When housing hijacks an economy

You might wonder why a lender would have first access to bank deposits ahead of, say the depositor himself (you). And that’s a fair question. It’s also why covered bonds are a bit controversial. Putting creditors ahead of depositors in line for the distribution of assets would be a public relations disaster.

But it would only be a disaster if the bank is actually wound up and creditors (the buyers of covered bonds) get your money while you (the depositor) get nothing. And of course, if a bank sources just a small portion of its funding from covered bonds, it doesn’t represent a mortal threat to depositors and their deposits (you and your money in the bank).

Yet it’s telling that the Gillard government and Treasurer Wayne Swan are considering the introduction of covered bonds in Australia. Joe Hockey likes this idea, which should scare you even more. It’s a bi-partisan agreement on how to put housing even more at the epi-centre of Australia’s economy. Anytime politicians from the major parties agree on something, it’s bound to be bad for you.

The Big Four would claim that covered bonds are an additional source of funding for the housing boom that allows banks to lower borrowing costs to Australians because it lowers their aggregate cost of funding. But remember, the collateral for the bonds is your money in the bank.

What could possibly go wrong?

Well, hypothetically, a fall in bank asset values (housing crash) would raise concerns about bank liquidity and lead to doubts about the likelihood of a bank paying out on its covered bonds. This is what has happened in Ireland.

When Anglo-Irish Bank had ratings on its covered bonds cut by Moody’s, it showed that the Irish banks increasingly at the mercy of the ECB for continuous funding and that alternate sources of funding were tapped out. It also meant that the collateral for the bonds was in doubt, and forced the Irish government to try to make it good.

This last point is really the most important. Covered bonds were just the last in a long-line of ideas to keep Ireland’s housing boom going beyond all bounds of normality. Once the money ran out to keep prices inflating, the housing market collapsed and took the entire banking sector with it. This is how housing hijacks an economy.

So what does all this have to do with Australia? Well, in our view, Australia’s market has been partially hijacked by housing. Covered bonds would only make the bubble bigger, which would make housing even more unaffordable and lead to bigger losses down the track.

The recourse to covered bonds is being sought to keep the housing bubble from deflating. The banks, having exhausted the supply of first buyers, need to find new sources of funding to offer new mortgage products. And they might be worried that the traditional sources of funding are getting more expensive and more reluctant to feed Australia’s bubble.

The big risk with covered bonds is that they get abused as a cheap of way of sourcing funding for reckless lending. It works as long as house prices go up and up. But if house prices fall, then not only are depositors imperilled, but the government will be asked to help the banks with more cash to pay off investors. And when the value of bank loans exceeds GDP, not even the government can make that good.

Of course that could never happen here.

By the way, covered bonds are legal now in New Zealand. In fact, kiwi banks are selling the bonds denominated in foreign currency, which you think would expose them to massive currency risk. Incidentally, Aussie banks have a heaping helping of assets. We’ll get the figures for you tomorrow.

And finally, get a load of this from Dow Jones Newswires overnight: Standard & Poor's Monday shifted its outlook on New Zealand's foreign currency credit rating to negative from stable, warning on the country's dependence on offshore markets to fund its banking network and putting a spotlight on the its tepid economic recovery.

Hmmn.