AussieMac won’t work

The commencement of a new easing cycle by the Reserve Bank of Australia has put the spotlight on mortgage interest rates and their relationship with the official cash rate.

Since the credit crisis began in August 2007, the Reserve Bank has allowed market-led increases in retail lending rates to partially substitute for increases in the official cash rate in achieving its desired level of credit restrictiveness.

However, this relationship between RBA policy actions and market-based retail lending rates is a symmetrical one. As recently as August 2006, the RBA rationalised an increase in the official cash rate on the basis that retail lending margins over the official cash rate had contracted, reflecting competition from non-bank lenders benefiting from what was then a healthy market for residential mortgage-backed securities (RMBS).

In the wake of the credit crisis, the RMBS market has suffered a temporary closure. This has led to the proposal to establish a US-style government-sponsored enterprise (GSE), dubbed “AussieMac” after is US counterpart, Freddie Mac. AussieMac would seek to exploit the government’s funding advantage in capital markets to support the market for RMBS, with a view to lowering retail mortgage interest rates.

But any benefits from the creation of AussieMac could be fully offset by the RBA as it sought to maintain its desired level of credit restrictiveness. The RBA has always calibrated monetary policy to prevailing financial market conditions. These two arms of government would be operating at cross-purposes, with no benefit in promoting cheaper housing finance.

The AussieMac proposal mischaracterises the domestic implications of the global credit crisis as a failure of competition. The problems in credit markets and the market for mortgage-backed securities are better characterised as a temporary negative shock to available financial technology and market liquidity.

The issue is whether government can supply a superior substitute technology on either a temporary or permanent basis that will result in long-term improvements in financial intermediation, with benefits for home borrowers and without significant risks to taxpayers.

US experience finds that most of the funding advantage enjoyed by their housing GSEs was not passed on to home-buyers, but was instead captured by the GSEs in the form of higher profits.

But even if lower wholesale funding costs were passed on to consumers in the form of lower retail rates and not offset by RBA policy actions, this would simply be capitalised into house prices, with no benefit to home-buyers.

Housing affordability needs to be tackled from the supply-side, not the demand-side. This means building more houses, not giving consumers more money to spend on the existing housing stock, which is currently in short supply.

The US experience also highlights the dangers to taxpayers associated with GSEs that exploit implicit or explicit government guarantees to secure funding advantages in capital markets. These guarantees are ultimately underpinned by the government’s power to tax.

For decades, US politicians have deluded themselves that Freddie and Fannie were helping US home-buyers, at no direct cost to taxpayers. At the same time, the US GSEs used their implicit government guarantee to become the dominant players in the US mortgage market, earning huge profits from their government-supplied funding advantage that should have been passed on to consumers.

Their implicit government guarantee allowed Freddie and Fannie to operate from a very low capital base and encouraged excessive risk-taking, leaving them dangerously exposed to even small changes in the value of their assets. In the wake of the downturn in the US housing market, Freddie and Fannie now find themselves undercapitalised and the US government has been forced to make its implicit guarantee explicit.

The final cost to US taxpayers of this guarantee is as yet unknown. But the US experience demonstrates that there is no free lunch in exploiting the government’s power to tax to secure funding advantages in capital markets. Taxpayers should not be surprised when faced with the clean-up bill for the financial risks they underwrite through government-sponsored enterprises, such as the proposed “AussieMac”.

According to the RBA’s August Statement on Monetary Policy, the average interest rate on household lending was 100 basis points above its post-1993 average. The average interest rate on business loans was also 100 basis points above its post-1993 average.

The increase in the cost of borrowing experienced by both business and households does not reflect the absence of a US-style housing GSE in Australia. It reflects the basic fact that Australia is integrated with global capital markets and must compete with the rest of the world for access to capital.