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She’ll be right, mate.  The phrase embodies the ingrained response of Australians everywhere to things gone awry.

When the Great Financial Crisis (GFC) engulfed most of the western industrialised world, Aussies looked around and in unison uttered that phrase – She’ll be right, mate.”  And lo and behold, Australia survived the GFC better than any country in the world.

However, in recent months things have changed – the US was downgraded, Europe’s debt crisis seems to have spiralled out of control and there are warning signs that China is slowing. Maybe she won’t be right.  Consumer confidence and spending is down; and there is a glimmer of evidence our exploding home prices are, dare I say it, decreasing.

The latest RP Data home value index shows a 3.2% decrease in housing prices in the first eight months of 2011. Additionally listings are up and clearance rates are sinking. All ominous signs. “Despite the low rate of unemployment and the strength of the resources sector, it is clear that the average Australian is content to pay-down debt and wait for some economic certainty to return,” RP Data research director Tim Lawless said.

Now there are those going so far as to speculate we may be in the midst of a housing bubble similar in size and scope to the one that burst in the United States and precipitated the GFC.  It cannot happen here, others say, because the lending practices of our Australian banks are more responsible than the lending system in place in the United States prior to the crash.  So what kind of irresponsible lending was going on over there that started all this trouble?

About three decades ago, most of the mortgage loans in America came from Savings and Loan Associations.  These distinct financial entities originated the loans and then held them on their books until they were paid off or refinanced.  Inflation in the period started the trouble and the legislative response of lowering required lending standards eventually caused multiple S&Ls to fail.

The US government believed the core of the problem was the retention of the loans, which reduced the available capital of the lending institution.  The solution was the creation of residential mortgage backed securities.

The idea was simple in concept but highly complex in execution.  Mortgage loan originators sold the loans to intermediary financial institutions who then packaged the loans in investment products, backed by the mortgages.  This seemed like a “win-win” solution since a loan of $100,000 would not encumber the lender’s books, freeing up that capital to be used for additional loans.

When the housing boom in the United States shifted into high gear, the demand for these investment vehicles skyrocketed.  They became infinitely more complex, with titles ranging from Structured Investment Vehicles, to Collaterised Debt Obligations.  Few investors could understand what exactly they were buying, but everyone was making a lot of money, so who cared?

The investment banks and others peddling these products were desperate for more, so they turned to the loan originators who were more than happy to oblige.  The unintended consequence of the system was the loan originator had no motivation to restrict their loans to qualified buyers.  If the buyer defaulted on the mortgage, the lender’s risk was minimal.

In hindsight, what happened next is hard to believe.  Borrowers got loans without documentation of income.  These “no-doc” loans were made on the buyer’s stated income.  Why take the time to verify the income when there was money to be made?  Sub-prime loans, once rare, became the rule of the day.  Some borrowers got loans at 120% of the purchase price, with the extra 20% thrown in to make the first few mortgage payments.

In the meantime, the US Federal Reserve lowered interest rates, adding fuel to the roaring fire, and prompting a refinancing boom as more and more Americans wanted to cash in on the escalating prices of their homes.

Hardly anyone over there saw what was coming because as long as housing prices continued to climb, everything would be all right.  Considering the fact US housing prices had been in a continual upward trend since the end of the Second World War, why worry?  After all, everybody was making a “ton of money,” as the Americans love to say.

But then housing prices did begin to fall and the entire house of cards came tumbling down.  Thousands of Americans were using their homes as ATMs, refinancing every few years to draw out the increased equity.  Many used the equity to buy additional homes as investments and now found themselves with no reserves to draw on to meet the mortgage payments.

What many fail to realise is that the housing boom was only one card in the house, albeit the one that supported the structure.  In theory, the effects should have been limited to those who bought the mortgage-backed securities and those who could not afford to make their mortgage payments.

In practice, it was hard to find a financial organisation anywhere in that country that had not invested heavily in mortgage-backed securities.  Hedge funds, pension funds, investment banks, commercial banks, and private investors all had jumped into that exploding market with both feet.

The real blow to the system came not from the loss on the mortgage-backed securities, but from the tangled web they had unwittingly woven with another revolutionary financial product stgeloped by those Wizards of Wall Street – the credit default swap.

Credit default swaps are even more complicated than RMBSs, but a simple way to think of them is as an insurance policy against loss on an investment.  Financial institutions with millions invested in mortgage-backed securities bought these credit default swaps as protection.  Only much to their surprise, many of the firms offering these credit default swaps had sold more than they could every hope to pay in the event of a collapse.  They did not have the capital to cover the swaps since they did not dream they would ever need it, and besides, they were making way too much money to worry.  

When the US government realized the scope of the problem, they stepped in to bail everybody out, with the exception of many homeowners facing foreclosure.  But it was not enough.  Warren Buffett calls credit default swaps financial weapons of mass destruction.  They are private agreements between two parties and as such, no one knows for sure who owes how much to whom.  Faced with massive uncertainty, global credit markets froze, as no financial institution was willing to lend money without the ability to evaluate the risk of default on the part of the borrower.

So that is what happened over there.  Over here, many people remain unconcerned because the majority of Australian mortgages remain on the books of the originating lender.  Our mortgage-backed security market is relatively small.  If you spend some time searching the Internet you will find estimates of bank exposure to the mortgage market ranging from 65% to 75%.

However, that advantage could rear its ugly head and bite us all in the event of a shock to our economy, such as a decline in exports to China.  The fact is our banks are highly exposed to the mortgage market.  Australian housing prices have exploded, leading to larger and larger loans and increased risk should the borrowers become unable to service their debt.  

As is the case with most western industrialised societies, Australians do not save much any more, so without a substantial deposit base, where are our banks getting the capital to make these huge loans?

We found out on 18 May 2011 when Moody’s downgraded the credit rating of Australia’s four largest banks.  Here is some more information about the downgrade:

•    Global rating agency Moody’s Investors Service downgraded the long-term debt ratings of Australia’s big four banks due to their sensitivity to volatile wholesale funding markets.

•    The global ratings agency said a 150 per cent surge in property prices in the decade to 2008 had helped push Australia’s household debt to disposable income ratio to 159 per cent in mid-2010.

•    This is a higher level than the US, UK and Spain at the peak of their housing cycles.

•    “The downgrade reflects our view of the Australian banking system’s structural sensitivity to conditions in wholesale funding markets”, Moody’s Senior Vice President Patrick Winsbury said in a statement.

•    “Australia’s major banks have relatively high levels of wholesale funding – at about 40 percent of liabilities on average – and the global financial crisis has underlined the speed with which shifts in investor confidence can impact bank funding,” Winsbury said.

•    “While the major banks have reduced their sensitivity to disruptions in the wholesale funding markets, the Australian financial sector’s long-term, underlying reliance on offshore debt remains in place.”

•    The country’s four biggest banks, led by Commonwealth Bank of Australia and Westpac Banking Corp., need to sell as much as A$150 billion of long-term bonds annually to fund their lending businesses, according to Moody’s Investors Service.

So there you have it.  Household and mortgage debt is at 159%; we have arguably the highest priced real estate in the world, and our banks are borrowing the money from foreign investors to raise the capital they need to make those mortgage loans.  If another credit freeze materialises, as some predict sovereign debt defaults in Europe might cause, where will our banks go to borrow the money?

But she’ll be right, mate. Why worry? We have China. Don’t we?

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