Consequences of the rejection of proposed US financial bail-out

From The Melbourne Age on 1st October 2008

Monday nights rejection by the US House of Representatives of the US Treasury Secretary Paulsons Troubled Assets Recovery Plan, which had been modified to accommodate the concerns of Congressional leaders, has propelled the financial crisis which began in July last year into a new and much more dangerous phase.

The Paulson plan was by no means flawless. But the history of financial crises which has been neatly summarized in a paper by two IMF researchers published last week shows clearly that financial crises such as the present one are rarely solved without the infusion of large sums of taxpayers money, as the Paulso plan proposed in this instance.

Together with what has been lent to Bear Stearns and AIG, the US$700bn envisaged by the Paulson plan amounts to around 6% of GDP which, as it happens, is equivalent to the average cost of the bailouts required in response to the 42 financial crises which the IMF researchers identify since 1970. It represents a lot less than what was eventually required to resolve Japans banking crisis of a decade ago, which amounted to 24% of GDP in part because the Japanese political system took so long to agree to the use of public funds in this way.

Far from saving their constituents US$700bn, the 228 members of the US House of Representatives who voted nay to the Paulson plan will ultimately cost them more more by way of the bigger bail-out which will be required the longer it takes a majority of Congress to get a grip on reality; more by way of the greater declines in house values and retirement savings accounts which will occur in the meantime; and more by way of the larger number of job losses which are likely to occur as the spillover effects of the financial crisis on the real economy (in which most Americans are employed) continue to mount.

Although Australias financial system is, as Ministers and Reserve Bank officials have (appropriately) continued to emphasize, in a much sounder condition than its counterparts in the United States and many European countries, it is not immune from the additional pressures which the rejection of the Paulson plan have set in train.

Australian banks have not engaged in imprudent mortgage lending to anything like the same extent as their American counterparts partly because of better and stronger prudential supervision, partly because the Australian legal system has more safeguards against reckless behaviour on the part of both borrowers and lenders, and partly because Australia (almost uniquely among Western countries) did not experience an extended period of excessively low interest rates in the early years of this decade (a tribute to the wisdom and courage of our central bankers in the face of political pressure to do otherwise).

Australian banks are thus continuing to add to their capital (and hence to their capacity to lend) through profitable operations, while American and European banks are destroying capital (and hence eroding their capacity to lend) through loan losses and write-offs.

However the Australian banking system has one point of vulnerability, which stems from the fact that Australians dont save enough in the form of bank deposits to finance all of the loans which they want to take out from banks, obliging the banks to rely on wholesale funding for the difference, to a greater extent than most overseas banking systems. This is the direct result of the fact that Australia runs the worlds fourth largest current account deficit (in absolute terms), and relies almost exclusively on the overseas borrowings of the Australian banks to finance it.

That borrowing has become more expensive since current financial crisis began to unfold in July last year, and dramatically so over the past two weeks. Yesterday, banks were having to pay almost a full percentage point above market expectations of where the cash rate will be for 90-day wholesale funds, compared with less than one-tenth of a percentage point before the present crisis began.

The intensification of this upward pressure on banks funding costs means that, if the Reserve Bank wishes to prevent the rates which household and business borrowers are paying from rising, it will need to cut the official cash rate at next Tuesdays board meeting. And if they judge that in the light of the deteriorating outlook for the global economy the rates which borrowers are paying should come down, then they made need to cut the official cash rate by more than the customary quarter of a percentage point.

And politicians who wish to continue to re-assure Australians of the soundness of their economys fundamentals by highlighting (among other things) the profitability of the banking system need to think twice about the wisdom (in these circumstances) of urging banks to reduce their profits by cutting their lending rates when their funding costs are actually going up

.

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Chris Lloyd
Chris Lloyd(@chris-lloyd)
13 years ago

Boy. This sure sounds like a post from someone who works for a bank. A year from now this will all be fixed and the exact terms of the bailout will be very important.

hc
hc
13 years ago

It does sound like the rationalisation of a banker. I wonder about the value of writing op eds of this type when you are in fact reciting the ideology of your employer.

The banks in Australia need a competitive kick in the ass – their continued profitable growth in times of difficulties suggests to me something more than efficiency and good regulation. A cosy protected oligopoly that charges high interest rates and gives lousy customer service?

vanaalst.robert
vanaalst.robert(@vanaalst-robert)
13 years ago

It would be good if people would say what they don’t like about Australian banks before complaining. From a personal customer service point of view, I think they do a fairly good job (far better, for example, than the post office, and generally quicker than my local supermarket) — not as good as some places like HK where you can go to the bank on Sunday, but at least for the Commonwealth they seem polite and fast to me (and I’ve noticed banks start to open on Saturdays here finally too). People should try going to a French bank at lunch time (12-2) if they think they have poor customer service.

If there are other things, like charging higher interest rates and fees then that’s obviously a different story, but if you don’t use all the speciality services, the main charge is an account and the Visa card fee. These two are free in some places of the world (but not others), but they are not exactly expensive here. Are they making more money on loans than other OS equivalent banks?

