UBS: Buy miners | Macrobusiness

Re-published with kind permission from Macrobusiness.

If you want to know why RIO is higher today than when iron ore was at $92 then check this out from UBS:

Hitting the Wall or Just a Wobble?

Australian equities performed poorly in May (falling 3%) despite global markets posting solid gains (rising 2%). The market weakness in May was overwhelmingly driven by the heavyweight banks sector. On balance we believe “hard landing” fears are overdone though we concede that the consumer outlook is lacklustre.

Staying Overweight Resources and Neutral Banks

We continue to overweight the resource sector on the basis of relative valuation, and benign (iron ore) to moderately constructive commodity expectations (copper, oil, mineral sands). With the bank sector off 10% (total return), we think the sector is once again looking “fair” in an absolute sense (12.8x and 5.9% yield) and notionally cheap in a relative sense. A constrained growth outlook and near-term capital uncertainty keep us neutral.

Other Favoured Themes

From a thematic standpoint two of our key themes remain 1) public infrastructure exposure (we continue to hold Boral and Lend Lease Group) and 2) domestic energy suppliers continue to be well supported by investors (we continue to hold AGL Energy, Origin Energy). We continue to overweight US$/US economy plays.


What can I say? That’s some crazy shit.

IMF warns about Chinese debt

From FT (via the Coppo Report at Bell Potter):

China’s leaders need to look beyond the current solutions being floated to tackle the country’s mounting corporate debt problems and come up with a bigger plan to do so, the International Monetary Fund’s top China expert has warned. The IMF has been expressing growing concern about China’s debt issues and pushing for an urgent response by Beijing to what the fund sees as a serious problem for the Chinese economy. It warned in a report earlier this month that $1.3tn in corporate debt — or almost one in six of the business loans on Chinese banks’ books — was owed by companies who brought in less in revenues than they owed in interest payments alone. In a paper published on Tuesday, James Daniel, the fund’s China mission chief, and two co­authors, went further and warned that Beijing needed a comprehensive strategy to tackle the problem. They warned that the two main responses Beijing was planning to the problem — debt­-for­-equity swaps and the securitization of non­performing loans — could in fact make the problem worse if underlying issues were not dealt with. The plan for debt­ for equity swaps could end up offering a temporary lifeline to unviable state­ owned companies, they warned. It could also leave them managed by state­ owned banks or other officials with little experience in doing so.

Bad debt is bad debt …… and nonproductive assets are nonproductive assets. Financial window-dressing like securitization or debt-for-equity swaps will not change this. The assets are still unproductive. Effectively, China has to stump up $1.3 trillion to re-capitalize its banks. And that may be the tip of the iceberg.

Real-time payments could hurt banks

Ruth Liew:

….the Reserve Bank of Australia pushes Australian banks to create the New Payments Platform, a new piece of open-source infrastructure being built that will move the payments system to real time. The RBA’s plans are echoed by the US and the eurozone, which are also planning to roll out real time payment infrastructure by next year. These payments would boost Australia’s economic activity, as money flow improves and Australians access their funds as they are deposited, [Don Sharp at InPayTech] argued.

Australian banks could lose $2.5 billion in interest earnings if instantaneous payments were adopted – and the figure could jump significantly as interest rates rise.

Payments held in the banking system are part of the “float” which banks use for interest-free funding of part of their balance sheet — a boost to interest margins. Switch to a realtime payments system would see this disappear.

Source: InPayTech plots capital raise and ASX IPO as real-time payments take off

APRA waves wet lettuce at bank offshore funding | MacroBusiness

From Leith van Onselen at Macrobusiness:

…..the banks’ reliance on offshore funding hit an unprecedented 54% of GDP in the December quarter:

As always, the key risk is that the banks’ ability to continue borrowing from offshore rests with foreigners’ willingness to continue extending them credit. This willingness will be tested in the event that Australia’s sovereign credit rating is downgraded (automatically downgrading the banks’ credit ratings), there is another global shock, or a sharp deterioration in the Australian economy (raising Australia’s risk premia).

