Big Profits, Huge Risk

Big profits, huge risk | macrobusiness.com.
au 14/02/11 7:02 AM
Home
About
Contact
Contributors »
Join Us
Disclaimer
Big profits, huge risk

Posted by Deep T. in Banks on Feb 10th, 2011 | 13 comments
Previously I have posted on how the major banks recycle capital in The
Capital Rort. I want to extend that subject by showing how mortgage
‘rehypothecation’ in Australia has led to the massive expansion in
liquidity available to Australian banks which is at the root of the
mortgage affordability issues in Australia and has put Australia’s
banking system on the unstoppable path to collapse or government
bailout.
What is rehypothecation? From “hypothecate”- to pledge collateral.

Rehypothecation is the reuse or pledging of collateral received from one
transaction in an entirely unrelated transaction. For more on the
definition try this interview with Gary Gorton, Yale University finance
economist.
To understand how rehypothecation applies to the Australian mortgage

markets, I’m going to start with where the money comes from to fund
our oversized mortgages and why? But to warn you, what I’m about to
describe is not pure rehypothecation because the mortgage collateral is
not directly passed to the lender but it is used to prop up the bank’s
balance sheet, the strength of which the lender relies on. So the ultimate
effect can be the same as rehypothecation.
I have updated to Dec 2010 a previous graph I’ve used comparing

residential loan, offshore borrowings and deposit growth:
http://macrobusiness.com.au/2011/02/big-profits-huge-risk/ Page 1 of 14
Big profits, huge risk | macrobusiness.com.au 14/02/11 7:02 AM
The graph represents a clear view of how offshore borrowings have

funded Australia’s growth in residential mortgages both in size and
number. However, there seems to be a puzzling change of trend in the
last few months with deposits increasing at a greater rate and offshore
borrowings decreasing. Maybe it’s not so puzzling. The following is the
RBA’s definition of Deposits and Non-Resident Liabilities:
‘Resident liabilities – deposits’ include: transaction and

non-transaction deposit accounts; and certificates of deposit.
From April 2002, this item includes both Australian dollar-
and foreign currency-denominated (AUD equivalent)
deposits. Prior to that date foreign currency-denominated
(AUD equivalent) deposits are included in ‘resident
liabilities – other liabilities’. Certificates of deposit relate
to both residents and non-residents. ‘Non-resident
liabilities – total’ refers to total liabilities on the
Australian books of banks that are due to non-
residents……
I have highlighted the relevant parts of the definition. I did a bit of a

double take when I saw this. In simple terms, loans or liabilities from
non-residents appear in both deposits and non-resident liabilities as
defined by the RBA. I do not see this as any action that’s deliberately
trying to deceive but rather a reflection of the poor information
produced by the banks and reported to APRA. Does anyone really know
how much non-residents have lent to Australian banks when non-
residents in the deposit base are not identified?
My proposition based on the above graphs is that a considerable amount

of what previously was properly defined non-resident liabilities have
been transferred to deposits and that overall bank’s liabilities to non-
residents continues its upward trend. This transfer is to the benefit of the
offshore lenders but at Australia’s cost and risk. I have three reasons for
my proposition.
Firstly, deposit rates are at all time high rates relative to the cash rate
and bank bills. Please take a look at this site which gives a good
summary of bank deposit rates across the board. With the CBA offering
a 1 year deposit rate of 6.1%, would this tempt any non-resident
investor? Maybe Bill Gross from PIMCO, the world’s largest fund
manager, provides the definitive answer to that question when advising
that investor’s portfolios perhaps should be:
…replaced with more attractive alternatives both from a risk

and a reward standpoint. It is still possible to produce 4–5%
returns from a conservatively positioned bond portfolio –
you just have to do it with a different mix of global assets.
I think that’s one for the affirmative, Matilda.
Secondly, the increase in the strength of the A$ across most major

