Bubble-Trouble Amongst Australian/Nz Mortgage Risk-Weightings
February 15, 2017
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Approaching a decade on from the global fiscal crisis (GFC), I perish on to rest amazed yesteryear how lilliputian the ground has learnt. Indeed, Commonwealth of Australia together with New Zealand, for instance, rest inward the grips of tape belongings bubbles at acquaint together with are repeating many, if non most, of the same mistakes. The same tin dismiss probable hold upwardly said of Canada, together with perchance the U.K. equally good (although I'm less confident on the latter).
While all sorts of novel banking rule has been proposed together with implemented inward the crisis' wake, the origin crusade of the crisis does non appear to take away keep been either recognized or addressed. Consequently, the same fundamental mistakes are recurring, but simply inward a dissimilar guise - namely the role of artificially-low mortgage gamble weightings. But commencement some quick background.
The truthful crusade of the GFC
In my opinion, the fundamental origin crusade of the GFC was a widely-held supposition yesteryear banks together with other fiscal marketplace position participants that past, statistically-based measures of habitation mortgage default rates could hold upwardly used equally a reliable indicator of futurity default risk.
At human face upwardly value, it seemed to hold upwardly a reasonable presumption. After all, the yesteryear lxx years of information indicated that private habitation mortgage default rates inward whatsoever given twelvemonth were low. Furthermore, inward the trial of default, at that topographic point was typically audio collateral coverage, together with and thence recovery rates inward the trial of default were typically high. That could hold upwardly expected to continue, together with thence the thinking went - after all, habitation prices almost ever rose over time. lxx years of information proved it.
This supposition allowed vast bulks of mortgages to hold upwardly securitized, rated, together with sold closed to the ground with express scrutiny, because everyone knew these mortgages were equally 'safe equally houses'. When this supposition was called into question, the stream of credit was interrupted together with occupation solid prices promptly crashed, because the availability together with cost of credit is what determines the grade of occupation solid prices.
The amount occupation with these models was that they considered mortgage default gamble inward much the same way equally an auto insurer mightiness facial expression at their gamble exposure from auto accidents. In other words, they assumed private defaults were uncorrelated and independent risk factors. Sure, on whatsoever given twenty-four hours an private borrower could lose their undertaking together with default on their mortgage, inward much the same what that whatsoever private could crash their car. But these risks are diversifiable, together with across a large portfolio, are depression gamble on a organisation basis, with highly predictable default probabilities.
The flaw with these models, to extend the insurance analogy, is that they didn't consider 'catastrophe risk' - e.g. the thought that a 100-year tempest could sweep through town together with harm a pregnant portion of the auto fleet inward i roughshod swoop. Insurance companies do consider these risks, but mortgage default models did not. That was fine for lxx years (long plenty for the Great Depression to hold upwardly forgotten). But when a nationwide housing crash occurred, the risks that were assumed to hold upwardly independent all of a abrupt became highly correlated - something the models had non taken into account. The final result was fiscal catastrophe.
Furthermore, these models non exclusively failed to accept into occupation concern human relationship organisation 'catastrophe risk', but were also active contributors to the formation of the bubble inward the commencement place. This should take away keep been predictable to thoughtful observers (and was to many - reckon The Big Short).
With involvement rates real depression during 2001-05 after the bursting of the tech bubble, investors needed yield. So they started to purchase higher-yielding mortgage securities, which were assumed to hold upwardly depression gamble (we all know what supposition is the woman nurture of). Banks did what banks do - equally intermediaries, seeing a large together with growing demand for higher-yielding mortgage securities, they rushed to manufacture to a greater extent than of them to encounter that demand. They needed raw fabric - mortgages - together with thence they paid mortgage brokers to source them to a greater extent than loans. Mortgage brokers lent to anyone they could to encounter the demand from Wall Street. Lending standards roughshod together with the final result was that anyone could acquire a loan, which drove the bubble. When the buyers of those mortgage securities all of a abrupt realized they were taking to a greater extent than gamble than they realized, they stopped buying them, together with the whole building crumbled. This should take away keep been predictable to regulators, and the crisis would never take away keep happened if dynamic risk-models actively took into occupation concern human relationship systemic gamble factors.
