/Debt panic is not a likely direct source of major problems for Australia. Still, we are badly exposed to the same general kind of risk.

Subprime no threat so far

The turmoil originating in US mortgage markets has, so far, had mainly indirect effects on Australia. A couple of hedge funds with exposure to the subprime market ran into difficulties last week. This week, there were big losses reported by two Macquarie funds with investments in senior secured US corporate loans.

As a result, the stock market has had some bad days, culminating in yesterday’s 3 per cent slump. The Australian dollar has fallen back a bit, not helped by yesterday’s trade statistics.

Quite possibly, there will be nothing more to it than that. Given reasonably strong macroeconomic conditions, financial markets are in a relatively good position to handle a panic originating with a particular class of financial instruments.

Still, there are some more worrying aspects to the developments of the last week. Until then, problems had been confined to the ‘sub-prime’ sector of the US markets, catering to borrowers with poor credit, many of whom would have been unable to get access to a mortgage in the past. While default rates for subprime borrowers soared, the rest of the market seemed unaffected. The most recent available statistics showed that default rates for prime and near-prime borrowers were well below the levels of the mild recession of 2001-02.

The news that triggered the current turbulence was an announcement by Countrywide Financial, the largest mortgage lender in the US, that borrowers with good credit records were defaulting on payments at a higher rate. The Countrywide announcement referred mainly to home equity loans. Other lenders have reported difficulties with ‘Alt-A’ loans, which are low-documentation loans favored by investors hoping for quick capital gains.

Problems spread rapidly to collateralised debt obligations, derived ultimately from mortgages. These securities are packaged in such a way that some investors are supposed to absorb the risk of default, leaving the rest with a high level of security, so high that a large proportion of CDOs have been rated AAA by agencies such as Standard & Poors, even where the underlying mortgages were subprime. In the last week, there has been a flurry of downgrades, raising questions about the validity of the initial ratings.

From the mortgage markets, problems have spread to debt markets in general, and particularly the market for debt used to finance company takeovers and leveraged buyouts. A number of deals have been abandoned or modified.

The effects on Australia of any economic disruption in the US remain to be seen. But we should be equally concerned that Australia is vulnerable to homegrown problems of the same kind.

Until recently, there was no reason to worry. It appeared that the Australian market had no real equivalent to the subprime market in the US. But many households have borrowed heavily on home equity loans, and plenty of investors who’ve followed a low-document route similar to the Alt-A class in the US.

So far, and despite statistics showing that many households are paying out a large proportion of their incomes in mortgage repayments, there is no indication of any real problem here. But then, unlike the United States, Australia has not experienced any broad decline in housing prices. With the exception of some parts of Sydney, prices have remained high or even grown further.

A substantial decline in house prices would certainly produce plenty of distress for households. Whether banks or other lenders have prepared adequately for such an event remains to be seen. They have had plenty of warnings, and the Australian Prudential Regulatory Authority remains cautiously confident that the risks are being managed.

There are deeper reasons for concern, though. The boom in house prices has been self-sustaining, and reflects the underlying logic of leverage. If interest rates are low, and asset prices are increasing, anyone can make money and does. As the saying has it ‘genius is a rising market’. Once the market starts falling, it usually turns out that lots of bad decisions have been made.

Australians have embraced the logic of leverage as individual property buyers. We have also embraced it as a nation. Current account deficits that would once have been viewed with alarm are now regarded with benign indifference.

The underlying assumption is that asset markets are now so flexible and sophisticated that there is no need to worry about Australia’s aggregate position. If individuals borrowers and lenders have made bad deals that is their problem. Contagious panics, it is assumed are a thing of the past.

More than likely, the current problems will pass smoothly. But as individuals, and as a nation, we would be well advised to check our exposure to risk.

36 thoughts on “The coming Australian debt crisis?

