A National Mortgage Bubble

Hey if the Aussie banks are well capitalised and not exposed to further real estate losses, why did Bendigo and Adelaide bank announce plans yesterday to raise $300 million in equity yesterday? The company said it’s moving to “strengthen its capital base.” It’s also tapping equity markets for funding because that funding is getting awfully hard to find elsewhere.

This brings us to a quick point about the Aussie property market. A frequent complaint in the e-mail box is that house prices are a local and not national phenomenon. If that’s right, then it doesn’t make any sense to talk about a national property bubble…because there can’t be one, can there!?

Well…no. Australia’s mortgage finance market is becoming more and more national each day. This makes for a national mortgage bubble, regardless of varying property prices locally. The growth of the mortgage market becomes crucial to the growth of bank earnings, making lenders less cautious and more likely to drive up prices by lending to increasingly marginal borrowers. This explains (along with the FHB grant) why suburbs that had lower median prices two years ago have seen the fastest house price growth rates in the last year.

One of the features of the late-stage property bubble in the U.S. was the acquisition of local and non-bank lenders by money-center banks and Wall Street brokerages. It was so profitable to originate mortgage loans (since they could be sold in the securitisation market thanks to credit default insurance sold by AIG), that Wall Street and large U.S. banks went out and bought non-traditional lenders (those who sourced their mortgage funding by borrowing rather than from deposits).

The result was a huge explosion in loans which drove up prices. Late in the game, Wall Street and the banks were forced to buy up most of the mortgages they had securitised. This put the risk of falling house prices right back on bank balance sheets. Falling house prices reduced the value of bonds made up of bundles of mortgages, bonds the banks now owned. The result was last year’s earnings catastrophe for financial stocks.

And not just for financial stocks! After the banks and Wall Street shut off the mortgage spigot in 2007, Congress forced Fannie Mae and Freddie Mac to resume lending and buying mortgages in the secondary market. The result has been more huge losses.

Those losses are so large, in fact, that they account for nearly half the spending increase in U.S. Federal spending this year. We learned yesterday that the U.S. budget deficit was $181 billion for the month of July and $1.3 trillion for the fiscal year (which ends in October). The deficit grew because tax revenues are falling while spending is rising (bad maths).

If you can believe it, U.S. spending is up $530 billion over this time last year. One cause is stimulus money being doled out to cronies. But the Congressional Budget Office reckons that more than half the increase in spending comes from the money Congress has allocated to Fannie Mae and Freddie Mac.

So the U.S. taxpayer (or the Chinese saver) is directly subsidising the U.S. mortgage market. We’d argue that this is what happens when the nation’s financial system becomes a vehicle for channeling capital into rising house prices. It’s a giant national bet that leaves the banks and government finances increasingly at risk.

Here in Australia, figures from the Australian Bureau of Statistics show that the big banks account for 92% of all mortgages. As University of New South Wales Associate Professor Frank Zumbo told a Senate inquiry yesterday, this has virtually eliminated competition in the mortgage market, giving a very few institutions nearly full pricing power.

But the bigger risk, we reckon, is that Australia’s banks will become increasingly reliant on rising house prices to spur demand for new mortgages. That’s the process that contributes to earnings and keeps the balance sheet ticking along. The loans made to mortgagees go on the balance sheet as assets. They are funded from money borrowed abroad, which goes on the balance sheet as a liability.

The trouble here is that assets can change in value while liabilities do not. The debt has to be repaid, even if house prices fall. Australia’s banks are gambling with the capital structure of the entire nation, sinking more and more borrowed money into residential housing. It’s the biggest and riskiest bet yet.

Dan Denning
for Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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2 Comments on "A National Mortgage Bubble"

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Unpopular Truth

It’s actually very clever of the banks to do that.

They’re tying their own success to something the politicians cannot ignore, and that’s the safety of people’s homes.

If it goes pear shaped, then they’ll be rescued by taxpayer money. If it goes well, they keep the profit for themselves (and their share holders).

To do otherwise would mean being crucified at the next election.

M. Forwik
Except that banks rarely loose out. If someone can’t pay the mortgage, bank sells their house. If it sells at a loss, the mortgagee must pay the bank that loss. If they can’t pay the loss, then they just make interest on this loss (even a $100,000 drop is only a few hundred interest per month). If the person can’t pay that, they file for bankrupcy. If they go bankrupt the goverment deducts money from their pay check as well as paying their taxes to the bank until the person is no longer bankrupt. If this still doesn’t cover the… Read more »
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