More competition or less debt?

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As usu­al, I’ll be putting an argu­ment that is con­trary to pop­u­lar opin­ion on the need for more com­pe­ti­tion I the bank­ing sec­tor. So to clar­i­fy the issue, here’s a quick poll: who thinks that Aus­tralia does­n’t have enough debt?

Nobody? OK, now let’s dis­cuss the “need” for more com­pe­ti­tion in the bank­ing sec­tor.

The rag­ing debate is miss­ing the point–Hockey and the Coali­tion are right to go after the banks, but they’ve made a mis­take in sug­gest­ing that the sec­tor’s ills would be cured by more com­pe­ti­tion. In fact, we allowed too much com­pe­ti­tion in the 1980s, and again in the 1990s. The out­come, both times, was too much debt—firstly for busi­ness­es, and then for house­holds. That’s the sec­tor’s real prob­lem, and adding a third dose of com­pe­ti­tion won’t fix it.

One of Paul Keat­ing’s mon­u­men­tal ‘achieve­ments’ when he was play­ing the role of the ‘world’s great­est Trea­sur­er’ was to let vir­tu­al­ly unlim­it­ed com­pe­ti­tion into Aus­tralia in the form of for­eign banks. The ini­tial pro­pos­al was to let four in, but Keat­ing’s ‘tri­umph’ was to suc­cess­ful­ly argue to allow six­teen to set up shop here. I thought nobody would for­get what hap­pened next, but since com­pe­ti­tion is once again being sug­gest­ed as a panacea, maybe every­one has for­got­ten. Cut-throat com­pe­ti­tion for mar­ket share poured mon­ey into the hands of Ponzi mer­chants like Alan Bond and Christo­pher Skase. That “Bondy” went bust try­ing to sell beer to Queens­lan­ders just about says it all about the peo­ple will­ing to lend him mon­ey.

The end of that era of excess saw most of the for­eign bank­ing capac­i­ty in Aus­tralia col­lapse, leav­ing the mar­ket pret­ty much in the hands of the Big Four – not for­get­ting that one of the them, West­pac, came close to mak­ing it the ‘big three’ when it too near­ly col­lapsed in 1992 with a then record $1.6 bil­lion loss.

After the col­lapse of Bond Corp, Qin­tex and oth­ers, Aus­tralia had vir­tu­al­ly noth­ing to show for it beyond a string of expen­sive hotels along our shore­lines and a moun­tain of busi­ness debt—the unwind­ing of which gave us “the reces­sion we had to have”. The Busi­ness sec­tor, which had gone from a debt ratio of 22% to 55% in just over a decade, began to rapid­ly delever to 40% of GDP by the mid-1990s.

But that is start­ing to look like ancient his­to­ry. The con­tem­po­rary debate on banks is square­ly focused on mort­gage lend­ing which, we are told, is uncom­pet­i­tive.

Give me a break. After the Wal­lis Inquiry in 1996, non-bank lenders were set free by their new abil­i­ty to raise funds through the secu­ri­ti­sa­tion mar­ket.  Aussie John Symonds and a throng of oth­ers began cut­ting mar­gins on home loans to build vol­ume, start­ing a race to the bot­tom that the banks, to a large extent, were forced to join.

Back when “the reces­sion we had to have” began, mort­gage debt was a mere 17% of GDP. It began to rise right from that time—even though unem­ploy­ment was explod­ing from under 6 to over 11 percent—and kept on ris­ing to its pre-First Home Ven­dors Boost (FHVB) peak of 81% of GDP. Cour­tesy of the FHVB, it rose again to again to 87%, from where it is now falling.

A large rea­son for this blowout was the com­pe­ti­tion for mar­ket share dri­ven by the growth of the non-bank secu­ri­tized lenders like Aussie Home Loans, Wiz­ard, etc.

I made a sub­mis­sion to the Wal­lis Com­mit­tee in 1996, and walked away stunned when they told me that one of their key rec­om­men­da­tions would be to allow secu­ri­tized lenders into the Aus­tralian mar­ket. Shocked at how blithe­ly the Com­mit­tee was con­sid­er­ing this, I wrote a sup­ple­men­tary let­ter to it the next day (July 12 1996), which in part stat­ed that:

The secu­ri­ti­sa­tion of debt doc­u­ments such as res­i­den­tial mort­gages does not alter the key issue, which is the abil­i­ty of bor­row­ers to com­mit them­selves to debt on the basis of “euphor­ic” expec­ta­tions dur­ing an asset price boom. The abil­i­ty of such bor­row­ers to repay their debt is depen­dent upon the main­te­nance of the boom…

Should a sub­stan­tial pro­por­tion of eli­gi­ble assets (e.g., res­i­den­tial hous­es dur­ing a real estate boom like that of 87–89) be financed by secu­ri­tised instru­ments, the inabil­i­ty of bor­row­ers to pay their debts on a large scale… will be felt by those who pur­chased the secu­ri­ties, or by insur­ance firms who under­wrote the repay­ment…

there would obvi­ous­ly be a col­lapse in the trade­able price, and, poten­tial­ly, the bank­rupt­ing of many of the investors…

Of course, my warn­ings were ignored in the gen­er­al eupho­ria for “more com­pe­ti­tion”, and the rest is his­to­ry: lend­ing stan­dards dropped as the old and new com­peti­tors fought it out for mar­ket share, debt to house­holds bal­looned, the bust in lend­ing arrived, the secu­ri­tiz­ers failed and these new com­peti­tors were tak­en over by the big Four once more.