  1. PrQ,
    With the exception of the low doc loans the ability to service the loan at various interest rate points is the key criteria for granting the loan for most institutions, and for all the major banks. The security taken (the mortgage) is a secondary consideration – as it should be.
    For the low doc loan the reason for the increased interest rate is simple – it goes to paying for lender’s mortgage insurance (LMI). Most lenders take out LMI as a matter of course on all their housing loans, with the borrower only paying the insurance premium if the loan to valuation ratio is over 80%.
    For most institutions, then the only real exposure is to the LMI provider, which is typically a local subsidiary (also regulated by APRA) of a large overseas insurer.
    To lose any substantial amounts on their housing loan portfolios, then, there would have to be large scale unemployment and/or large increases in interest rates and the LMI providers would have to collapse through the collapse of their (predominately) overseas parents.
    Not impossible, granted, but not a scenario I would put a heavy bet on.

  2. “The underlying assumption is that asset markets are now so flexible and sophisticated that there is no need to worry about Australia’s aggregate position. ”

    I agree, Australia’s aggregate position is nothing to worry about. However, I differ a little as to the source of the comfort. IMHO, there is no need to worry about Australia’s aggregate position because Australia is one of the wealthiest countries per capita in the world in terms of real resources.

    While I would have to agree that the assumption stated by JQ is quite widely held, I have no confidence in the output of the producers of weasel-word such as “flexible�, “sophisticated�.

    As for financial markets, the assumptions which matter to me are the assumptions underlying the mid-1970s theoretical result by Oliver Hart, namely that each and every one of the individuals in the market (all interrelated financial markets) has strictly risk averse preferences and price expectations must be in a ‘closed cone’ (not to divergent).

    Sub-prime markets seem to violate the first assumption and, IMHO, the expectation of lower wages (labour market deregulation) and the expectation of higher profit (investors in share markets) are not necessarily consistent with the closed cone assumption.

    All markets are interrelated (although they tend to differ in speed – financial markets are relatively fast). In Australia and elsewhere some individual investors leverage their share market portfolios with home equity loans (heavily promoted by ComSec). I don’t have data on the quantitative exposure regarding margin calls but I have enough information to say that falling share markets have flow-on effects and being ’employed’ is not the crucial factor. (The unemployed who do not own real estate in cities are not in the game in the first place.). Also, some of those who leveraged their home equity to get money into super-funds may not like their first return notice – and I wonder how much money their will be for capital investment in the higher education sector at the end of the year.

    So, we shall see what happens – to individuals and in aggregate. I notice the share price index for ‘consumer discretionary’ has fallen quite a bit more than the All Ord – good news for the international trade statistics?

  3. Ernestine,
    Could you provide a link to the Oliver Hart piece on risk preferences? I would be interested to give it a read. The psychology of risk aversion is quite important to me.

  4. You don’t actually stick you neck out and say what will happen. There are problems in the US and they may or may not impact here. I don’t know either so I can’t criticise you. But what is it you are saying?

    My guess is that we have got used to living in an unending expansion so that we underprice risk and leverage up too much. This gives us an exposure to changed circumstances. Maybe we need a bleep (dare I say temporary recession) to restore a healthy sense of caution.

    The point I have argued before is that with greater stability grows greater risk as people become more adventuous. This means we cannot escape macroeconomic risk with very good macroeconomic management.

    There seems to be an optimal degree of bankruptcy and economic failure.

  5. AR,
    I can’t give you a link but here is the reference: O.D. Hart, “On the Existence of equilibrium in a Securities Model”, Journal of Economic Theory, Vol 9, No 3, Nov 1974.

    NB, there is nothing on the ‘psychology of risk aversion’ in this paper.

  6. ProfQ. Speaking of a debt crisis, why are so many economic commentators not alarmed about our chronic current account deficit and massive foreign debt? Australians’ borrowings seems to be directed towards asset inflation and consumpton, not capital goods. Why won’t we pay the price in higher interest rates demanded by foreign lenders or a steep drop in our exchange rate?