The same fault is beingness made with depression mortgage risk-weightings
Unfortunately, lilliputian has changed, and the occupation is similar a shot manifesting inward the way depository fiscal establishment regulators decide mortgage risk-weightings, which much similar the above, seem custom-designed to both overlook systemic gamble piece at the same fourth dimension maximizing the existence of that risk. Central banks take away keep also been slashing involvement rates again. When I facial expression at Commonwealth of Australia together with NZ, it almost appears to me equally if depository fiscal establishment regulators, politicans, together with key bankers looked at what happened inward the US during 2002-09 together with said "hey, that seems similar a skillful idea; let's elbow grease it".
In the banking industry, risk-weightings are used to decide how much uppercase a depository fiscal establishment needs to concord against a given block of risks it is taking. For loans that are considered riskier than average, a gamble weighting to a higher house 1x volition hold upwardly applied, which requires proportionately to a greater extent than uppercase hold upwardly held against such loans. Conversely, loans or assets that are considered lower gamble require a less than proportionate amount of precautionary uppercase hold upwardly held.
What is extraordinary is that the risk-weighting applied to habitation mortgages inward Commonwealth of Australia is exclusively 16% (although APRA is considering raising this to 25%). Bank regulators deem habitation mortgages to hold upwardly together with thence safe, that exclusively most 1/6th of the uppercase backing a typical loan demand hold upwardly held for habitation mortgages. Put some other way, it way banks tin dismiss brand vi times equally many mortgage loans for every dollar of uppercase held vs. assets with a par gamble weighting.
This is pure folly for a issue of reasons:
*Firstly, it makes the exact same error equally the mortgage securitization models inward the US made pre GFC - namely looking at mortgage gamble from a purely uncorrelated, private basis, using historical information equally a guide, instead of via a thoughtful consideration of systemic gamble factors.
*Secondly, low-risk weightings take away keep contributed - with depression involvement rates - to the evolution of a housing bubble inward Australia/NZ inward the same way false securitization model appraisals led to an excessively unloose stream of credit into the mortgage marketplace position inward the US pre-boom, because they take away keep encouraged banks to lend to a greater extent than to the housing sector inward lodge to maximise their returns on equity (and management bonuses). Indeed, most two-thirds of Australian banks remainder sheets are exposed to habitation mortgages - a real high amount.
*Lastly, no adjustment is made to risk-weightings to reverberate the riskiness of the underlying collateral at dissimilar points inward the bike (APRA's recent proposal is also lilliputian also late). After a housing bubble has popped together with occupation solid prices are depression (and capitalization rates high), housing loans are non real risky. However, when occupation solid prices are real high (and capitalization rates real low), they are much riskier (see the convexity give-and-take below). Constant risk-weightings assume that risks are equal at all points of the cycle, but this is plainly false. This is an inexcusable regulatory oversight together with failure of leadership inward my see - peculiarly given that the GFC should take away keep alerted regulators to these risks.
The banks take away keep also exercised almost no self-restraint, together with take away keep behaved inward precisely the way primary street loathes - i.e. taking huge risks to maximize brusk term profits together with bonuses.
The world, unfortunately, has learnt nothing.
Convexity maximizes the risks at this dot inward the cycle
It is of import to appreciate that the convexity characteristics of belongings prices together with other yield assets perish fairly extreme at depression involvement rates/capitalisation rates. For a belongings with a gross yield of 10.0%, a 100bp increase inward involvement rates together with corresponding capitalization rates would exclusively cut down the property's value yesteryear most 10%. Furthermore, inward an surroundings of 10% involvement rates, y'all likely take away keep at to the lowest degree 3-4% inflation, together with and thence over the course of report of 2-3 yrs, rents would ascent yesteryear most 10% together with the adjustment would hold upwardly a wash. Property prices would simply stabilize for a period. Something akin to this has been the typical sense historically.
However, at a gross yield of 2.5%, a 100bp increase inward involvement rates together with capitalization rates would cut down belongings values yesteryear most 30% (merely repricing gross rental yields to 3.5%). This is convexity - fancy bond investor parlance for the fact that uppercase values alter much to a greater extent than significantly inward reply to a given ground dot alter inward involvement rates when yields are depression vs. when they are high.
This is important, because involvement rates take away keep non been this depression earlier historically. Consequently, nosotros take away keep no reliable information on how belongings prices volition perform inward a futurity catamenia where involvement rates ascent from real depression levels. If the US sense during 2005-08 is whatsoever indication, however, it could hold upwardly pretty ugly. Needless to say, the gamble of a 80-90% LTV mortgage is much higher when involvement rates together with cap rates are depression than when they are high, due to these convexity characteristics, together with yet the regulatory risk-weighting is the same.
