A year ago the thought of a second coming of the Great Financial Crisis of 2008 existed only in the minds of the most bearish of doomsday financial prophets. Today you find an increasing number of opinions all over the Internet about the possibility of a GFC2.
If you know the history of the first crisis, you know it began in the United States housing market and quickly spread into the financial sector, infecting their banking system and threatening the stability of the entire global economy. Banks throughout the world ended up needing government assistance.
Could it happen again? Australia emerged from the first GFC relatively unscathed and today we hear from some reliable sources we can do so again in the event GFC2 does happen.
The IMF recently pronounced Australia’s banking system up to the challenge and the president of the World Bank, Robert Zoellick, reaffirmed the conclusions reached by the IMF.
However, anyone who was following events in early 2007 knows there were multiple experts at that time who told us repeatedly everything was going to be okay. Of course, it wasn’t okay.
Some investors emerged from that time with an added dose of skepticism. That skepticism appears justified in today’s climate where for every opinion that the Australian banks are healthy, or that commodity prices will not fall, you can easily find a contrary opinion.
Ultimately we all need to judge for ourselves but there is one helpful quote we would like to share for anyone trying to sort through the maze of conflicting views:
• There are no such things as facts; only interpretations of events.
The original quote from philosopher Friedrich Nietzsche ended with “interpretations”; the source of the addition of the word “events” is unknown. The power in this quote comes from the realisation we all have “filters” through which we view facts and interpret them. In investing language, a bull and a bear will view the same “facts” and interpret them in contradictory ways.
Skeptics do not stop with the conclusions; they also consider the filter used by the source. With that in mind, trying to make sense of what is going on around us comes down to critical thinking and applying your own interpretations, recognizing your own filters. If you tend to be bullish, be wary of agreeing with everything you read that supports your own filter.
In GFC1 the world began to unravel when the banking sector was affected. It only stands to reason to consider the possibility of GFC2 in light of the banks.
In March, rating agencies downgraded Australia’s big banks, citing overreliance on foreign borrowing to fund domestic loans. How are our banks doing now? Here are seven “events”, in no particular order, which could stress our banking system:
1. The 2 Speed Economy
2. Banking Exposure to Retail
3. Business Insolvencies
4. Housing Market
5. Foreign Borrowing
6. European and US Debt Concerns
7. Credit Availability
The 2 Speed Economy
While the mining sector continues to boom, the rest of the Australian economy is showing signs of weakness. The fact is the vast majority of Australians are only indirectly affected by the high speed growth in the mining sector. The percentage of people directly employed in mining is miniscule – less than 2% compared with 10% employed in retail – and even if you could factor in the people employed in related industries, you would still find the majority of Australians outside the soothing effects of the boom.
The rise in unemployment in July of 2011 could be a significant warning sign for Australia’s big banks.
Banking Exposure to Retail
If the Australian consumer continues to be stressed, how seriously will the banks be affected? To interpret the unemployment event we went to the recently released financials for one of Australia’s strongest banks – the Commonwealth Bank of Australia (CBA.)
CBA reported a net profit after tax (cash basis) of 6,835 billion dollars. Of that amount, $2,845 billion came from retail banking with another $1,039 coming from business and private banking. Institutional banking and markets accounted for an additional $1,004 billion.
Retail banking services accounts for about 42% of CBA’s profit with home mortgage lending increasing 7% this year. Home loans, personal loans, and credit cards account for the lion’s share of income. While bank financial statements can be confusing to the layperson, the picture here can be interpreted as the bank being at risk to economic shocks to the retail sector.
Continued rise in unemployment could lead to increasing payments in arrears and foreclosures and bad debt write offs. The annual report includes the following statement about arrears payments:
• The retail portfolios arrears improved over the first half; however there were some increases in arrears over the second half of the year. Home loan arrears reduced over the first half of the year, but that trend reversed over the second half with 30+ day arrears increasing over the full year from 1.90% to 2.08% and 90+ day arrears increasing from 1.02% to 1.17%. The increase in arrears is due to loans originated in 2008 and early 2009, along with the impact from some home owners finding it difficult to service their higher monthly payments arising from increasing interest rates.
If you add the profit from business and private banking into CBA’s retail services profit, the combined total of business and retail represents about 55% of their profit. If unemployment is threatening the consumer, insolvencies are threatening businesses.
In 2009, the Australian Securities and Investment Commission reported a drop of 7.2% in business insolvencies, but by the end of May, 2011, there was an increase of 4.4%. The year over year total reported at the end of June showed a total increase in business insolvencies of 5.9%.
Whether or not Australia is in the middle of a housing bubble is one of those “events” subject to a variety of interpretations. However, the most recent events suggest the possibility of trouble.
Housing prices have been falling for six months, although a counter interpretation points out this varies in different parts of Australia. Some say we have a housing shortage, but more and more real estate sites are pointing to a slowdown in home sales and a rise in unsold properties.
In early August, ratings service Moody’s stepped into the picture and announced it would re-evaluate Australian housing and the RMBS (Residential Mortgage Backed Securities) markets.
It appears the big banks have reduced reliance on foreign borrowing, but how much and is it enough? Here is a quote from an Australian investment advisory firm about our banks foreign borrowing:
• Australian banks have managed to slightly reduce their reliance on foreign borrowing, but still have high levels of loans to their core deposit bases.
How does one interpret “slightly?”
European and US Debt Concerns
Of all the signs, this is the most problematic as how the US and Europe handle their debt concerns could lead to significantly slower growth. China exports most of its manufactured good to the US and Europe and a recession or worse could seriously impact China. If China’s demand for what we have slows, our two speed economy would be in for a downshift.
Credit Demand and Availability
Banks make money by lending money and as Australian households try to reduce their levels of household debt by saving more and borrowing less, and more and more businesses deleverage, credit demand is slowing. With a slowdown in home sales, banks are starting price wars to attract buyers. In short, one interpretation here is that the banks could be in big trouble in the event demand for credit from both businesses and consumers continue to fall.
Gauging the probability of GFC2 involves little more than a series of educated guesses about a potential perfect storm of events, but if you want to engage in tracking it, follow the banks. It’s always about the banks.
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