  7. I think those commentators who are alarmed (including me) have raised false alarms too many times, and have been forced to issue warnings in more muted tones, as in the article above.

  8. “My guess is that we have got used to living in an unending expansion so that we underprice risk and leverage up too much. ”

    It may well be that there is some habituation (eg the assumption mentioned in JQ’s post, which seems to be popular). As for ‘underprising risk and leverage’ I should think the mechanical application of ‘re-leveraging formulae’ in training oriented Finance courses, geared toward what practitioners want because they do it, almost gurantee the underprising of risk in situations of ‘capital structure changes’ (eg highly leveraged buy-outs). And this matters ‘in aggregate’ when the ‘plays’ involve ‘large’ (financial market value) corporations.

  9. “My guess is that we have got used to living in an unending expansion so that we underprice risk and leverage up too much.”

    The Austrian critique is simply that continual expansion of the money supply is what causes this ‘unending expansion’ you speak of and what’s more, the malinvestments that will be unsustainable and ultimately need correcting. Essentially we have invested in RE rather than real investment for production. If they’re right and I think they are, then we are in for a real hammering, given the large and sustained increase in global money supply over the years. It is Asian savers who will lose the most in the large US borrower default, but that will be a one off before they demand a larger risk premium. We are about to live in interesting times again.

  10. Observa, how do the ‘Austrians’ define money supply and how do they measure it and how do they distinguish ‘money’ from ‘credit’?

  11. Well Ernestine, money is broadly the stuff in our wallets and on our dressing tables, as well as those demand deposits at our banks. However it’s only when we all want those deposits at the same time that we realise just how much of the stuff we have sorta printed and now actually need to print real quick. That’s when Austrian fans shake their heads knowingly and remind everyone what they’ve been banging on about for ages. Like this bloke here
    We’re about to see if they’re right or not.

  12. Australia won’t see the same decline in housing prices as the US because of the massive State taxes on construction and the tight control exercised by the States over supply.

    Of course, in artificially constraining supply State governments are creating a far greater long-term structural problem: most people not already in the housing market will now never get in.

    My advice to younger Australians, particularly educated ones: emigrate to the US as soon as possible. You will live a far better life.

  13. Observa, your ‘Austrians’ have apparently never heard of an ‘IOY’ and they don’t seem to be clear on the identity of the issuers of various forms of ‘IOYs’ versus currency issued by national governments.

  14. The Austrians come in flavours and it seems to me that it is the Rothbardian flavour that is most concerned (incorrectly in my view) with fractional reserve banking and it’s consequences. Personally I think inclusion of demand deposits in any definition of money proper is flawed. Demand deposits can not act as a unit of account and are in fact dependent on a unit of account for their very definition. As such demand deposits should be treated as credit with immediate optional maturity.

    I take my monetary philosophy from the supply-side school of thought that shares a lot with the Austrians in general but little with the Rothbardians. Stable monetary policy (or naturally self stabilising private commodity money systems) is that which gives rise to a currency that is stable in value rather than stable in quantity. The gold standard worked because the US dollar (and other currencies) were adjusted within the gold window such that their value remained stable relative to gold (and gold remained stable relative to other aggregate price points).

    I do share the Austrians general cynacism towards government central banking.

  15. Terje, As long as there are no unanticipated floods, earthquakes, (private) wars, and other forms of ‘destructions’ and the world population is with each ‘mini-tribe’ (family) having at least one ‘rational member’, private commodity money would be conceivable. It would consist of state contingent delivery contracts, written in commodities. I am not aware that the Arrow-Debreu model has been written by an ‘Austrian’.

  16. I don’t disagree with you Observa, I just don’t know. I have watched the high growth rates in credit and the money supply for many years now and did my PhD when peoople did take Milton Friedman seriously.

    It worries me but, as I say, I don’t know.