currencies did not come about because of current account surpluses, we
still have deficits. Global punters have been buying A$ and lending
those A$s to Australia. Why they are doing this is not the point. The
point is that if you buy A$s it must be used to buy assets or equities or
as a loan or deposit. I’m betting on the later with the clear support of
Mr Gross. For the moment anyway, I’m also sure that Mr Gross or any
other possible investor does not care one iota that imposing this strength
on the $A is slowly strangling Australia’s manufacturing, tourism and
overseas student education sectors.
Thirdly and by no means the least of the reasons, is the credit risk of
certificates of deposit. If an Australian ADI/Bank collapses, deposits are
generally believed to rank ahead of other wholesale lending for
repayment. That’s why deposit interest rates are considerably lower than
other types of securities issued by banks. What the actual credit ranking
is very complex? See for yourself.
Regardless, in an environment where in effect the Australian

government has shown their willingness to step in and support our
banks come what may, as a deposit holder in a major Australian bank,
your risk is as good as the Commonwealth of Australia itself. Forget the
Banking Act, the market believes that the Australian Government will
not let any bank default on deposits but just may let defaults occur on
wholesale funding. At over 6% for 12 months, I’m again betting that our
Mr Gross thinks that’s great value “from a risk and a reward
standpoint.”
In summary, because of deposit interest rates, FX strength of A$ and

credit risk, offshore funds continue to pour into Australian banks but in
a different and riskier form for Australians. Whilst I don’t have enough
data, this is a provable proposition once data becomes available.
The last point on credit risk is what links me back to the continual
rehypothication of Australian mortgages by the Aussie major banks. The
offshore investors who are pouring money into Australia on an ever
increasing basis do not want to worry about credit. It’s not their
bailiwick. Absolute returns over the next year or so relative to the
alternative global investment are what they are after. These money
jockeys will plow funds into Aussie banks so long as relative returns
continue and the perceived risk is not worth worrying about.
So for risk oversight they’re relying on APRA and for credit opinions
on the rating agencies. I gotta tell you at this point my friends, I’m sure
glad I’m not in either of those shoes. Relying on continual mortgage
rehypothication to prop up the perceived credit risk and support capital
levels (aka haircut) of the Australian banks is a very dangerous game.
It is a truism that any financial system that can continue to increase

borrowings to meet liquidity requirements will not fail. The question is
when or if the “continue” stops. My proposition for Australia is that it’s
a “when” due to excessively aggressive mortgage rehypothication.
Don’t get me wrong, like securitization, rehypothication is a valuable
financial tool, so how did things get out of control?
In my post, “The Capital Rort”, I explained how the bankers were

rorting the system to fill their fat wallets by reducing capital allocated to
each mortgage as property values rise. Now we need to take that
analysis to another level, to show how they’ve actually put Australia’s
financial system on the relentless march to either collapse or further
government rescue. But don’t be concerned about our friends the
bankers as they’ll continue stuffing their wallets until this occurs and if
offshore experience is anything to go by for sometime after that as well.
For information I’m going to refer to: The RBA publication, Australian
Bank Capital and the Regulatory Framework by Adam Gorajek and
Grant Turner.
Confirmation of the banks using internal models to determine capital for

residential mortgages is given in words and numbers. The words:
Some banks, including the four largest, use an alternative

Internal Ratings-based approach whereby risk weights are
derived from their own estimates of each exposure’s
probability of default and loss given default.
But also from Table 2 in the paper as it relates to residential mortgages:
Exposure Average Risk-weighted assets

risk-weight
$ billion Per cent $ billion Per cent of total
1,157 26 302 22
Under APRA’s Prudential Standard APS 112, the lowest standard risk
weighting for mortgages is 35% for a standard mortgage with an LVR
of 60% (Table 4). The above table produced by the RBA states that the
average weighting across the whole ADI mortgage book is only 26%!
Clearly the internal risk models are gaining an incredible regulatory