The Federal Budget, too, is now hostage to the banks’ offshore borrowing binge as it cannot borrow to spend on infrastructure or other initiatives for fear that Australia will lose its AAA credit rating, potentially leading to an unraveling of the private debt bubble created by Australia’s banks.

That APRA could stand by and allow the banks’ to borrow externally like drunken sailors is a hallmark of regulatory failure.

One in four dollars of bank assets is funded by offshore borrowing. A precarious position even for a stable economy (like Ireland?), let alone one hitched to the boom and bust commodity cycle. Smacks of moral hazard by the banks.

Source: APRA waves wet lettuce at bank offshore funding – MacroBusiness

APRA confirms further capital adequacy measures

From Robin Christie:

The Australian Prudential Regulation Authority (APRA) has confirmed that the country’s largest banks will face increased capital adequacy requirements for residential mortgage exposures – and hasn’t ruled out further rises.

The regulator made it clear yesterday that the new rules would be an interim measure based on the Financial System Inquiry’s (FSI) recommendations – and that it was keenly awaiting guidance from the Basel Committee on Banking Supervision before making any further changes.

The new measures, which come into effect on 1 July 2016, mandate that authorised deposit-taking institutions (ADIs) that are accredited to use the internal ratings-based (IRB) approach to credit risk must increase their average risk weight on Australian residential mortgage exposures to at least 25 per cent. According to APRA, the current average risk weight figure sits at around 16 per cent….

This is a welcome first step. Increases in bank capital will improve economic stability. Even at 25 percent, however, a capital ratio of 10% would mean that banks are holding 2.5 percent capital against residential mortgages. Further increases over time will be necessary.

Read more at APRA hints at further capital adequacy measures.

Bank chiefs in last-ditch plea to David Murray on tougher rules | The Australian

From Richard Gluyas at The Australian:

THE four major-bank chief executives have each made an eleventh-hour appeal to members of the Murray financial system inquiry ahead of Tuesday’s closing date for final submissions, as concerns mount that the sector could be forced to hold even higher ­levels of bank capital due to the ­inquiry’s emphasis on resilience. The closed-door meetings with the inquiry panel members come as Steven Munchenberg, chief executive of peak lobby group the Australian Bankers’ Association, said the industry was “jittery” about the inquiry’s focus on ­balance-sheet resilience because more onerous capital requirements would affect the banks’ ability to lend and serve the ­economy.

I disagree. Banks with strong balance sheets are better able to serve the needs of the economy. Highly leveraged banks leave the economy vulnerable to a financial crisis and are more likely to contract lending during periods of economic stress.

The shrill outcry may have something to do with the impact on bankers bonuses. Incentives based on capital employed would shrink if shareholder’s capital is increased.

Bank shareholders on the other hand are likely to benefit from stronger balance sheets. Reduced default risk is likely to enhance market valuation metrics like price-earnings multiples. Reduced risk premiums will also lower cost of funding and enhance lending margins. And shareholders are also likely to benefit from enhanced growth prospects. Analysis by the Bank for International Settlements in the post crisis period shows banks with higher capital ratios experience higher asset and loan growth.

World wakes to APRA paralysis | Macrobusiness

Posted by Houses & Holes:

Bloomberg has a penetrating piece today hammering RBA/APRA complacency on house prices, which will be read far and wide in global markets (as well as MB is!):

Central banks from Scandinavia to the U.K. to New Zealand are sounding the alarm about soaring mortgage debt and trying to curb risky lending. In Australia, where borrowing is surging, regulators are just watching.

Australia has the third-most overvalued housing market on a price-to-income basis, after Belgium and Canada, according to the International Monetary Fund. The average home price in the nation’s eight major cities rose 16 percent as of June 30 from a May 2012 trough, the RP Data-Rismark Home Value Index showed.

