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."

Saturday, October 2, 2010

Some of the best RBA analysis going around: system stability

Twice a year the RBA produces the Financial Stability Review (FSR), which is basically a health-test for Australia's financial system. To my eyes, it is probably a more difficult document to deliver--in certain respects--than the Statement on Monetary Policy since it is constantly trying to break new ground with the data and analysis it presents (and I am guessing that the team that works on it is smaller).

The FSR is overseen by Dr Luci Ellis, who is an impressive lady and will, I hope, soon be the central bank's first-ever female Assistant Governor. While I would never advocate pushing a candidate based on their identity, it is disappointing that the RBA has never had a female in this top job.

Another outstanding candidate for an Assistant Governor’s role has to be Dr Anthony Richards, who has pioneered a lot of critical analysis of Australia's housing market. Dr Richards is currently head of the RBA’s economic analysis group, and is analogous to its chief economist under Assistant Governor Lowe. Dr Richards has, I believe, also been one of the key advocates--alongside Stevens, Lowe and Kent--for a more activist role for monetary policy vis-à-vis financial stability risks. I covered this in great detail last week, and after considerable reflection have become more sympathetic to the Bank’s way of thinking, as Nicholas (brother of David) Gruen has noted with some disappointment.

Turning back to the FSR, it really is an amazing feat. I have excerpted below some of the more interest charts, but it is worthwhile reviewing the whole thing. Before discussing them, I would recommend you keep an eye out for Luci Ellis's speech next week. On this note, I hope she pushes the envelope and takes a leaf out of the book of the Bank of England's outstanding Andy Haldane. RBA speeches tend to be interesting, but rarely engaging or exciting. That is, they are unnecessarily dry. If nothing else, it is just good public relations maintaining a stimulating dialogue with the community (as opposed to a dialogue that turns folks away).

Off the top of my head, some of the more important subjects Dr Ellis could address include:

(a) what the heck do we mean by "financial stability" (ie, define it);

(b) reference Rismark's work on the secular confusion between the riskiness of a diversified portfolio of housing as proxied by a broad-based house price index, and the economic risks borne by Australia's individual home owners, which, as we have demonstrated, are around 5-6x more volatile than the 3-4% pa risk associated with our national hedonic index; and

(c) let's not dip back into self-aggrandizing policymaker speak about all the different initiatives they undertook to save the nation’s bacon. Let's be a bit more brave and emphasise the role of providence in Australia's recent success and the need, therefore, to be constantly vigilant about protecting our vulnerabilities.

Now quickly to some of the charts I found interesting. The first simply shows that Australia's banks have outperformed. The second illustrates a point I made in this paper on the US banking system's inherent problems: the US deposit-taking system has been historically very decentralised (until the late 1980s and 1990s), which is part cultural and part a function of the establishment of Fannie and Freddie, and has exhibited a peerless propensity for institutional failure.

The third chart shows the updated mortgage default stats I and others have presented many times before--Australia's arrears rates are a fraction of most of our peers notwithstanding much higher rates.

The fourth depicts the boom and bust in global commercial property markets, which, as I have discussed here before, the RBA thinks are in many ways more risky than global housing markets in the context of system stability.

The next three charts are interesting: they tell us that (a) bank profits are expected to be at record levels next year; (b) bank net interest margins are currently higher than they were several years before the GFC emerged; and most remarkably, (c) bank RoEs hardly fell at all during the GFC.

Graphs 29 and 31 are important. Graph 29 demonstrates that while over 3.5% of all Australian bank business loans are currently "impaired" only around 0.7% of home loans fall into this category. Graph 31 illustrates something even more important: whereas just under $2 billion worth of bank home loans are impaired, more than 10x that amount--specifically, nearly $25 billion--worth of business loans are presently impaired. This is precisely why all those arguing that banks should be doing less housing lending and more business lending--normally on the utterly false pretext that business lending is "more productive" than housing lending (refer to my analysis of productivity and housing, which every credible economist I know agrees with)--are actually arguing for Australia's banks to take on far riskier assets. It is also why business lending gets a much higher risk-weighting than residential lending, and why business, and not residential, lending has historically been the main driver of institutional failure (the recent episode in the US aside).

Graph 65 is interesting and not something I have seen before. It tells us that about 83% of all borrowers are paying away less than 40% of their disposable incomes to meet their mortgage repayments. The penultimate chart shows that repossessions have recently risen most rapidly in WA, which is a little curious, and QLD, which collectively helps explain the weaknesses in house prices in those states.

The final chart informs us that about 32% of all residential borrowers start out with LVRs greater than 80%, which is consistent with Rismark's analysis during the GFC when we were concerned about the risks posed by a unilateral reduction in maximum LVRs to just 80% as occurred in NZ. So while Australians do have high starting LVRs, they tend to reliably pay down these loans ahead of time due to the non-deductibility of owner-occupied mortgage debt.