capital advantage for those banks that use them. With risk-weighted
assets allocated capital at the rate of 8% the total amount of regulatory
capital required against the total $1.157 Trillion mortgages on the banks
books is only $24 billion a rate of a touch above 2%. Are you shocked?
Be shocked, but I have to admit that it’s not quite as bad that raw 2%
figure indicates. We need to take account of mortgage insurance as
approximately half (the riskiest half) of $1.157Trn of mortgages is
covered by mortgage insurance.
Ok, so how much capital is behind the mortgage insurers? The vast
majority of mortgage insurance is provided by just 2 companies ie
Genworth and QBE LMI (formerly PMI). An analysis of the accounts
should reveal the capital held against the risk of Australian mortgages.
Well, be my quest. For Genworth and for QBE. I could not figure out
from these published accounts, the very simple piece of information that
is, how much capital is held against Australian mortgage risk?
At this point, and although I cannot produce public information to

support my case, I need to use my knowledge of the capital position of
the mortgage insurers. To the nearest percent, the collective capital base
of Genworth Australia and QBE LMI against approximately $600bn of
Australian mortgages is 1%.
So in simple terms the total amount of capital in Australia dedicated to

the risk on $1.157 Trillion of mortgages is approximately $30bn. How
did this occur and how is it being allowed to continue?
It occurred because APRA allows the capital requirements of banks and

insurers to be adjusted down as the value of the collateral behind
mortgages increase. For collateral, see house prices. But those
organizations make more and more money by writing bigger and bigger
mortgages. So APRA and regulation have created a system which
incentivises the lenders and insurers to take more and more risk on the
basis that bigger and more loans reduce the risk of the mortgage book.
This is absurd. But every participant has their snout in the trough, all the
while publicly espousing the quality of Australian mortgages. When all
they’ve done is expose every Australian to massive systemic risk. How
can we believe that in a country which has the most unaffordable
housing in the world also has one of the lowest mortgage risk? If it
quacks like a duck…
However, no system is sustainable without a continual money supply

which is where the rehypothecation of mortgages comes to the fore. By
continually revaluing the mortgage collateral to support further
borrowing without needing to provide significant amounts of extra
capital (hair cut, in securities rehypothecation), provides the turbo
charge to excessive lending and the relentless march to systemic failure
or government rescue. But this is done by piling more and more risk on
every Australian, not just homeowners, not just by using the artificially
created equity that may accrue in a house but also the real equity, which
provides the base that spins money flow through excessive
rehypothecation. This has all occurred under APRA’s reign and
encouragement, so much for reliance on public institutional oversight.
So when will the money wheel stop and the gangs take over the
highways? I have a few ideas on that but it’s certain that it’s not never.
Deep T. is a senior banking insider who is fed up with his colleague’s

reliance on public support.
13 Responses to “ “Big profits, huge risk”
1. PeterJB says:
February 10, 2011 at 9:19 am
This is a huge risk: I must say that I thank you for for validating
my instincts here which essentially is at full obligation of the Oz
– no doubt at all.
But I ‘smell’ that there are actually (perhaps) x3 re-

hypothecations going on in this chain (keyword: smell):
1: As you point out above (deposits/f. liability)
2. Securitized mortgages RMBS
3. Purchase of these RMBS by the taxpayers agent, the
Government
At 7% over 30 years the buyer is paying x3 times the “set price”

of his home and that is inflation corrected.
Most interesting article – thank you
PeterJB
Reply
2. PeterJB says:
Apologies but I just had a flash; It has always worried me that the
OZ govt debt is low where the worrying point it that our
government does not fund the future of Australians ie it focuses
on Marxism disguised as Social democratic practices of funding
only current comforts (so as maintain the longevity of office
model running (for themselves)).
And, where it is actually Australia’s private debt that funds

Australia’s insipid future growth. Damn: this process is – must be
– appears as, Policy (Classified).
This answers a powerful lot of questions and besides, it is a huge

/massive drain on Australian’s wealth cum productive capacity –
just to fill some pockets.
PeterJB
Reply
3. True Blue Perspective says:

Thanks Deep T. Your insight to our failing banking system is

awesome. There are massive problems with the system and it
looks like either the gangs will rule the highways or the
government will bail them out. We need some Solutions and
Action!
Reply
4. Sean says:
My concern is that our Govt will do the same thing as Ireland’s

and take over the banks’ bad books (also happened with the SA
govt and State Bank of SA in the 90ʹ′s) forcing taxpayers to pick
up the tab. If the banks actually do succeed in crashing the
economy on the back of this engineered Ponzi scheme we call
housing then perhaps we should seriously consider Ben Chifley’s
idea of nationalising domestic banking or at least stiff regulation
against residential property speculation.
Reply
5. FrankieFourFingers says:
February 10, 2011 at 1:01 pm
We have the bank executives whose primary objective is to get

their big bonuses, and we have the politicians whose primary
objective is to get elected. In order to meet those objectives, it is
in the interest of both bank executives and politicians to keep
house prices rising any which way. The financial stability of our
nation is of secondary concern.
Reply
6. 787 Dudliner says:

Don’t sell if you don’t have to. At -10% negative equity switch to
Rexona Sports as the fear stench may upset your co-workers
http://www.smh.com.au/business/property/if-you-dont-need-to-
sell-dont-20110209-1amn5.html
Reply
7. Stewart says:
I must say: though i’m skeptical of banking “security” in general,

i DID think that, at least we did things a bit more sensibly here in
Australia, that our banking system really was one of the more
“robust” in the world.
Now, i guess that is indeed possible, but it really comes out like
this: that we’re the best amongst an array of the bad – which is
not really that good after all, is it??
Quite concerning and sobering, really.
Thanks Deep T.
Please keep it up…
Stewart
Reply
8. graham.tomlin says:
In a nutshell this is credit default swaps by another name–think

Bear-Sternes/Lehman Bros
Reply
9. JR86 says:
You might even be high estimating the amount of capital at the

mortgage insurers. Genworth claims to have 1.4 billion in capital
supporting it’s Australian mortgage insurance book which insures
over 283 billion in mortgages. Talk about a lack of oversight.
200x leverage? On an average LTV of over 65%? Someone needs
to shake the regulators silly.
Reply
10. PhilBest says:

As Michael Lewis pointed out recently in his article on the Irish

crash, it actually is not necessary to have layers of complexity in
the form of CDO’s and CDS’s and derivatives, to engineer a
massively over-leveraged property bubble. The Irish bubble was
quite simple; it was based on Irishmen selling bits of Ireland to
each other at ever-inflating prices, with money borrowed mostly
offshore.
Alan Moran and Bob Day and Hugh Pavletich can tell you about
the connection between land regulations and the Irish bubble too.
It is THE common ingredient everywhere these bubbles have
happened. In fact, it is easier to look for where the bubbles
HAVEN’T happened, and note the ABSENCE of a land supply
racket enabled by the local “planning” authorities.
The reason that this is a truly international phenomenon, is that

global warming mania and its love child, anti-sprawl mania, is a
truly international phenomenon.
“Sean” above (11.40AM Feb 10) is absolutely right (Irish name,

Sean?). It is sickening to see taxpayers now on the hook for
decades, while investors who are supposed to have been exposed
to risk, get paid out. The international opportunists that “Deep T.
In Banks” identifies absolutely should NOT be bailed out by the
Australian taxpayer. If an international investor has not learned
enough by NOW to do due diligence on the fundamentals, he/she
most definitely deserves to lose their shirt. They are little more
than international bubble-chasers.
Reply
Sean says:
Actually Phil my mother just happened to love Sean

Connery – I’m from Melbourne. And I’m 100% with you,
shareholders have to lose out by definition. Pyramid was
another taxpayer bailout disaster worth mentioning but we
can thank Jim Kennan (then Vic treasurer) for that ball and
chain…
Reply
11. Deep T: Australian Banking System on Unstoppable Path to
Collapse or Government Bailout « naked capitalism says:
[...] By Deep T., a senior banking insider who is fed up with his
colleague’s reliance on public support. Cross posted from
MacroBusiness. [...]
Reply
12. William says:

Do you really think the Australian banking system in under-
capitalised? APRA’s application of Basel requirements is one of

the most stringent in the world (one can add 2-3 percentage points
against Tier 1 measures when compared to UK banks for
example). Of course, as time goes by LTV falls, and is obviously
accelerated during property boom times. So while they may hold
less risk weighted capital as a result, the buffer before bank loss
starts also increases. I note that the regulator overseas both the
banks and LMI – and sets their capital levels for both. Over the
past decade the regulator and government has undertaken very
proactive assessment of the situation, and have a history of stress
testing the system, and enforcing greater capital if deemed
necessary (see apra website). Due to such measure taken, current
stress testing of the system, by APRA, and also independently by
Fitch Ratings show that a heavy, far reaching scenario (ie gdp
contraction3%, unemployment 11%, property prices down 40%,
and macro econ slowdown in China) can be absorbed with
manageable impact on capital (ie under the worst case Tier 1 fell
3.1% over the 3 years of stress).
In regard the property bubble: In the short/medium term prices are

underpinned by demand, the main question in regard this is why
the both political parties, during their times in office over the last
decade or so, have let the preferential property investment tax
system fuel such a bubble?
The politicians have already answered this: Finance minister

Lindsay Tanner April 2010 “The key reason why governments of
both persuasions have not interfered with negative gearing is of
course that that any dramatic change in the overall investment
framework could lead to a stampede of people out of property,
which could lead therefore to dramatic drops in prices which of
course you’re seeing in other economies around the world and
you see the economic devastation that flows from that” – and no
side of government wants this to happen on their watch.
I also note that perhaps the movements in deposits and offshore

funding is a result of the banks intentionally doing this mainly to
comply with the new basel stable funding and liquidity
requirements. These have been known for months, with APRA
detailing their final requirements in December (hence the
movement over this time). Such requirements need more stable
funding (ie retail deposits-hence the domestic competition in
rates), and less reliance on offshore funding sources – which is
why you see recent movement in these levels.
Reply
13. Non-Resident says:

“Does anyone really know how much non-residents have lent to
Australian banks when non-residents in the deposit base are not

identified?”
It is perhaps just a minor point, but this could be the reason for
the abiblity to identify the holders:
http://www.ato.gov.au/businesses/content.asp?
doc=/content/50240.htm&page=43&H43
Reply
Leave a Reply
Name (required)
Mail (will not be published) (required)
Website
Submit Comment
About Us
Four bloggers have combined to bring you a new concept in business

media - the 'superblog'. We cover the Australian economy via no
nonsense analysis of the big picture and its effects on your assets and
business. Enjoy and prosper!
All Posts Feed

Enter your email address:
Subscribe
Individual Feeds (RSS)

Delusional Economics
Houses and Holes
Unconventional Economist
Sell on News
Popular Posts
Big profits, huge risk
Weekend reading: Blowoff time
The Baby Boomer Bust?
More on New Zealand's Deleveraging
Green waste
Bizarro World
Just how low will Queensland go ?
Archives
February 2011 (60)
January 2011 (116)
December 2010 (138)
November 2010 (156)
October 2010 (121)
September 2010 (62)
August 2010 (40)
July 2010 (80)
June 2010 (63)
May 2010 (124)
April 2010 (11)
Categories
Aussie dollar (1)
Australia/China links (1)
Australian Economy (24)
Banks (25)
Capitalism (1)
China economy (8)
Commodities (4)
Economics (1)
Equities (15)
Global Housing Bubbles (5)
Global macro (3)
Interest rates (5)
Links (23)
New Zealand economy (3)
Oz Housing Bubble (27)

Uncategorized (784)
US economy (6)
Blogroll
Abnormal Returns
Alphaville
Baseline Scenario
Billy Blog
Bronte Capital
Calculated Risk
China Financial Markets
Econompic
Fed Watch
Financial Follies
Metal Prices
Naked Capitalism
Tasmanian Real Estate Trouble
Zero Hedge
Resources
ABS Financial Accounts
AOFM RMBS
B3 Offshore liabilities
Coking coal price
DO2 Credit aggregates
Exports
F3 Bank spreads
House prices
Housing stock
Iron ore price
LIBOR
Thermal coal price
Wholesale guarantee
Top Home & Land

Packages
$10K Off Land Block
& $1K Deposit*. Make
Your Move Now with
Stockland.
MakeYourMoveNow.com.au/…
No BAS Low Doc

