Why Low Interest Rates Are Dangerous For Australia

New Zealand’s economic fortunes took a bizarre turn last night. The plot was straight out of the movie series Terminator. Keep in mind about a quarter of NZ’s exports are dairy products…

At 10:33 New York time, news site Bloomberg released the headline ‘WHOLE MILK POWDER PRICES FALL 11.5%’. Algorithms designed to read headlines and trade them faster than humans instantly did their damage. Currency markets went bananas as the New Zealand dollar tanked.

Luckily for the Kiwis, there are still a few real people around in trading pits. Unlike computer algorithms, these traders have an appreciation for human error. It turned out that Bloomberg released last month’s result again instead of the new data. The human traders recognised this about the same time as the algorithms finished driving down the Kiwi dollar. And so the human traders jumped in. They cleaned up while Bloomberg corrected the headline. The algorithms had to reverse their position, making the Kiwi surge back in the opposite direction.

Huzzah! Man over the machine.

But don’t feel too pleased. Back in the real world (outside financial markets) and on our domestic shores, there’s some bad news. The lucky country’s ‘misery index’ is at a six year high. The total score of nine is the sum of inflation running at 3% and unemployment at 6%. We’re officially worse off than the US and Britain, not to mention having a higher unemployment rate than the Americans.

A misery index score as high as in 2008 should be damning for the nation’s top central banker. But Governor Glenn Stevens doesn’t seem to be copping much flak. Perhaps it’s his knack for explaining things:

‘I’d still maintain up to this point that we’re doing what can reasonably be done, but if there’s more that can be reasonably done at some point then obviously we’d do that. But I’m content right now.’

Err, righto.

Then there’s this illuminating phrase he also came up with: ‘Low interest rates are doing the sorts of things they normally do in most respects…’ Normal? Most respects?

We don’t know what Glenn is thinking, let alone saying. But one thing we do know is how dangerous it is to keep interest rates well below the rate of inflation. It lowers the bar for borrowing so much you have to dig it out. Here’s what we mean…

If you could access finance at the Reserve Bank of Australia’s cash rate and buy the basket of goods used to measure inflation, you’d be making half a percent profit. That doesn’t sound like much. But you’re not risking any of your own money. An infinite amount of leverage is the key to theoretically infinite profits. It’s just a matter of how much you can borrow. Borrow a billion from the RBA and you’re making a tidy five million dollar profit. Without having to invest a cent of your own money, that means a return of an infinite percent.

Of course, that’s only theoretical. Only the banks get access to the RBA’s cash rate. And only as a minor funding source. But the same point is still true to some extent. Australians can borrow at surprisingly low rates, given the rate of inflation. Many goods and services are rising faster than the CPI. The point being there is an enormous incentive to binge on debt.

If interest rates are low enough, borrowing can smell like the very win-win scenario that brought sub-prime borrowers through mortgage brokers’ doors. Whether that statement applies to the US in 2006 or Australia today is up to you.

By the way, one of Australia’s biggest property developers is forecasting residential property price growth at 1%. Stockland’s CEO Mark Steinert said the country needs more affordable housing. Even the United Nations has caught on. In its latest report on our economic region, it warned about an Aussie property bubble. But 1% isn’t so bad, is it? Well, where would 1% price growth leave all those negative gearers? On realestate.com.au is our guess. If you’re losing money on your property and the capital gains aren’t compensating you for it, why hold on?

But if Australia’s property market had to make sense it would’ve crashed long ago.

What about the stock market? Earnings season is in full swing. And it’s a mixed bag so far. Accounting is the practice of obfuscating corporate results. Fellow editor Greg Canavan is the expert at unravelling that web, so we’ll leave it to him.

But what’s noticeable is that Australia’s key big industries are having a rough time off the books in particular.

BHP and QBE are both looking to divest themselves of divisions of their businesses. BHP hasn’t finalised what’s in and what’s out of the new business. But the market delivered its verdict anyway, with shares plunging more than 4% in UK trading.

QBE will be looking to list its Lenders Mortgage Insurance (LMI) business. That’s interesting news. We covered competitor Genworth’s listing a few months ago in The Money for Life Letter. As far as we’re concerned, touching any LMI businesses with a barge pole is quite dangerous. The business model is to insure mortgages against default. If Australia is in a housing bubble with an impressively high misery index featuring as well, it’s asking for trouble to insure mortgages.

QBE has been treading a finer line when it comes to the $250 billion in higher risk mortgages it insures. Analysts have been warning about the very low levels of capital at the insurer.

Then there’s the loan application form (LAF) manipulation scandal we’ve been covering. It’s also become the thesis of our postgraduate studies. We hope permission to begin interviewing mortgage brokers will come through from our university’s ethics committee today.

If we’re right and a very large proportion of Aussie mortgages feature LAF manipulation, mortgage insurers haven’t got a clue what sort of mortgages they’re insuring. In such instances, they think they’re insuring well off solicitors and stock brokers earning $150,000 a year. In reality, the mortgage brokers just made some amendments to the loan application form in order to obtain approval. In cases I’ve seen they crossed out ‘pensioner’, added in ‘solicitor’, and put a ‘1’ in front of the $50,000 income the pensioners actually do have.

As soon as house prices fall and people can’t just sell their home to repay their mortgage, the size of the LAF manipulation scandal will be exposed. And the mortgage insurers will be on the hook if they don’t take some sort of legal action for the LAF scandal or rely on fraud related exclusions — in which case, the banks and credit providers will be the ones on the hook.

The banks are in a muddle off the books too. Their reporting season may be throwing off ever impressive numbers. Profits and bonuses are up. But some are under fire for providing dodgy financial advice while paying their financial advisors big bonuses. Ben Butler and Adele Ferguson explained the matter in The Age:

‘[Executives] Grahame Petersen and Annabel Spring received million-dollar pay rises and big cash bonuses despite a Senate inquiry that called for a royal commission after allegations of fraud, forgery and a management cover-up in the unit.’

No bad deed goes unrewarded if you’re a banker. Maybe their conscience demanded compensation.

The story is similar over at Macquarie Bank. Put together, CBA and Macquarie have to contact about 560,000 clients they may have provided poor advice to. And both banks’ compensation schemes are widely criticised. Even by the regulator ASIC, whose oversight of the whole affair has also been questioned.

Just how much their poor financial advice will cost the banks in compensation in the end is a wild card. But it will probably show up as a blip on financial statements.

If only that were true for their victims.


Nick Hubble
For Markets and Money


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Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like.

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