A quite shocking article was published late inward Commonwealth of Australia that indicated 20% of Australian households felt they would deal to encounter ongoing mortgage payments if involvement rates were to ascent yesteryear simply 50bp. 50bp off tape lows! That is a genuinely terrifying statistic, together with if it is true, the application of a 16% risk-weighting to mortgages is folly inward the extreme.
Conclusion
As should hold upwardly apparent from the above, I am steering good clear of the Australian banks with my investment activities on the long side. I really shout back at that topographic point is a not-inconsiderable gamble they attempt to hold upwardly insolvent together with destination upwardly needing to hold upwardly bailed out yesteryear the Australian tax-payer, equally a lot of their putative 'profits' rely on perpetually rising occupation solid prices together with depression involvement rates to hold upwardly sustainable, together with inward the meantime, they are paying out high fractions of their newspaper earnings inward dividends. I also ain no physical belongings inward Commonwealth of Australia together with NZ together with take away keep absolutely no wish to do so.
I take away keep looked at ways to elbow grease to brusk the banks but to no avail. The ords are expensive to brusk together with timing is extremely difficult to acquire right. Leverage is express when shorting the ords equally good - the most y'all tin dismiss brand is 100% of your initial at-risk capital, prior to send costs (which are high). In addition, a housing crash together with banking crisis inward Commonwealth of Australia is exclusively i of many potential outcomes. The existence of systemic risks does non guaranty that a crisis volition move on - only that the potential for i exists. A issue of factors take away keep to come upwardly together for the pulverization keg to really explode (a precipitous together with sustained ascent inward international wholesale involvement rates could do it). I am non predicting a crash - exclusively pointing out that the risks of i occurring a real.
Ideally, y'all wish to ain derivatives with large asymmetric wages potential if a blow-up does occur. Paulson, for instance, bought securities pre-GFC where the downside was 2-3% of his portfolio but where the maximum wages potential was a 10x gain on his entire portfolio. Needless, to say, he did extremely good inward 2008. Unfortunately, equally a small-time punter I don't take away keep the resources to walk into an investment depository fiscal establishment together with enquire them to construction me custom derivatives that would allow me to lucre from whatsoever A/NZ housing bust, inward the mode Burry together with Paulson et al did inward the US pre 2007. CBA CDSs seem cheap, but the Australian authorities volition probable bail out the Australian banks, wiping out shareholders but protecting debt-holders. Buying long dated puts on the Ausy dollar could hold upwardly i way to play it.
If anyone has whatsoever thought I'm all ears.
LT3000
While all sorts of novel banking rule has been proposed together with implemented inward the crisis' wake, the origin crusade of the crisis does non appear to take away keep been either recognized or addressed. Consequently, the same fundamental mistakes are recurring, but simply inward a dissimilar guise - namely the role of artificially-low mortgage gamble weightings. But commencement some quick background.
The truthful crusade of the GFC
In my opinion, the fundamental origin crusade of the GFC was a widely-held supposition yesteryear banks together with other fiscal marketplace position participants that past, statistically-based measures of habitation mortgage default rates could hold upwardly used equally a reliable indicator of futurity default risk.
At human face upwardly value, it seemed to hold upwardly a reasonable presumption. After all, the yesteryear lxx years of information indicated that private habitation mortgage default rates inward whatsoever given twelvemonth were low. Furthermore, inward the trial of default, at that topographic point was typically audio collateral coverage, together with and thence recovery rates inward the trial of default were typically high. That could hold upwardly expected to continue, together with thence the thinking went - after all, habitation prices almost ever rose over time. lxx years of information proved it.
This supposition allowed vast bulks of mortgages to hold upwardly securitized, rated, together with sold closed to the ground with express scrutiny, because everyone knew these mortgages were equally 'safe equally houses'. When this supposition was called into question, the stream of credit was interrupted together with occupation solid prices promptly crashed, because the availability together with cost of credit is what determines the grade of occupation solid prices.
The amount occupation with these models was that they considered mortgage default gamble inward much the same way equally an auto insurer mightiness facial expression at their gamble exposure from auto accidents. In other words, they assumed private defaults were uncorrelated and independent risk factors. Sure, on whatsoever given twenty-four hours an private borrower could lose their undertaking together with default on their mortgage, inward much the same what that whatsoever private could crash their car. But these risks are diversifiable, together with across a large portfolio, are depression gamble on a organisation basis, with highly predictable default probabilities.
