The familiar path to financial crisis

Critics have been vocal about the efforts by government to pump up the property bubble – including the doubling of the First Home Owner Grant, negative gearing and the halving of capital gains tax.

However, there's another measure that seems to have been overlooked.

In a statement on Friday, Treasurer Wayne Swan said:

"Today I announce that I have directed the Australian Office of Financial Management (AOFM) to invest a further $4 billion in high-quality, AAA-rated Australian residential mortgage-backed securities (RMBS) to help smaller lenders continue to offer competitive loans to families and small businesses."
Source: www.news.com.au

Sounds innocent enough. No one would criticise the government for helping families and small businesses, would they? This blogger would!

The government’s meddling in the property market is going to end in tears. And it will be tears of those families and small businesses (or at least their owners) that the government is supposedly trying to help.

Let me explain:

Banks are in the business of giving loans and collecting interest. Without going into the details of fractional-reserve banking, in order to make a loan, banks need to find money to loan out. Ideally, this would come from other people depositing their savings. But because saving is out of fashion, banks need to find the money from elsewhere. They could borrow it from another bank, but this is expensive because then the other bank can’t make as many loans of their own.

So this creates somewhat of a natural limit which prevents debt from growing too quickly. If people are not saving, lending is automatically constrained.

American banks weren’t happy when they came up against this restriction in the first half of the last decade. So they invented a product called collateralised debt obligations (CDOs). This complicated derivative involved bundling up existing home loans and on-selling them to institutional investors. The banks got cash up front. And the investors got the promise of on-going mortgage repayments from American home owners.

Because it was believed that house prices could never go down, and that Americans loved their homes so much that they would do whatever it took to continue paying off their mortgage, the rating agencies gave these bundles of goodness the highest possible credit rating, AAA.

The banks used the extra income from selling CDOs to make more loans, which they on-sold for more cash, and so on. Finally, they had found a way to make an almost endless number of loans.

More importantly, they were able to do so without risk – because this was transferred to the investors (who weren’t too worried because the CDOs were rated AAA because house prices can never fall and Americans love their homes). The result of this transfer of risk was that home loans were given to families that could never afford them.

Of course, house prices in America did eventually fall, home owners defaulted on their loans, the AAA-rated CDOs become worthless and the institutions that bought them filed for bankruptcy. Banks could no longer transfer the risk and so stopped lending to families, to small businesses and to each other. Credit ground to halt. The punch bowl had been taken away from the debt party that had been keeping the American economy going and the resulting hangover is what we call the GFC.

Fast forward to the present day and Aussie banks are now falling over themselves (and even breaking up with each other) to give out home loans. And, as happened in America, they can’t find enough money from depositors.

So they too have bundled existing mortgages in the hope of on-selling them. In Australia, these bundles are called residential mortgage-backed securities (RMBS) and are also rated AAA (because house prices cannot fall and Aussies also love their homes). Even so, Australian investors are not keen to buy them.

This is the market’s cue that we’ve reached out natural debt limit; that we in fact need to reduce debt in order to get the economy on a more stable footing. Or going back to the party analogy, it’s time to go home and sleep it off.

Enter the government who doesn't want the party to end on their watch. So they’re buying another $4 billion dollars’ worth of punch – or so-called high-quality, AAA-rated residential mortgage-backed securities … with tax-payers’ money.

The result:

1. Banks are able to continue lending without risk;
2. More first-home owners are encouraged to buy into one of the most inflated property markets in the world – with virtually no deposit – to keep the property Ponzi scheme going a little longer;
3. Over-indebted households and taxpayers are left to suffer the consequences when the bubble inevitably bursts.

We’re repeating the mistakes of America. The only difference is that in America, the taxpayer bailed out the banks after the crash, while in Australia, it’s happening in a futile attempt to prevent it.

Comments welcome.

Cheers,
Andy.

Click here to vote for the GetUp campaign to stop tax-payer funding of the housing bubble.