–There’s nothing in the stock market text book that says stocks can’t continue to rally after going up 55.27% in the last two years. In fact, in the stock market text book, there would be one condition under which stocks would be sure to rally after two good years. You’d call it a bull market.
–But if Aussie stocks are climbing a wall of worry, they are an even better climber than that French Spiderman guy who’s making a nuisance of himself in Dubai. Market’s had to deal with another ambiguous announcement out of Japan that the situation at Fukushima remains “unpredictable”.
–There’s also Libya’s civil war. And the Greater Arab Revolt. There’s poor old Europe with its big old debt and large protests. And there’s bankrupt America giving itself up to manipulation of its financial markets by a clueless central banker.
–But no worries! The ASX/200 is up over 55% since the lows in the first week of March 2009. Not that that has anything to do with Quantitative Easing (rounds one and two). Incidentally, you can see from the chart below just how good QEI and QEII have been to the S&P 500. It’s up nearly 90% since the March 2009 low. Ben Bernanke’s S&P airlift is the greatest airlift since the Berlin airlift that began in 1948.
Helicopter Ben Rescues the S&P 500…and the All Ords
–Because of the rampaging Aussie dollar, you wouldn’t have done as well in the U.S. market as a U.S.-based investor. But it has worked out well for Aussie investors in another way. Bernanke’s systematic trashing of U.S. purchasing power has driven global speculators into the high-yielding arms of the Australian dollar and dollar-denominated, commodity-linked assets.
–Remember what we learned in 2008 though. Hot money is easy come, easy go. It keeps on coming at the moment. But what would make it decide to get going?
–One thing that would get money out of the lucky country as sure as water’s wet is the popping of China’s own enormous credit bubble. China is nearly alone in the world in having so far avoided the fallout of the GFC. Bad loans haven’t been recognised, much less written off. And the whole export-driven economy continues to suck up mass quantities of Aussie iron ore, coal, zircon, titanium dioxide, rutile, copper and more.
–Did you know that the world’s largest bank (by market capitalisation) lent nearly $100 billion to local governments in China after the credit bubble burst worldwide? Today’s Financial Times reports that the Industrial and Commercial Bank of China (ICBC) has 10% of its loan book tied up in loans to local governments made after the GFC hit in 2008.
–Risky? The bank’s Chairman, Jiang Jianqing says, “I don’t believe this problem poses a systemic risk to the Chinese banking system.” He says the default rates on loans made to local governments for infrastructure and building projects are low.
–Local governments spent to avoid recession in China. Huge fixed-asset investment is what has driven the increase in iron ore and coal prices, firing Australia’s terms of trade to record highs and generating huge export earnings.
–But we know that in a credit bubble, capital is always misallocated to unproductive investments—like unoccupied cities and vacant shopping malls. What we’re waiting to find out is how much of Chinese lending went to finance uneconomic projects…when the bust will come…what it will do to Chinese banks…and what will happen to China’s demand for iron ore and coal (which has been indestructible so far).
–Speaking of banking, a quick return yesterday to the subject of covered bonds. Do they present a “systemic risk” to the Aussie banking system? Or are they just a clever way for bankers to lower the price they pay for money and transfer risk to the government and ultimately to you as the tax payer?
–Let us turn to the Reserve Bank of Australia for the answer. In its latest Financial Stability Review (always a must read) published last Thursday, the RBA went into an extended discussion on covered bonds. It turns out that covered bonds may not provide the stability the banks are after, at least in terms of lower funding costs.
–According to the RBA appendix, covered bonds spreads in Europe widened during the GFC and liquidity evaporated. Instead of being a reliable, alternative source of funding, the European Central Bank had to step in and buy €60 billion worth of bonds to keep the market operating normally. In the end, the government had to buy bank debt.
–The RBA also pointed out that until recently, it was mostly non-deposit-taking institutions that used covered bonds as a funding source. A non-deposit-taking institution, naturally, does not put depositors second in line behind creditors in the event of a bank failure or liquidation. The Aussie banks are, of course, deposit-taking institutions and depositors would be second in line behind creditors should it come to that.