  17. Ernestine,

    Supply shocks will obviously lead to changes in the relative value of the currency if the currency is a natural commodity (eg gold where production via mining is low relative to the existing stock). For instance in Europe during the dark ages the black plague killed lots of people and hence production relative to the stock of money (gold) fell. In that instance the result was a short lived period of localised inflation and an outflow of gold to the rest of the world. It is not clear that such an effect was entirely negative as the price signal was indicative of reality (local food production was scarce in relative terms but hard assets were still abundant).

    Historically speaking unanticipated floods, earthquakes, wars and other such supply shocks (eg spanish mercantilism and American plundered gold) were never so massive as to render the gold standard seriously unstable. During the 1800s for instance the price level in Britian halved (ie average deflation of about 1% per annum). During the Californian and Australian gold rush the new supplies of gold caused consumer inflation to peak at 2-3%. The system did not deliver 0% consumer price inflation but no system ever will.

    The gold standard did cause significant deflation at times where it was re-adopted following a float and where the new peg price was indifferent to preceeding inflation. For instance when Churchill took the pound back onto gold in 1925 his chosen pre WWI conversion rate was highly deflationary. This was not an instability caused by gold but rather one caused by an arbitrary but painful adjustment of the unit of account. Such events did give gold a bad name on occassion. The post civil war adjustment in the USA was another similar instance.

    The gold standard when properly maintained produced price stability according to three measures:-

    1. Consumer price inflation.
    2. Commodity price volatility.
    3. Exchange rate stability.

    By comparison the modern mix of monetary policy can only be said to deliver price stability under the first of those measures.

    Austrian economics predates the Arrow-Debreu model. As does empiracle experience with the gold standard and other commodity standards (eg Rum in NSW). Your suggestion that commodity currency may be conceivable is quaint given that such systems prevailed for most of human history.


  18. Terje, I think we are talking at cross purposes – I didn’t talk about a ‘commodity currency’. I interpreted your words ‘private commodity money’.

  19. Harry, I think we’ve all been fooled for longer than usual by some underlying demographics. In the early 70s, expansionary money in the hands of all that baby boomer youth was going to produce inflationary spending immediately and it did. Fast forward to the last few years and that same demographic will use that expansionary money to bid up asset prices.(directly or via their super funds) To such an extent that others (Asian savers) will happily lend them more to gear those asset prices even higher. Of course they’re doing that for a reason, assuming that will produce an adequate income stream in retirement. That could well be a nasty fallacy of composition when they all begin to liquidate their investments, only to find out what all that abundant liquidity really means. That’s where I think the Austrians are absolutely correct, with that important ceteris paribus qualification. Very large demographic bulges are not ceteris paribus, but they may well be in the long run.

  20. I interpreted your words ‘private commodity money’.

    Perhaps my use of the word “private” was confusing. If the government produces coloured pieces of paper we may in some contexts interprete these as being a commodity. I merely used the word “private” to indicate that I was refering to a commodity such as gold or silver that was not created or managed by the public sector according to a public policy motive. In hindsight I accept that I was probably using it in a rather obscure manner. Maybe the word “natural” would have been clearer.

  21. No, the word “natural” would not have been any clearer (both coloured pieces of paper and gold bullions are produced commodities, irrespective of the ownership of the producer).

    The latest financial markets history provides yet another opportunity to observe the sequence of events: The actions of private issuers of financial securities preceded the actions of various reserve banks.

    Last Friday, around 13:00 hrs the share price of the ASX Lt dropped by about 6% against the All Ord Index decline of about 3%. So, we have here an instant in time when ‘the market’ valued itself less than economic activites that are ‘valued’ (priced) in the same market.

    By the close of day, the ASX Lt share price went up to match the All Ord. So, there was ‘money’ to be made during the day for small traders who watched the ASX Lt.

  22. Sorry, Ernestine – can you explain this

    Last Friday, around 13:00 hrs the share price of the ASX Lt dropped by about 6% against the All Ord Index decline of about 3%. So, we have here an instant in time when ‘the market’ valued itself less than economic activites that are ‘valued’ (priced) in the same market.