The flaw with these models, to extend the insurance analogy, is that they didn't consider 'catastrophe risk' - e.g. the thought that a 100-year tempest could sweep through town together with harm a pregnant portion of the auto fleet inward i roughshod swoop. Insurance companies do consider these risks, but mortgage default models did not. That was fine for lxx years (long plenty for the Great Depression to hold upwardly forgotten). But when a nationwide housing crash occurred, the risks that were assumed to hold upwardly independent all of a abrupt became highly correlated - something the models had non taken into account. The final result was fiscal catastrophe.
Furthermore, these models non exclusively failed to accept into occupation concern human relationship organisation 'catastrophe risk', but were also active contributors to the formation of the bubble inward the commencement place. This should take away keep been predictable to thoughtful observers (and was to many - reckon The Big Short).
With involvement rates real depression during 2001-05 after the bursting of the tech bubble, investors needed yield. So they started to purchase higher-yielding mortgage securities, which were assumed to hold upwardly depression gamble (we all know what supposition is the woman nurture of). Banks did what banks do - equally intermediaries, seeing a large together with growing demand for higher-yielding mortgage securities, they rushed to manufacture to a greater extent than of them to encounter that demand. They needed raw fabric - mortgages - together with thence they paid mortgage brokers to source them to a greater extent than loans. Mortgage brokers lent to anyone they could to encounter the demand from Wall Street. Lending standards roughshod together with the final result was that anyone could acquire a loan, which drove the bubble. When the buyers of those mortgage securities all of a abrupt realized they were taking to a greater extent than gamble than they realized, they stopped buying them, together with the whole building crumbled. This should take away keep been predictable to regulators, and the crisis would never take away keep happened if dynamic risk-models actively took into occupation concern human relationship systemic gamble factors.
The same fault is beingness made with depression mortgage risk-weightings
Unfortunately, lilliputian has changed, and the occupation is similar a shot manifesting inward the way depository fiscal establishment regulators decide mortgage risk-weightings, which much similar the above, seem custom-designed to both overlook systemic gamble piece at the same fourth dimension maximizing the existence of that risk. Central banks take away keep also been slashing involvement rates again. When I facial expression at Commonwealth of Australia together with NZ, it almost appears to me equally if depository fiscal establishment regulators, politicans, together with key bankers looked at what happened inward the US during 2002-09 together with said "hey, that seems similar a skillful idea; let's elbow grease it".
In the banking industry, risk-weightings are used to decide how much uppercase a depository fiscal establishment needs to concord against a given block of risks it is taking. For loans that are considered riskier than average, a gamble weighting to a higher house 1x volition hold upwardly applied, which requires proportionately to a greater extent than uppercase hold upwardly held against such loans. Conversely, loans or assets that are considered lower gamble require a less than proportionate amount of precautionary uppercase hold upwardly held.
What is extraordinary is that the risk-weighting applied to habitation mortgages inward Commonwealth of Australia is exclusively 16% (although APRA is considering raising this to 25%). Bank regulators deem habitation mortgages to hold upwardly together with thence safe, that exclusively most 1/6th of the uppercase backing a typical loan demand hold upwardly held for habitation mortgages. Put some other way, it way banks tin dismiss brand vi times equally many mortgage loans for every dollar of uppercase held vs. assets with a par gamble weighting.
This is pure folly for a issue of reasons:
*Firstly, it makes the exact same error equally the mortgage securitization models inward the US made pre GFC - namely looking at mortgage gamble from a purely uncorrelated, private basis, using historical information equally a guide, instead of via a thoughtful consideration of systemic gamble factors.
*Secondly, low-risk weightings take away keep contributed - with depression involvement rates - to the evolution of a housing bubble inward Australia/NZ inward the same way false securitization model appraisals led to an excessively unloose stream of credit into the mortgage marketplace position inward the US pre-boom, because they take away keep encouraged banks to lend to a greater extent than to the housing sector inward lodge to maximise their returns on equity (and management bonuses). Indeed, most two-thirds of Australian banks remainder sheets are exposed to habitation mortgages - a real high amount.
*Lastly, no adjustment is made to risk-weightings to reverberate the riskiness of the underlying collateral at dissimilar points inward the bike (APRA's recent proposal is also lilliputian also late). After a housing bubble has popped together with occupation solid prices are depression (and capitalization rates high), housing loans are non real risky. However, when occupation solid prices are real high (and capitalization rates real low), they are much riskier (see the convexity give-and-take below). Constant risk-weightings assume that risks are equal at all points of the cycle, but this is plainly false. This is an inexcusable regulatory oversight together with failure of leadership inward my see - peculiarly given that the GFC should take away keep alerted regulators to these risks.