–And by the way, even though both Canada and the U.S. allow covered bonds, both established a much lower ceiling for the percentage allowed. In Canada, it’s four percent of bank assets. It the U.S., it’s four percent of bank liabilities. Wayne Swan’s proposal is to allow Aussie banks to issue covered bonds up to 8% of the banking system’s assets.
–That higher percentage allows Aussie banks to cover the funding cost of new loans and loans that must be refinanced in the next twelve months. In other words, the percentage allowed pretty much matches the financing needs of the banks—needs that might not be met (or met at a higher cost) without covered bonds.
–Well, the RBA makes some conclusions on whether covered bonds actually lower funding costs (the stated aim of the banks, so they can keep credit affordable to everyone else. The bank says (emphasis added is our own):
The net effect of increased covered bond issuance is uncertain. By committing banks assets to secure payments on covered bonds, unsecured senior bonds as well as more junior debt securities are effectively lowered in rank, so investors in them might demand higher returns to the extent that that the impact on credit quality of those securities is perceived as material. Total wholesale funding costs therefore might not fall.
–It turns out that it’s not just depositors who are subordinated by covered bonds. So is everyone else who has bought bank debt, secured or otherwise. But don’t worry! You will not be second best. The RBA says that, “Depositors are also subordinated, but are partly protected from this risk be deposit insurance schemes.”
–Keep in mind that what sunk the banking sector in Ireland and has led to systemic weakness in America is just this: the transfer of banking sector liabilities to the public sector. Yet this is exactly what the covered bonds scheme achieves here in Australia. Indeed, the whole Financial Claims Scheme squarely transfers the liability for catastrophic bank losses directly on to the Australian tax payer.
–Now, you might say that catastrophic losses for an Aussie bank are highly unlikely. Deposit insurance (via the Financial Claims Scheme) is there to inspire confidence in the security of your assets. It’s not, you know, there to actually be used.
–However, what we’ve learned from the last few years is that when banks can rely on government to cover loan losses, or when they can pass on credit risk to investors (via securitisation), then there’s no real bottom-line check on the kind of lending they engage in. As a result, they do everything they can to grow the balance sheet. Practically, that means going crazy with the loan book and giving anyone who wants one a mortgage, two credit cards, and a personal line of credit to boot.
–Of course that could never happen in Australia. Aussie banks would never sell covered bonds in order to finance new lending to homebuyers. And the government would never have to step in and buy those bonds if the market doesn’t, even though this is exactly what’s been going on in the residential mortgage-backed securities markets. It’s simply impossible that the whole covered bond scheme is a back-door attempt to keep housing prices rising and the real estate industry happy. Isn’t it?
–There’s no way the RBA and the government would do the bidding of the real estate industry and the banks, would they? Hmmm.
–Interestingly enough, the RBA seemed to warn the banks that happy days were not here again in a different section of the Financial Stability Review. In its introductory overview, the Bank wrote (emphasis added is again ours):
The very rapid growth in the financial system over the years that preceded the crisis seems unlikely to be repeated, since to a significant degree it represented a one-time adjustment to financial deregulation and the shift to low inflation. If that view is correct, then banks’ domestic growth opportunities will be more limited in the years ahead. There is no reason why the financial system cannot adapt smoothly to a slower rate of expansion, but if industry participants were to attempt to return to their earlier rates of growth, they could be induced to take risks that may subsequently be difficult to manage. Maintaining a more moderate pace of balance sheet expansion, particularly one that is more easily able to be funded by deposits, will also assist in further strengthening bank funding profiles.
–Hmm. In light of this comment, the whole covered bond affair seems like an end-around to the RBA’s relatively hawkish statement on bank balance sheet growth. Tomorrow, then, we’ll take up the issue of the RBA itself. Who runs it? Whose interests does it really serve? And how is it different or similar to the U.S. Federal Reserve?