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, November 18, 2010

Professor Ian Harper backs RMBS guarantee in AFR today

Professor Ian Harper, who was one of the key authors of the 1997 Wallis Inquiry report, has published a solid op-ed in the AFR today calling for a government guarantee of residential mortgage-backed securities to level the competitive playing field vis-a-vis the larger institutions:

"The major banks have benefited from government support in ways that smaller banks and non-banks have not. The majors now fund themselves more cheaply than their rivals because they are perceived as being “too big to fail”...One solution would be to introduce an appropriately priced government guarantee of selected securities, whether held as assets of securitisation vehicles or on the balance sheets of banks. Such an explicitly priced government guarantee would support capital markets as well as banks and serve to even the playing field. It would not do so completely because the too-big-to-fail guarantee is implicit but it would at least counter the impression that the major banks are the only safe haven...The government would offer to guarantee the AAA-rated tranche of securitised issues for a fee, in similar fashion to current practice with most RMBS issues. The presence of a government guarantee would also expand the potential investor base for Australian RMBS."

This was actually something that I proposed way back in April 2009 ( (see here and here). To quote from my first article:

"One simple, low-cost and tactically efficient solution would be for the government to extend the guarantees from the institutions to the assets they lend (and thus also include the non-banks). This would directly vouchsafe liquidity rather than relying on bank CEOs bending to the policymakers’ will. By applying the guarantees to AAA-rated home loans...the government could help reopen the securitisation markets, which have been further decimated by the bank’s funding guarantees. This could create a level playing field amongst all lenders irrespective of size, who would pay the same low fee (0.3 per cent based on recent AAA-rated state government precedents) when lending the same assets in contrast to the current situation where the big banks get preferential funding terms with uncertain lending outcomes.

It could also help enhance the monetary policy transmission mechanism by stimulating competition on rates...[and] generate revenues through the fees government would receive...Insuring 'conforming' AAA-rated residential and commercial property loans is, by definition, less risky for taxpayers than guaranteeing the liabilities of more poorly rated banks over which they have little control. Importantly, guarantees are also easier to remove once conditions stabilise than newly created institutions."

Regular readers will also recall that Professor Harper kindly backed the call for a new financial system inquiry, or a "Son of Wallis", which I and five other economists first made in July 2009 in the now oft-referenced "Six Economists Letter". The ACTU, Joe Hockey and Bob Brown also supported this initiative. It is worthwhile excerpting the first few paragraphs of this letter to remind folks of our arguments one and a half years ago:

"Ever since the severe market failures in Australia’s securitisation industry were identified in 2008, we have been concerned that these problems were partly attributable to more fundamental flaws in Australia’s ageing regulatory architecture and the inadequately defined role of government in dealing with such crises.

The shortcomings within our governance system have been exacerbated by the relentless changes that have occurred in financial markets since the essential elements of our regulatory infrastructure were put in place decades ago. One example of this is the 1996 Wallis Inquiry’s rejection of the use of deposit guarantees, which have been critical tools for maintaining stability during the current crisis. Following the lessons that have been learned during the global financial crisis, and the 12 years that have elapsed since the last such exercise, we believe that a broad-based inquiry into the integrity of Australia’s financial system is now warranted...

We are still in the midst of understanding the consequences of the global financial crisis and the actions of governments (including Australia’s) in response to it. Importantly, it remains uncertain to what degree Australia’s comparatively successful performance in navigating through this catastrophe has been due to our own regulatory foresight or just good luck. We would do well not to discount the possibility that a ‘good roll of the dice’ left us without more significant system failures such as those seen in the UK. In future crises, we may not be so lucky."

Some of the specific issues we suggested should be investigated by Son of Wallis included the following ideas, which, it would seem, are only all the more germane today:

* Will the Australian government seek to establish a regulated clearinghouse for the hundreds of billions of dollars worth of over-the-counter derivatives contracts that are otherwise beyond the remit of policymakers;

* Should banks be subject to a ‘systemic capital charge’ to account for the risks associated with the correlation between bank balance sheets given that current capital charges reflect the idiosyncratic risks to the institution itself, and may not be collectively large enough to compensate for system-wide catastrophes;

* Will the deposit and/or wholesale funding guarantees be phased out and, if so, what new policy guidelines will explain how they might be redeployed when capital markets seize up again in a manner that minimises disruptions to other sectors (such as the knock-on effects seen in non-guaranteed areas like the commercial paper debt markets, the mortgage trust industry, and the CMBS and RMBS markets). If they are not phased out, how will the terms and price of these subsidies be determined and what regulatory constraints will be applied to prevent the emergence of moral hazard risks. More broadly, what parts of the credit markets will or will not be guaranteed in the future;

* Has this crisis reminded us that Australia’s major banks fulfill a unique community role akin to public-private utilities that warrant special controls to guard against system stability risks? Here it is odd that we’ve been repeatedly told that our banks were lucky not to have had substantial overseas exposures and yet they now appear to be rushing offshore to obtain exactly these;

* Can real competition emerge while consumers face significant costs in switching between financial institutions? Does a government-regulated securitisation market provide an opportunity to consolidate mortgage account standards and more effectively enable switching;

* Where government guarantees are deemed necessary is it preferable for them to be offered against complex institutions like banks, or against tangible portfolios of assets the characteristics of which can be relatively easily assessed by independent experts;

* China Strike Force ipod Should citizens who feel unsure and unqualified to shop wisely in our financial markets be able to access basic savings, payments, and wealth management products that have been vouchsafed by governments as being safe and professionally managed (eg, why can’t Australians invest with the Future Fund)? In this regard, is there a role for a publicly-owned entity, akin to KiwiBank in New Zealand, to offer essential services in Australia’s finance sector that leverage off unique government infrastructure (eg, Australia Post, the tax system, and the government bond market);

* How will policymakers remedy the regulatory asymmetry between institutions like the larger banks that rely on short-term retail deposits as their primary source of funding (in combination with wholesale debt) and many of their competitors that depend on the longer-term and (ironically) ‘matched’ funding furnished by the RMBS market? Whereas banks benefit from a range of government subsidies (implicit and explicit deposit guarantees, term funding guarantees, RBA liquidity support, etc), which glue together the enormous asset-liability mismatch created by funding 30 year loans with at-call deposits, Australia’s regulatory architecture does nothing to maintain the liquidity and integrity of its securitisation market. This contrasts with the Canadian system, which has remained open and functional throughout the crisis (and displayed lower default rates than Australia).