There are two things I can think of where they could improve. First, I think their web pages are cruddy — some overseas banks (like HSBC HK) allow you to do essentially anything with one account (OS currency, OS shares, gold, commodoties…), but is this because they are regulated so they can’t or are they just lazy? Second, I would like one account for everything (loans, salary etc), but this costs more. But it does at all the small banks that offer it too. Is this because they are ripping me off compared to other banks or is that standard for the world?

Rex Ringschott
Rex Ringschott(@rex-ringschott)
13 years ago

All this whingeing about local bank profit strikes me as just a tad too convenient and partisan. It’s a line that is strikingly similar to the rapid reality re-engineering being performed by the Republicans these days. The “Mavericks” who are promising to pin a tin star to their chests and stride purposefully down Wall St. with their trusty sixshooters picking off the corrupt and contemptible pin striped elite.

Don’t forget it wasn’t very long ago that Australians were bingeing on credit like there was no tomorrow. We’ve had record house prices, record car sales and record credit card debt, and all of this the banks have been happy to supply us while the neoliberals have pontificated on the magic of the market at work and smugly dismissed any suggestion that being a net debtor nation might one day be a problem.

Well now that it is a problem – because it is our banks that are the principle holder of this net debt to overseas interests – and now that the banks want to hold on to a bit of extra margin as a buffer – so that they can pay some of that debt down, and better deal with difficulties rolling that debt over, they are being criticized for trying trying to save their skin.

If the neoliberal hadn’t gone all hypocritical on us they’d be cheering from the sidelines as the mortgage defaulters have to hand over their keys. It is after all the market at work – clearing the inefficient players out of the system.

Excessive bank profits? Bah! Just excessive cognitive dissonance.

Rex Ringschott
Rex Ringschott(@rex-ringschott)
13 years ago

Jacques. Let’s turn it round. What neoliberals don’t pontificate about the magic of the market?

hc
hc
13 years ago

This excerpt from the Australian in 2007 is interesting:

“AUSTRALIA’S major banks were enjoying record profit margins when they cried poor and lifted mortgage interest rates independently of the Reserve Bank.

Official figures show the profit margin for the major banks was 54.8 per cent in the March quarter, resulting in $1 profit for every $2 in interest and fee income they charged.

The banks’ profit margin during the quarter was more than double the long-term average return of 26.9 per cent.

The record margins coincided with claims by major banks that higher funding costs made it necessary to lift interest rates by more than official RBA increases, claims supported by Treasurer Wayne Swan.

The Commonwealth, the National Australia Bank, the ANZ and Westpac all lifted their mortgage rates by more than the Reserve Bank”.

Last year Saul’s bank, the ANZ, increased profits by 13% to about $4.2 billion. This tear its profits fell by 7% partly as a consequence of higher funding costs but also as a consequence of its hopeless lending decisions in groups such as Centro and other groups. Times are tough but it is doing pretty well – unlike other firms in the economy which are exposed to more competition.

Tel_
Tel_
13 years ago

People should try going to a French XXXX at lunch time (12-2) if they think they have poor customer service.

Where XXXX != restaurant, you are gonna have a problem. Not really the bank’s fault.

some overseas banks (like HSBC HK) allow you to do essentially anything with one account (OS currency, OS shares, gold, commodoties),

I’ve found that to be the case with Australian banks as well, you usually have to login with a different password for the trading website, and a different password again to actually trade (but the money all slops in the same pool underneath).

… more by way of the greater declines in house values and retirement savings accounts which will occur in the meantime; and more by way of the larger number of job losses which are likely to occur as the spillover effects of the financial crisis on the real economy (in which most Americans are employed) continue to mount.

Money does not create wealth, printing more money does not increase wealth. Money is merely a tool for annotation of wealth and for the transfer of wealth between individuals. When prices go down, that is known as a “correction”. Logically, keeping those prices high would be “incorrect”.

Job losses are indeed a problem, some would say they are the major problem in the US economy at the moment. However, job losses were happening even back when Wall Street was all systems green, and people were saying a year ago that the combination of mounting job losses, rising inflation and industry going offshore was adding up to a disaster — but the bankers were the last ones to listen. On what basis would we believe that saving the banks is going to fix anything in the real world?

However the Australian banking system has one point of vulnerability, which stems from the fact that Australians dont save enough in the form of bank deposits to finance all of the loans which they want to take out from banks, obliging the banks to rely on wholesale funding for the difference, to a greater extent than most overseas banking systems. This is the direct result of the fact that Australia runs the worlds fourth largest current account deficit (in absolute terms), and relies almost exclusively on the overseas borrowings of the Australian banks to finance it.

Every banking system has the same vulnerability, if confidence is lost and the “at call” deposits all get called, then the system falls in a heap. It’s been that way since before Great Britain started pushing opium. In Australia they just pass the pain down to the variable rate mortgage holders and the risk to bank profits is minimal.

But there’s a bit more to it than that. Foreign banks are welcome to trade in our markets (you see ING ads all over the place), they seem to be able to deal with our current system. Plus there was a large increase in effective bank deposits when superannuation became compulsory (a scam, in my opinion, but it did push capital into our banking sector and offer a competitive source of finance).

