The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Thursday, July 22, 2010

So you're bearish on house prices and wanna short the Aussie banking system?

Well, the conservative local banking regulator, APRA, which is run by the very bright former central banker, John Laker, has done some of the hard analytical yards for you. As this recent speech explains, APRA undertook a comprehensive three-year stress-test of the Australian banking system during the GFC, which contains only one shortcoming I can identify. The key assumptions in APRA's simulation were:

1) A sharp 3 per cent contraction in real GDP in the first year followed by a V-shaped recovery;
2) A rise in the unemployment rate to 11 per cent;
3) A peak-to-trough fall in housing prices of 25 per cent; and
4) And a peak-to-trough fall in commercial property prices of 45 per cent.

Now, if you reckon this was a marketing exercise for the banking system, think again. In October 2003, APRA undertook a similar stress-test of all deposit-taking institutions based on a 30 per cent fall in real house prices over a 12 month period, which is on par with what we saw in the US. A second series of tests were conducted again in September 2005, as outlined in this comprehensive working paper. All of this was, of course, excellent preparation for the GFC.

The findings from APRA’s macroeconomic stress-tests during the credit crisis were as follows:

1) None of the banks would have failed;
2) None of the banks would have breached the 4 per cent minimum Tier 1 capital threshold of the Basel II Framework; and
3) The weighted-average reduction in gross Tier 1 capital ratios from the beginning to the end of the three-year stress period was 3.1 percentage points (‘gross’ in the sense that this test did not account for issuances of new capital, reductions in dividends, repricing of risk, etc).

In reflecting on these results, John Laker commented:

“To put APRA’s stress-test into perspective, the reduction in Tier 1 capital ratios are at the higher end of the range of macroeconomic stress-test results in other jurisdictions with which we are familiar.”

What is missing from all of the above is ‘liquidity’—that is, access to funding. This analysis does not account for bank runs (ie, depositors withdrawing money), or denying banks access to wholesale funding. APRA tells us that it has carried out separate liquidity tests of the banks, but did not (for obvious reasons) disclose their results other than to say that, “where weaknesses were identified, APRA addressed these with the ADIs concerned.”

When all is said and done, liquidity is not really a risk for Australian banks since we know that the Commonwealth will backstop them with its pristine AAA-rating when push comes to shove. With the explicit backing of the Commonwealth, one is left with the impression that the Australian banking system is able to withstand pretty much any storm. Of course, the real question is what would be the cost to taxpayers.

As a final thought, let me address Jeremy Grantham’s spurious claims on the housing market, which have, I suspect, contributed to the hedge fund interest in shorting our banks. First, I cannot locate any GMO research on the Australian housing market. The single statistic Grantham quotes is that Australian house prices are 7.5 times family incomes. This is categorically false, as we and the RBA have demonstrated with independent analysis. The best current estimate is that Australian dwelling values are 4.6 times disposable household incomes.

When I logged on to the GMO website, the only reference to Australian house prices I could find is in a Financial Times article by an employee who goes the name of Edward Chancellor. Mr Chancellor in turn attributes his views to this discredited Demographia work and Associate Professor Steve Keen. Yes, you see what I am saying. This is a classic game of intellectual pass-the-parcel. From Grantham to Chancellor to Steve Keen abetted by Demographia. Need I say more?