Home Loans
Lo Doc loans 8.12%
No BAS, no bank
statements.
www.novafinanceaust.com.au
Risk Thinkers
Risk Thinking Risk
Reviews Insurance
Tenders
riskthinkers.com.au
Home Loans and

Mortgages
Enter the Mortgage
Business Own your
own Business with
Leverage
www.mortgagehouse.com.au
AML/CTF Solution
Detailed AML/CTF
program. Compliance
reporting.
www.CompliSpace.com.au
TAGS
Aussie dollar Australia/China links Australian Economy Banks Capitalism China
economy Commodities Economics Equities Global Housing Bubbles Global macro
Interest rates Links New Zealand economy Oz Housing Bubble
Uncategorized US economy
Powered by WordPress | Built by Sean

Big Profits, Huge Risk - Macro Business

Încărcat de

Informații document

Descriere originală:

Titlu original

Drepturi de autor

Formate disponibile

Partajați acest document

Partajați sau inserați document

Opțiuni de partajare

Vi se pare util acest document?

Este necorespunzător acest conținut?

Drepturi de autor:

Formate disponibile

Big Profits, Huge Risk - Macro Business

Încărcat de

Drepturi de autor:

Formate disponibile

Big profits, huge risk | macrobusiness.com.

What is rehypothecation? From “hypothecate”- to pledge collateral.

To understand how rehypothecation applies to the Australian mortgage

I have updated to Dec 2010 a previous graph I’ve used comparing

The graph represents a clear view of how offshore borrowings have

‘Resident liabilities – deposits’ include: transaction and

I have highlighted the relevant parts of the definition. I did a bit of a

My proposition based on the above graphs is that a considerable amount

…replaced with more attractive alternatives both from a risk

I think that’s one for the affirmative, Matilda.

Secondly, the increase in the strength of the A$ across most major

Regardless, in an environment where in effect the Australian

In summary, because of deposit interest rates, FX strength of A$ and

It is a truism that any financial system that can continue to increase

In my post, “The Capital Rort”, I explained how the bankers were

Confirmation of the banks using internal models to determine capital for

Some banks, including the four largest, use an alternative

But also from Table 2 in the paper as it relates to residential mortgages:

Exposure Average Risk-weighted assets

$ billion Per cent $ billion Per cent of total

Clearly the internal risk models are gaining an incredible regulatory

At this point, and although I cannot produce public information to

So in simple terms the total amount of capital in Australia dedicated to

It occurred because APRA allows the capital requirements of banks and

However, no system is sustainable without a continual money supply

Deep T. is a senior banking insider who is fed up with his colleague’s

13 Responses to “ “Big profits, huge risk”

But I ‘smell’ that there are actually (perhaps) x3 re-

At 7% over 30 years the buyer is paying x3 times the “set price”

Most interesting article – thank you

And, where it is actually Australia’s private debt that funds

This answers a powerful lot of questions and besides, it is a huge

3. True Blue Perspective says:

Thanks Deep T. Your insight to our failing banking system is

My concern is that our Govt will do the same thing as Ireland’s

We have the bank executives whose primary objective is to get

6. 787 Dudliner says:

I must say: though i’m skeptical of banking “security” in general,

Quite concerning and sobering, really.

Please keep it up…

In a nutshell this is credit default swaps by another name–think

You might even be high estimating the amount of capital at the

10. PhilBest says:

As Michael Lewis pointed out recently in his article on the Irish

The reason that this is a truly international phenomenon, is that

“Sean” above (11.40AM Feb 10) is absolutely right (Irish name,

Actually Phil my mother just happened to love Sean

12. William says:

Do you really think the Australian banking system in under-

capitalised? APRA’s application of Basel requirements is one of

In regard the property bubble: In the short/medium term prices are

The politicians have already answered this: Finance minister

I also note that perhaps the movements in deposits and offshore

13. Non-Resident says:

“Does anyone really know how much non-residents have lent to

Australian banks when non-residents in the deposit base are not

Mail (will not be published) (required)

Four bloggers have combined to bring you a new concept in business

All Posts Feed

Individual Feeds (RSS)

Oz Housing Bubble (27)