“There’s definitely room for caps on lending,” said Martin North, Sydney-based principal at researcherDigital Finance Analytics. “Global house price indices are all showing Australia is close to the top, and the RBA has been too myopic in adjusting to what’s been going on in the housing market.”

Australian regulators are hesitant to impose nation-wide rules as only some markets have seen strong price growth, said Kieran Davies, chief economist at Barclays Plc in Sydney.

…“The RBA’s probably got at the back of its mind that we’re only in the early stages of the adjustment in the mining sector,” Davies said. “Mining investment still has a long way to fall, and also the job losses to flow from that. So to some extent, the house price growth is a necessary evil.”

…The RBA, in response to an e-mailed request for comment, referred to speeches and papers by Head of Financial Stability Luci Ellis.

…The RBA and APRA have acknowledged potential benefits of loan limits “but at this stage they don’t believe that this type of policy action is necessary,” said David Ellis, a Sydney-based analyst at Morningstar Inc. “If the housing market was out of control and if loan growth, particularly investor credit, grew exponentially then it’d be introduced.”

What do you call this, David:

ScreenHunter_3294 Jul. 14 11.51

Reproduced with kind permission from Macrobusiness

Bankers’ political influence cause for concern

I am not sure of the background to this, but it certainly looks as if the big UK banks were able to exert enough political pressure to remove Robert Jenkins from the Financial Policy Committee, the UK’s new stability regulator. Anne-Sylvaine Chassany at FT writes:

An outspoken advocate of tough bank regulation who has worked in banking and asset management, Robert Jenkins left the committee earlier this year after not being reappointed by George Osborne, chancellor.

If bankers’ influence was the cause, it certainly is cause for concern.

via Barclays’ threat on lending under fire –

Lessons for Australian banks: Why Risk Managers Should Be Spymasters | ProPublica

Jesse Eisinger’s interview with risk specialist John Breit highlights an issue facing Australian banks. Residential mortgages are allocated a low risk weighting — 15% to 17% because of historic performance — compared to 50% for US banks. The big four banks piled into this area because of the perceived low risk, leveraging up to 50 times capital. Risk-weighted capital ratios (around 10%) still appear healthy, but they conceal a hidden danger from the resulting housing bubble.

[Breit] despises the concept of “risk-weighted assets,” where banks put up capital based on the perceived riskiness of the assets. Inevitably, he argues, banks will “pile into” the same types of supposedly safe investments, creating bubbles that make the risks far more severe than the initial perceptions. Paradoxically, risk-weighting can leave banks setting aside the least capital to cover the biggest dangers.

“I could not be more disappointed,” he said. “The cynic in me thinks this is all in the interests of senior management and regulators to avoid blame. They may not think they can prevent the next crisis, but they then can blame the statistics.”

Read more at Why Risk Managers Should Be Spymasters – ProPublica.

Fed’s Fisher: Too-big-to-fail banks are crony capitalists | Reuters

Pedro Nicolaci da Costa reports

The largest U.S. banks are “practitioners of crony capitalism,” need to be broken up to ensure they are no longer considered too big to fail, and continue to threaten financial stability, a top Federal Reserve official said on Saturday……

[Richard Fisher, president of the Dallas Fed] said the existence of banks that are seen as likely to receive government bailouts if they fail gives them an unfair advantage, hurting economic competitiveness.

Read more at Fed's Fisher: Too-big-to-fail banks are crony capitalists | Reuters.

Volcker: Wall Street Kills Regs By Running Out the Clock

Josh Boak at Fiscal Times writes:

…..So when Volcker declared on Monday that the financial regulation system is broken, it’s time to sound the alarm. The gist of his complaint is that Dodd-Frank was passed in the middle of 2010, yet many of its biggest regulations have not been finalized and there is no end in sight.

