Don’t Put Your House on it

August 27, 2009

By Jeremy Thompson

The mining boom in Australia is being depicted as an epochal shift in Australia’s industry base. Less noticed is that it follows another profound change in how the Australian economy is structured. Over the last two decades, the industrial economy has been replaced by a financial economy. “We have made money for each other by borrowing and building houses and taking fees off that,” says one fund manager. “It equals a balance of payments problem.” Capital, especially banking capital, was kept thin, mainly through the use of off-balance sheet mechanisms.

This shift to the financial economy has in Australia been inseparable from the rising value of property, and it poses a threat to the banking system. It is true that domestic banks have mostly avoided the excesses of sub-prime mortgage lending and the credit crisis that are crippling the American financial system and increasingly harming British banking.

Australian lending practices have for the most part been more sane. The big write-downs by the NAB and the ANZ, big as they are, can justly claim to be on the margin. If many American and European banks were so aggressive in writing off their exposures to collateralised debt obligations and other forms of securitised instruments, they would probably no longer be in existence.

The heavy dependence of Australia’s capital base on property still makes Australian banking, and the economy, vulnerable to a downturn in prices. Australia’s financial system may have avoided the post-modern absurdities of the current global credit crisis, with its blizzard of meta-instruments underpinned by Triple-A ratings that apparently are not worth the rating agency they are written on. The NAB’s 90 per cent write-down of $1.2 billion of securities backed by US home loans was all theoretically Triple-A debt.

But the financial system is still vulnerable to a more conventional credit squeeze because of a fall in property values. The rise in local house prices cannot be divorced from the series of global asset bubbles that have emerged since 2001 as a result of the US Federal Reserve’s loose monetary policy, sparked by its efforts to avoid Japan-style deflation. This led to an era of cheap debt that Australian financial companies, particularly real estate property trusts, exploited aggressively.

It also led to many Australian businesses profiting from borrowing and investing in property. JP Morgan analyst Brian Johnson notes that the surge of business lending since 2002 is not explained by concomitant increases in capital expenditure or inventory build up. Instead, the debt was channelled into commercial property on an increasingly geared basis, pushing yields on commercial property at the end of 2007 down to historical lows compared with interest rates.

That game is well and truly over. But it only serves to further underline how dependent the Australian economy has become on its property bubble.

On the face of it, Australian banks are not especially vulnerable to a run on housing. A “stress test” by the investment bank UBS, for instance, recently concluded that there would only be total major bank mortgage losses of approximately $1 billion if there is a recession similar to that now afflicting the United Kingdom. UBS suggested that the Commonwealth Bank would have possible losses of $300 million, the NAB and ANZ $250 million and Westpac $200 million.

But if there is one lesson from the global credit crisis, it is that assumptions about risk management are not always reliable. In fact they can be downright dangerous. Nasty surprises can and do occur, and the easy ride of the last five years seems to have turned vicious.

The “finance economy” that has so benefited the Australian stock market and Australian economy appears to be at the end of its run. Until the credit crisis, property was scarce, and capital and most consumers goods plentiful.

Now, capital is scarce, although arguably housing property is also still scarce in Australia. However, new scarcities are emerging that will shift attention away from property. Most obvious are price rises in fuel and food, but increasingly energy will become problematic. The notion that nothing is safer than “bricks and mortar” seems to have run its course, and the stresses on Australia’s financial system may prove to be severe.