When housing hijacks an economy

There is a system for dealing with bad loans made by bank officers: it’s called bankruptcy. The EU/IMF solution to Ireland’s problem is to borrow from someone else to pay for the mistakes made by the Irish banks. The people who should really lose money, as Jim Rogers pointed out, are the shareholders and bondholders in the banks. This is not a risk free world we live in.

Rogers pointed out that Ireland’s banks borrowed up to 80% of Irish GDP to fund that country’s property boom. A lot of the loans went to developers as well as individual borrowers. When the property market went bust after the banks soon turned to the European Central Bank for repeated helpings of credit to delay the inevitable. This week, the inevitable arrived.

Could such a thing happen here? Well, according to the June issue of APRA’s always-scintillating “Quarterly Bank Performance,” Aussie banks have a combined $1.45 trillion in housing loans. The report says, “The banks showed a 4.0 per cent decrease in total assets over the year to 30 June 2010, driven predominantly by falls in other assets. Total housing loans increased by 12.3 per cent to $1,145.0 billion over the year.”

Hmm. So total housing loans (assets) for banks are about equal to total GDP. Now keep in mind Aussie banks have not borrowed all that money from abroad. Just some of it (quite a lot of it). This is one reason why Australia’s net foreign debt is around $670 billion. The housing boom has been financed with foreign money.

That’s not a problem, unless foreign money gets expensive or is no longer as forthcoming. As long as you can sell bonds to foreign borrowers you’re alright. But it’s a bit of a worry for the major banks, based on the charts below from the RBA, that foreigners may not be as keen to buy bonds issued by Aussie banks, although keep in mind the banks might not be keen to sell debt right now either when they can raise money through equity financing.

All three charts show that conventional and unconventional debt instruments have all declined as a source of funding since the GFC. The government has stepped into the Residential Mortgage Backed Securities (RMBS) market to support non-bank lenders and offer other sources of competition for bank lending. But for the most part, the unconventional sources of asset securitisation haven’t recovered to their pre-crisis highs.

Which brings us to covered bonds. No, it’s not a new type of underwear. It’s a source of funding for banks which uses deposits as collateral against default. In other words, the bank sells a security and the buyer of the security is first in line to be paid from bank deposits in the event that the bank is wound up.