The banks take away keep also exercised almost no self-restraint, together with take away keep behaved inward precisely the way primary street loathes - i.e. taking huge risks to maximize brusk term profits together with bonuses.
The world, unfortunately, has learnt nothing.
Convexity maximizes the risks at this dot inward the cycle
It is of import to appreciate that the convexity characteristics of belongings prices together with other yield assets perish fairly extreme at depression involvement rates/capitalisation rates. For a belongings with a gross yield of 10.0%, a 100bp increase inward involvement rates together with corresponding capitalization rates would exclusively cut down the property's value yesteryear most 10%. Furthermore, inward an surroundings of 10% involvement rates, y'all likely take away keep at to the lowest degree 3-4% inflation, together with and thence over the course of report of 2-3 yrs, rents would ascent yesteryear most 10% together with the adjustment would hold upwardly a wash. Property prices would simply stabilize for a period. Something akin to this has been the typical sense historically.
However, at a gross yield of 2.5%, a 100bp increase inward involvement rates together with capitalization rates would cut down belongings values yesteryear most 30% (merely repricing gross rental yields to 3.5%). This is convexity - fancy bond investor parlance for the fact that uppercase values alter much to a greater extent than significantly inward reply to a given ground dot alter inward involvement rates when yields are depression vs. when they are high.
This is important, because involvement rates take away keep non been this depression earlier historically. Consequently, nosotros take away keep no reliable information on how belongings prices volition perform inward a futurity catamenia where involvement rates ascent from real depression levels. If the US sense during 2005-08 is whatsoever indication, however, it could hold upwardly pretty ugly. Needless to say, the gamble of a 80-90% LTV mortgage is much higher when involvement rates together with cap rates are depression than when they are high, due to these convexity characteristics, together with yet the regulatory risk-weighting is the same.
A quite shocking article was published late inward Commonwealth of Australia that indicated 20% of Australian households felt they would deal to encounter ongoing mortgage payments if involvement rates were to ascent yesteryear simply 50bp. 50bp off tape lows! That is a genuinely terrifying statistic, together with if it is true, the application of a 16% risk-weighting to mortgages is folly inward the extreme.
Conclusion
As should hold upwardly apparent from the above, I am steering good clear of the Australian banks with my investment activities on the long side. I really shout back at that topographic point is a not-inconsiderable gamble they attempt to hold upwardly insolvent together with destination upwardly needing to hold upwardly bailed out yesteryear the Australian tax-payer, equally a lot of their putative 'profits' rely on perpetually rising occupation solid prices together with depression involvement rates to hold upwardly sustainable, together with inward the meantime, they are paying out high fractions of their newspaper earnings inward dividends. I also ain no physical belongings inward Commonwealth of Australia together with NZ together with take away keep absolutely no wish to do so.
I take away keep looked at ways to elbow grease to brusk the banks but to no avail. The ords are expensive to brusk together with timing is extremely difficult to acquire right. Leverage is express when shorting the ords equally good - the most y'all tin dismiss brand is 100% of your initial at-risk capital, prior to send costs (which are high). In addition, a housing crash together with banking crisis inward Commonwealth of Australia is exclusively i of many potential outcomes. The existence of systemic risks does non guaranty that a crisis volition move on - only that the potential for i exists. A issue of factors take away keep to come upwardly together for the pulverization keg to really explode (a precipitous together with sustained ascent inward international wholesale involvement rates could do it). I am non predicting a crash - exclusively pointing out that the risks of i occurring a real.
Ideally, y'all wish to ain derivatives with large asymmetric wages potential if a blow-up does occur. Paulson, for instance, bought securities pre-GFC where the downside was 2-3% of his portfolio but where the maximum wages potential was a 10x gain on his entire portfolio. Needless, to say, he did extremely good inward 2008. Unfortunately, equally a small-time punter I don't take away keep the resources to walk into an investment depository fiscal establishment together with enquire them to construction me custom derivatives that would allow me to lucre from whatsoever A/NZ housing bust, inward the mode Burry together with Paulson et al did inward the US pre 2007. CBA CDSs seem cheap, but the Australian authorities volition probable bail out the Australian banks, wiping out shareholders but protecting debt-holders. Buying long dated puts on the Ausy dollar could hold upwardly i way to play it.
If anyone has whatsoever thought I'm all ears.
LT3000