    By the close of day, the ASX Lt share price went up to match the All Ord. So, there was ‘money’ to be made during the day for small traders who watched the ASX Lt.

    It makes no sense to me. ASX Ltd. is the company operating the market – not the market itself.

  23. AR, Yes, the ASX Lt is a company. It is a listed company. It is listed on ‘the market’, which it makes. It is ‘the market itself’. I can’t see anything unclear about that.

    What do you mean by ‘the market itself’?

  24. The share market is more than just the ASX. The ASX provides a framework on which many of the shares in Australia are bought and sold – but many are traded off exchange and, provided the sales are reported, there is nothing wrong with that. “The market” also includes all the individuals and firms trading in the market.
    To my understanding at least to say that the ASX is “the [share] market” is just as nonsensical as saying the RBA is the “the [banking] market”.

  25. Yes, the ASX Lt is a ‘market maker’ in the sense of providing a set of rules for a ‘market place’ where, conditional upon the rules, privately issued securities, called shares, can be offered for sale and bought. Being a ‘market maker’ in this sense is an activity and I believe one can call it an economic activity.

    My statement: “Last Friday, around 13:00 hrs the share price of the ASX Lt dropped by about 6% against the All Ord Index decline of about 3%. So, we have here an instant in time when ‘the market’ valued itself less than economic activites that are ‘valued’ (priced) in the same market.” says that the activity of (share) market making was valued less than other economic activities.

  26. Ernestine,

    Okay the word “natural” has some problems also. I think I need to invent a new word. The word I’m looking for means “production not monopolised by law”. I considered un-regulated but that does not really capture the essence of it either. Maybe I’ll just abbreviate it as PNMBL.

    A PNMBL commodity currency achieves stability by virtue of any minor inflation or deflation feeding back into production costs and in effect governing the rate of flow of new currency into the market. Generally paper money (eg little coloured notes) would fail to stabilise if they were merely treated as a commodity. However promisory notes (with contractual value) derive their value via a different mechanism and they are credit devices rather than money proper.

    Like demand deposits, promisory notes should not be included in any account of money proper. And whilst the Rothbardians will tie themselves in knots worrying about quantities of credit the supply siders say that the value of the currency should be stable and the credit mountain will self moderate well enough. Of course when the mountain builders build on gold they know that there is nobody that can bail them out, whilst those that build mountains on fiat know that the custodians of the printing press will generally “share their pain”.


  27. p.s. Oops. Paper would not fail to stabilise as a pure PNMBL commodity. It would just fail to stabilise anywhere near the value of fiat currencies of today. Although rare cases like the Swiss Dinar (see Wikipedia article) show that if production is constrained due to technological reasons then paper with the right qualities can readily maintain significant utility (and hence value) as a trade good.

  28. Terje, If I were you, I’d start studying mainstream economics, including its history.

  29. I’m sorry, Ernestine, but if there is any sense in your statement about the ASX I cannot find it. The ASX makes its money from several activities, only one of which is affected by the price of shares traded on it – in that it earns some money based on the number of shares traded by their value.
    Thus the drop in price could be related either an anticipated drop in volume or value or both.
    It also charges fees to those companies listed on the exchange for the privilege of being listed and to the brokers to allow them to trade there, as well as making money from providing information about the trades made on it.
    ASX shares are therefore only going to be loosely tied to the overall value of the shares listed on it and over the long term.
    Perhaps you should study mainstream share price theory, including its history.

  30. AR, I think we might be talking at cross purposes.

    I had said that I recorded an observation about interday trading of ASX Lt on one day. Mainstream ‘share price theory’ (security market valuation models) says something about relative prices. My statement is about relative prices. All the ASX Ltd activities you have listed belong to ‘market making’.

  31. Terje, If I were you, I’d start studying mainstream economics, including its history.

    You being me is not a very likely scenerio. Although you may find it humourous for an hour or two. 🙂

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