Yet here we are again with peo­ple argu­ing that more com­pe­ti­tion will improve things. The num­bers from the past decade and a half tell a com­plete­ly dif­fer­ent sto­ry. Even if you accept the gen­er­al eco­nom­ics mantra that more com­pe­ti­tion is always good thing in prod­uct mar­kets—which I don’t—the usu­al basis for that is the belief that more com­pe­ti­tion will mean high­er out­put at low­er prices. But the out­put of the bank­ing sec­tor is debt-based mon­ey: we may want debt to have a low­er price, but do we real­ly want more debt?

Be care­ful also about want­i­ng a low­er price—in terms of the mar­gin between the RBA’s base rate and the vari­able mort­gage rate. One way price can be dri­ven down in com­pe­ti­tion is by offer­ing a low­er qual­i­ty prod­uct, and that’s cer­tain­ly what hap­pened as com­pe­ti­tion in the post-Wal­lis Com­mit­tee era. Lenders replaced care­ful val­u­a­tions with dri­ve-by checks to see that there was a build­ing on the block, and care­ful assess­ment of capac­i­ty to pay with “liar loans” and 30-minute online loan appli­ca­tions (see page 34 of this report by the Home loan lend­ing prac­tices and process­es House of Rep­re­sen­ta­tives hear­ing back in 2007):

CHAIR—We will ask Mr Warn­er for a com­ment on that. Also we would be inter­est­ed in know­ing is there an issue with the val­u­a­tions of prop­er­ties.

Mr WARNER: … We do not have val­uers going out doing asset tests on all loans that are under­tak­en by finan­cial insti­tu­tions. Some banks get their own either ex-man­agers to dri­ve by to see if the actu­al house exists or we have a low­er form of val­u­a­tion being under­tak­en.

These days it is get­ting to the point where you actu­al­ly have the val­uer who would not actu­al­ly even see if the house or asset exist­ed in the first place. You have a dri­ve-by which is at best a cur­so­ry glance to see if there is a prop­er­ty on the lot that has been pur­chased.

With low­er qual­i­ty val­u­a­tions and many oth­er cost cut­ting mea­sures like this, the inter­est rate mar­gin dropped. RBA fig­ures show that head­line vari­able mort­gage rates which in the 1980s had been 400 basis points over the RBA cash rate, came down to less than 200bps through the peri­od 2000 to 2008.

So the big para­dox for the dom­i­nant “we need more com­pe­ti­tion” argu­ment in the cur­rent debate is why, if the banks have lent on much tighter mar­gins, are they so prof­itable? The answer is to be found the ris­ing vol­umes of cred­it extend­ed from the mid-1990s to the present.

Lend­ing vol­umes are now 400 per cent of what they were in 1992. That would make sense if the econ­o­my and pop­u­la­tion had increased in equal mea­sure, but they have not. The banks kept lend­ing through the GFC, and Aus­tralian home­buy­ers kept up their fren­zy of bor­row­ing until March of this year, when the mort­gage debt to GDP ratio peaked at 87 per cent. That fig­ure is now com­ing down as house­hold­ers delever­age.

You might think that the banks should turn next to busi­ness lend­ing, where there have been valid com­plaints that mon­ey for work­ing cap­i­tal needs is too hard to obtain. How­ev­er this is add odds with the aggre­gate lend­ing data for busi­ness – it peaked at 63 per cent of GDP in 2008, and has been com­ing down quick­er than home­lend­ing.

This is why Joe Hock­ey’s attack on the lack of com­pe­ti­tion is flawed—what we need is not more lend­ing but less, and not a low­er price but a high­er qual­i­ty. This is where both the oppo­si­tion and gov­ern­ment should be look­ing. Instead, Trea­sur­er Wayne Swan is try­ing to kick along more lend­ing by buy­ing up RMBS issues, there­by play­ing the game both the banks and the non-banks want – to keep vol­umes grow­ing.

Fur­ther cut throat com­ple­tion to grow vol­umes would be madness—we are sat­u­rat­ed with hous­ing debt and the long delayed delever­ag­ing cycle will go on, what­ev­er Wayne Swan does to give it a boost.

What we need are meth­ods to reg­u­late the vol­umes of debt offered by the banks to stop this hap­pen­ing again, with­out putting upward pres­sure on the cost of house­holds have to pay for it. That may sound like an eco­nom­ic impos­si­bil­i­ty, and it would be if “free com­pe­ti­tion” between banks were expand­ed.

In fact there is noth­ing ‘free mar­ket’ about bank­ing in the first place. Our big four banks are rais­ing cov­er­ing their short­fall between loans and deposits by bor­row­ing vast sums abroad—equivalent to 40 per cent of mort­gages in Australia—exposing the econ­o­my to future cred­it shocks, and all on the back of actu­al, and implied deposit guar­an­tees pro­vid­ed will­ing­ly by the gov­ern­ment.

That is mas­sive reg­u­la­tion of a pos­i­tive kind for banks. It’s time to bal­ance that with some less pos­i­tive regulation—policies that reg­u­late and con­trol the vol­umes these state-under­writ­ten enti­ties can lend.