Finally, we had a major resources boom. That’s the place where the wealth actually comes out of. It’s easy to have a healthy banking sector when there is plenty of high value revenue coming from existing economic activity.

Fred Argy
Fred Argy(@fred-argy)
13 years ago

Of course the banks need to get “a competitive kick in the ass” – but not now when they face a very poor borrwing environment.

In any case, they dont all have to move in line, even if asked. They can compete with each other and take the consequences.

As for Saul Eslake, he has always been a pretty brave man in his day. He refused to avoid criticising the Howard Government – even after an attempt was made to silence him.

hc
hc
13 years ago

Fred, So they need competition but not now and, in any event, they don’t all have to ‘move in line’ because ‘They can compete’. Errr….I am lost.

By the way isn’t the point of the $4 billion investment in non-bank lending by the Rudd government an attempt precisely to generate more competition for the banks in the mortgage market.

Quoting one of Labor’s leading intellectuals:

Mr Swan said the unprecedented Federal Government move into the home loan market would help the non-bank lenders compete against the big four banks.

“We need to have a competitive mortgage market so that people out there who are under financial pressure can get a fair go,” Mr Swan said.

Fred Argy
Fred Argy(@fred-argy)
13 years ago

Sorry,I still don’t see your argument.

The Government (by buying up mortgage-backed securities held by non-bank lenders) is indirectly reinforcing the pressure on banks to compete in the long run. But it is doing nothing to force their hand in the short run. The banks are free to do whatever they like, having regard to their own balance sheet. They do not have “populist” pressures on them of the kind Turnbull wants to launch on them.

If you want to read a balanced appraisal of the Turnbull argument, you should read Lenore Taylor in The Australian, 4-5 Octoberr 2008 (“Morphing Malcolm on familiar ground”).

Tony Harris
Tony Harris(@tony-harris)
13 years ago

As far as I can make out, classical liberals don’t expect free markets to solve every problem under the sun, just the ones that are caused by counter-productive interventions. And that is a long list of problems!

vanaalst.robert
vanaalst.robert(@vanaalst-robert)
13 years ago

I’m not sure how stuck the smaller banks are with lending now, but when I got my loan, I was surprised by how simple it was for me to get a far better rate than any of the four big banks were giving. It took me about 15 seconds searching on the internet (even clicking on pop-up adds on real-estate sites will get you a better rate), and since I don’t spend all day doing this sort of thing (I’ll try and avoid more conflicts of interest here :), I also let a broker do a search for me, and they paid me for finding me an even cheaper rate. If the four big banks are making squillions out of mortgage lending (excluding the current situation for which I’m not familiar), then this isn’t because there isn’t a lot of competition out there and other places you could get loan — there must be a hundred different places offering better rates. I assume that what is happening here is that people are going to the big banks for much the same reason as they eat McDonalds — or is this just my experience?

NPOV
NPOV
13 years ago

“…people are going to the big banks for much the same reason as they eat McDonalds”

I’m sure there’s large element of that (there’s plenty of evidence that humans aren’t collectively very rational consumers in many areas), but at least in the case of getting a mortgage etc. there is a rational desire to be with a “safe” player. Certainly I’m in principle happy to pay slightly more to have my money with a bank that I can be sure is extremely unlikely to ever collapse, though to be honest the deal I have with the NAB is pretty much unbeatable, due to various contacts I had at the time we needed the loan.

ken.miles
ken.miles
13 years ago

but at least in the case of getting a mortgage etc. there is a rational desire to be with a safe player.

What is the worst that can happen to a mortgagee if their lender goes under?

Surely their mortgage would be sold to bigger fish and life goes on.

NPOV
NPOV
13 years ago

Ken sure, but like many others, I enjoy the convenience and perks I get from combining my mortgage with various other banking needs.

Patrick
Patrick(@patrick)
13 years ago

What is the worst that can happen to a mortgagee if their lender goes under?

The lender could sell the property?

The new lender could reset the rates, terms and conditions?

Bingo Bango Boingo
Bingo Bango Boingo
13 years ago

Patrick, if those rights aren’t in the mortgage, how would any assignee of the mortgage debt acquire them? And, leaving aside the rates (which are adjustable under the terms of any standard variable rate mortgage), if any assignee of the mortgage debt could simply ‘reset’ the others terms and conditions of the mortgage, can I suggest that there is no enforceable mortgage at all? Contract law makes few demands, but actual promises is one of them.

BBB

Niall
Niall
13 years ago

I’m in favour of the proposed RBA rate cut, if & when it comes, remaining partially with the Banks, per se. Not that any of our domestic banks need assistance to bolster their bottom lines, but practically every finance house needs help convincing it’s peers of solvency. Being granted a handout of, say, 25 basis points while generous, actually aids the overall economy by presumably restoring some level of confidence.

Of course, that’s the desirable world view. In reality, even giveaways are unlikely to resolve any solvency difficulties while-ever the insolvency crisis lives on in the States. Which it will for a long time to come.