Some guy recently asked me how closely the government’s efforts to support the securitisation matched Joshua Gans and my original prescriptions. To date, they have invested $16 billion into the program.
The short answer is that the policy has almost exactly reflected our advice. (I have been critical of the government for not introducing new regulation of securitisers in return for the support, but then we did not advise them to do this at the time.)
In shedding more light on this subject I am also happy to publish for the first time some of the advice that we delivered to government (upon their request) in July 2008 several months prior to them announcing the policy measure.
We started thinking about this idea in around January 2008, and Joshua and I published our first paper to articulate the policy in March 2008. Prior to releasing this study, we had already started canvassing the idea directly with the Prime Minister’s office and other parliamentarians. We remained in close contact with the PMO, Opposition and Treasury in the months that followed through to the formal announcement of the policy by Wayne Swan at the end of September 2008. While I have written about this many times before, a brief summary of our thinking was this:
1) Liquidity in a key economic market—the market for residential mortgage-backed securities (or RMBS)—had collapsed due to an external or ‘exogenous’ shock that actually had nothing to do with Australian home loans (ie, the US sub-prime crisis);
2) We argued that during times of crisis government had an obligation to provide what we called the ‘public good of liquidity’ to support funding and price discovery in this market (as they automatically did in the alternative ‘deposit-taking’ sector), which many smaller banks, building societies and non-banks had come to rely heavily on;
3) We further argued that there was a fundamental flaw in Australia’s regulatory architecture whereby banks received enormous support from the government (think the deposit and wholesale debt guarantees) and the RBA (via various ‘liquidity facilities’) in exchange for being regulated by APRA, but this new industry, known as the securitisation market, was completely unregulated and thus had (not unreasonably) zero public support;
4) We argued that the regulatory architecture had not evolved sufficiently quickly to recognise these new funding sources. Over time, we also noted that securitisation is actually a much safer ‘matched’ form of funding (notwithstanding the stigma associated with it in the US) than the funding that banks ordinarily rely on—ie, short-term deposits and wholesale debt. And so the argument made by many folks, including some government officials, that securitisers had flawed business models was itself specious: in a world with no regulatory support, the securitiser’s business model is inherently much safer than a bank’s structure, which relies on an extreme ‘asset-liability mismatch’ (they borrow short from depositors etc and lend long via 25 year home loans). As I have noted many times before, this is, in fact, why we have central banks: to provide liquidity to the intrinsically fragile banking system that takes out short-term savings and translates these into long-term credit (known euphemistically as ‘maturity transformation’);
5) Anyways, we argued that a permanent, government-owned entity, which we deliberately left undefined, should be established to issue government-guaranteed debt and then use these funds to buy AAA-rated mortgage backed securities (thus there would be no increase in ‘net debt’) to support the liquidity of Australia’s RMBS market during times of crisis;
6) We were very careful to say that this new government institution should only really act in the event of extreme illiquidity, much like the RBA does when it lends to banks when their funding sources collapse (such as during the GFC);
7) In June 2008, we stated in a report that if there was a pressing need to implement our ideas, they “could be operationalised in the interim through the Treasury’s Australian Office of Financial Management (AOFM), which is purpose-built for this type of activity…The Australian Office of Financial Management (AOFM) manages Australian Government debt and associated financial assets…”;
8) The obvious point here was that since the AOFM is responsible for issuing government debt, it could do so for the purposes of raising funds to invest directly into the RMBS market, as we had proposed our alternative government entity do;
9) In July 2008, very senior government officials reached out to us to ask whether we could help formulate an exact plan as to how our ideas could be put into practice. After some discussions, we crafted the following formal advice, which was sent to government in mid July (nb: this is an excerpt only):
“The goal is to get the non-deposit taking institutions back into the home lending market. Currently, the RBA is helping really only the deposit taking institutions but as you know that is not going to help competition.
The solution is as follows:
(1) Formally give the Treasury's AOFM the mandate to buy AAA-rated mortgage-backed securities (using the AOFM means no setup costs, no new organization);
(2) Limit the liquidity budget to, say, $5 billion - $10 billion initially (this is only 20% of typical total annual securitization issuance), which would be funded by issuing $10 billion worth of government debt and would yield significant profits to the Commonwealth given the 'spreads' (also supports govt bond market);
(3) Require that anyone selling the securities retains a minimum capital margin of, say, 5% (should not be much more than this) in order to qualify for the program--this is sensible risk management and means only the stronger--but still small--lenders will be able to use it;
(4) Price the liquidity such that it is still expensive for the bigger banks relative to using deposits, but provides an "economic" return for smaller lenders (ie, smaller lenders have a higher propensity to use it). The AOFM would be able to do this…
What this will do:
(1) The very fact that the Commonwealth will be buying these securities will get the other investors back into the market who are currently picking those securities up for a song. This will immediately reduce spreads.
(2) This is explicitly not a Fannie or Freddie move but a move to sustain home lending competition and enhance short- and long-term housing affordability.
(3) The main criticism you will get is that you are not including the major banks. So be it. When it comes down to it, they will benefit indirectly if investors get back into the market quickly and they will lose out because they will have to keep interest rates down.
(4) The unions, non-ADIs, mortgage customers, etc., will all love this.
(5) Not only will this not cost any money, it will make money as there is a clear gap in the market that private players are not covering.”
10) What Wayne Swan eventually announced reflected this advice with the key exception that the initial tranche of funding was $4 billion, not the $5-10 billion that we had advocated. Of course, with the passage of time Swannie lifted the commitment to $8 billion and then $16 billion;
How has the policy worked? As I noted here, many smaller banks, building societies and non-bank lenders are quite upfront in acknowledging that without this program that would not have been able to continue lending during the GFC. Indeed, some of them would have gone out of business altogether.
But the policy itself has much more far-reaching ramifications than a short-term fix to a liquidity crisis. It represents the first time the Commonwealth has formally recognised the importance of the securitisation system, which is a key complement to the deposit-taking industry. In the medium term, I believe that the primary providers of funding to the securitisation market will be super funds. If these funds lift their allocations to fixed income, as I have repeatedly suggested they should consider doing, they can, in effect, become alternatives to the major banks by taking in workers' savings and redistributing that money as credit to both businesses and households via the corporate debt and mortgage-backed securities markets. Crucially, they would also be lending (pun intended) a great deal of support to smaller banks, building societies, and non-banks by doing so, since these institutions are most dependent on securitisation to underwrite their activities. In this way, super funds have a key role to play in remedying the current competition concerns that exist in the banking and finance sectors.
An extremely intelligent and successful fund manager cum public company director (who has incidentally been a major bank apologist for as long as I have known him) presciently remarked to me the other night that when the CEO of a bank comes out and says they will have to lift fees due to rising funding costs, you know that you have big competition problems.
His point was the fact that one of these oligarchs can simply announce that they are effectively a price-setter, and will unilaterally set price according to their own requirements, is very different to the old world we used to live in whereby competitive pressures would have prevented a bank CEO from making such statements. I thought that this was a pretty interesting observation. His underlying message was that it was an insanely stupid admission to make, and will only provide further ammunition for the bank bashers.