“I know it’s a complicated bill. I know the markets are complicated,” Volcker said at a conference for the National Association for Business Economics. “Two-and-a-half years later you can’t have a regulatory apparatus that’s devised by the most important piece of legislation in recent years? That suggests something is rather wrong. Something is dysfunctional.”

Read more at Volcker: Wall Street Kills Regs By Running Out the Clock.

S&P declares Australia a “one trick pony” |

By Houses and Holes on November 22, 2012

One-Trick Pony

London-based Kyran Curry, the long-time primary credit analyst for Australia at S&P, is back and the news is getting worse. From the AFR:

“The banks are highly indebted, they’re highly leveraged, they are the main vehicle Australia uses to fund its current account deficit…Australia has, as we see it, got some credit metrics that are right off the scale when it comes to assessing Australia’s external position….It’s got high levels of liabilities, it’s got very weak external liquidity and that basically means the banks are highly indebted compared to their peers….They’re benefiting from a safe haven at the moment – nonetheless investor sentiment can turn very quickly…We just worry that at some point, the people who are funding the Australian banks may decide that enough is enough and may begin to lose confidence in the bank’s ability to roll over their debt….That would come through a weakening in Australia’s major trading partners flowing through to a dramatic weakening in Australia’s fiscal position.”

Curry said this could be a two or three year scenario. But he added:

“Anything that weighs on the ability of Australia to bring forward new energy projects and that weighs on its export growth potential, that’s something that would put pressure on the rating. Australia is looking increasingly like a one-trick pony.”

Regular readers will note that S&P has pretty much captured my entire ‘peak Australia’ thesis. It is simultaneously ripping aside the veil of invisopower that regulators have dispersed around the banks and seeing for it is the singularly backward macroeconomic strategy of embracing Dutch disease. My two great fears.

The last line is the worst. I am of the view that LNG will rationalise – the current set of projects that is – not the fictitious pipeline. That means there is a risk that this is not a two or three scenario at all. Which does offer an answer to the question: why is S&P ramping its warnings now?

Canberra must immediately dispatch to Beijing a high level delegation to demand further stimulus. Perhaps a high-speed rail link from Beijing to the Bush Capital? That way, when they’re ready, the Chinese can relax in comfort on the way down to buy our banks.

Reproduced with thanks to Houses and Holes at

Australia: Did APRA assume a bailout in its stress test?

Houses and Holes at makes an important point regarding the Australian mortgage insurance sector towards the end of this article:

Stress Test

John Laker, head of APRA, is out today with a speech in which he announced the results of a recent APRA stress test of Australian banks. Here is the scenario and the results:

The ‘what if’ scenario was built around a further deterioration of global economic conditions, with a disorderly resolution of the fiscal problems in Europe triggering a dislocation in global debt markets and a sharp downturn in the North Atlantic economies. China is assumed to be unable to fully offset the decline in its exports with domestic spending and, as a result, the rate of growth of the Chinese economy slows sharply. The implied reduction in Chinese demand for minerals lowers commodity prices significantly, with a consequent deterioration in the exchange rate for the Australian dollar. Domestically, households and businesses respond to the external shock by reducing consumption and investment expenditure. As a result, GDP falls and unemployment rises substantially, which feeds back into rising defaults and sharp falls in house prices and commercial property prices.

In this scenario, the key macroeconomic parameters for Australia used as the basis for the stress test were:

  • a sharp (5 per cent) contraction in real GDP in the first year;
  • a rapid rise in the unemployment rate to a peak of 12 per cent;
  • a peak-to-trough fall in house prices of 35 per cent; and
  • a fall in commercial property prices of 40 per cent.

This is a tougher stress test than the one APRA undertook in 2010. The projected economic contraction is deeper and more prolonged, with a weaker recovery and a longer period before return to growth. The rise in unemployment is higher and the impact on the housing market therefore more pronounced; there is a greater peak-to-trough fall in house prices. This time, the stress test also addressed liquidity consequences. The dislocation in global debt markets results in the largest banks being unable to access global funding markets for six months. The consequence is more intense competition for deposit funding and an increase in funding costs, weighing on lending margins and acting as a drag on revenues.

