Australian banks at risk

Despite yesterday’s blowout $6 billion or so profit from ANZ, it turns out all is not entirely well in Australia’s financial services industry. For the last five years, the pattern in the markets has been the same. A crisis starts at the margin, with a peripheral player, and then moves its way up the food chain.

That’s what happened when non-bank US lenders got in trouble in 2006. Then it was the mortgage lenders in 2007. Then it was the highly-leveraged investment banks (all of them) in 2008. And then it was the big money-centre banks in 2009.

The same pattern held in Europe, with a few slight differences. The marginal players were marginal for different reasons. Iceland, Ireland, and Spain had bubbles in the property market. But in Greece, the low interest rates created a bubble in government debt. In all cases, the debt crisis struck first at the ragged edge and then moved inwards, like a financial tapeworm.

Australia avoided this fate, or has seemed to, but at a cost. The marginal players and non-bank lenders either disappeared or were swallowed by the Big Four banks. The mortgage market, and lending risk, has concentrated in a few big players. NAB, Commonwealth Bank, ANZ, and Westpac have a combined $1.4 trillion in gross loans and advances, according to August data from APRA.

That’s 78% of the entire market. You have less competition and arguably a lot more systemic risk in the home loan market than you did at the beginning of the financial crisis. From a risk perspective, things have actually gotten worse, not better.

This is all part of Australia having an over-sized banking industry relative the country’s economy. But there is a more immediate worry for 3,000 people in Victoria. About $660 million in savings is in limbo after non-bank lender Banskia Securities Limited called in receivers yesterday. The company operates in regional Victoria and lends mostly for property purchases, according to the Australian.

Australian big 4 banks

There is always risk in high-yield, unsecured investments. But Australia is one of the only places left in the world where people fear missing property gains more than losing money. The psychological attitude toward the market is as bullish and irrational as ever. But even the Reserve Bank is preparing for the worm to turn.

Earlier this week the RBA published new rules regarding its Committed Liquidity Facility (CLF). The CLS is set to launch in 2015. It’s an emergency loan program which allows Australian banks to trade in Residential Mortgage Backed Securities (RMBS) to the RBA for short-term loans in the event of…you know…a crisis.

The RBA is going through the rigmarole of what look like tough standards. It doesn’t want to create the impression that if a financial crisis ever hits the Aussie banking sector, the RBA would become a giant cesspool of mortgage debt/risk. But that’s exactly what would happen.

Under the Basel III banking rules, banks are required to hold a higher percentage of high-quality assets on their balance sheet. Government debt is usually considered a high-quality asset (when it is AAA rated). This sounds ludicrous, of course, given the fiscal positions of so many Western governments. But Australia’s government debt market, though growing, is not big enough to provide Aussie banks with assets they can hold on the balance sheet to meet the Basel III requirements.

Enter the CLF, which at least from a distance resembles a money-laundering operation. The Aussie banks trade in AAA-rated mortgage-backed debt for RBA cash. One balance sheet asset is exchanged for another, allowing banks to transfer mortgage risk (temporarily, of course) to the RBA in exchange for your cold, hard, tax-payer cash. In case of window, break glass.

The new rules published by the RBA earlier this week are designed to reassure the public that the bank will not be taking on undue risk through the CLF. It will force banks to disclose what’s in the RMBS. You will know how many of the loans are low-doc and how many are full-doc. And you certainly won’t get the toxic layer cake loan packages that populated the Collateralised Debt Obligation (CDO) market.

But as a thought experiment, ask yourself where the risk of a housing crash resides in Australia? Is it with Australian banks? Well, in theory yes! But because they’re an even bigger part of the mortgage market than they were four years ago, the Aussie banks are even more ‘too big to fail’ than ever!

The RBA can’t let that happen. In a genuine funding crisis, where international lenders can’t or won’t loan to Aussie banks, that leaves the RBA on the hook. Can you just feel the squirming begin?

Of course, none of this will ever be a problem if house prices never fall and home loans are good investments. And there would have to be a funding crisis in the banks for the RBA to be put in the line of fire. Australia is not Greece, is it? Would foreign lenders ever turn their back on the Lucky Country and cut off the supply of credit to a country with a household-debt-to-GDP ratio of 150%?

Hmm. Questions to think about over the weekend. In the meantime, it is not all bad news for the financial services industry. AMP reported $605 million in cash flow for the third quarter ended in September. The big driver was 422% increase in cash from the self-managed super business, up from $40 million last year to $209 million this year.

Nobody needs to pay an adviser to get clobbered by the market, do they?

But here is the problem: if the mining sector is getting clobbered on lower profits, and if the financial services sector is more systemically vulnerable than ever, what should you do with your money? The market is storming along. Should you be long or short?

We put the question to our embattled trader Murray Dawes. He’s currently short five stocks, including three financial service firms and two miners. You’d probably recognise all the names. Murray reckons the false break is in and the market is headed lower. Stay tuned for an update on Monday.