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. 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.

  2. 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.

  3. 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’?

  4. 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”.

  5. 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.

  6. 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”.


  7. 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.

  8. 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.

  9. 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’.

  10. 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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