Remember, this is a hypothetical. It is in no way a forecast or a central expectation for the course of the Australian economy. Rather, the stress test was intended to test the boundaries of ‘severe but plausible’, especially given the current relatively strong position of the Australian economy. Benchmarked against recent industry-wide stress tests in other countries, the severity is confirmed by the fact that the GDP shock is more than four standard deviations based on the annual volatility of GDP in Australia since 1960; the shock was one-to-three standard deviations in other major tests. As a test of plausibility, the macroeconomic scenario would be comparable with the actual experience of the United Kingdom, United States and some European countries during the global financial crisis.

Although the macroeconomic scenario was tougher than in the 2010 exercise, the actual mechanics of the stress test were largely the same. The advanced banks were asked to apply the macroeconomic scenario in their own models and provide their assessment, in quite granular detail, of the impact on the ratings migration of assets, default behaviour, profitability and capital. After analysing this information, APRA then determined a common set of portfolio-specific risk measures that were applied to the banks’ loan portfolios.

Reflecting the severity of the scenario, the advanced banks all reported significant losses, driven by much higher bad debt expenses. Credit loss rates in aggregate were comparable with the experience in the early 1990s, although not quite as high as the peaks then reached. As expected, total losses were larger than in the 2010 exercise.

Despite the deterioration in labour market conditions and the projected stress on the housing market, residential mortgages, which account for nearly half of the advanced banks’ credit exposures, contributed only a fifth of total losses. The mortgage portfolio alone was not the principal driver of losses, a reflection of the structure of the domestic mortgage market as well as the general tightening in lending standards following the crisis. Losses were realised across a range of loan portfolios, particularly corporate, SME and commercial property portfolios. Losses on these business portfolios were more front loaded, materialising earlier in the scenario than losses on residential mortgage portfolios, which tended to lag the increase in unemployment.

The main results of the stress test for the five advanced banks, taken as a group, are as follows:

  • none of the banks would have failed under the downturn macroecnomic scenario;
  • none of the banks would have breached the four per cent minimum Tier 1 capital requirement of the Basel II Framework in any year of the stress test;
  • and the weighted average reduction in Tier 1 capital ratios over the three-year stress period was 3.8 percentage points.

This is a very positive result. It reflects the efforts of the advanced banks to strengthen their Tier 1 capital positions since the crisis began through ordinary equity issues and profit retention. It leaves these banks well positioned to transition to the new Basel III capital regime.

Well…bonza! But just one question. What did the stress test assume about the Lenders Mortgage Insurance sector (LMIs)? They are those hapless gents sitting on wafer thin capital buffers but carrying the risk of all the banks’ riskiest mortgages.

If the APRA stress test assumed a smooth and uninterrupted flow of payouts for losses from the LMIs to the banks then it also assumed their defacto nationalisation. In reality, under extreme stress, there is a very serious risk is that the LMIs will be wiped out and their relationships with the banks will descend into legal chaos as the two parties aim to survive at the cost of one another. You may recall that the biggest losers on Wall St in the GFC were insurers (think AIG), not banks.

In short, in the kind of scenario painted by APRA, it is quite possible that the government would have to step in and the post-nationalised LMIs would continue to pump a river of public cash into the banks via a backdoor bailout (ala AIG in the US).

So, if we are to take this excellent stress test result seriously, we really need to know what APRA assumed about the LMIs. Hmm?

Reproduced with thanks to Houses and Holes at

Are Australian banks adequately capitalized?

Basel III Capital Adequacy Ratios (CAR) will require banks to hold a minimum Total Capital of 8% against risk-weighted assets (RWA), the same as under Basel II, but with additional capital buffers of between 2.5% and 5.0% depending on credit market conditions. With an average ratio of 11.5% (September 2011), Australian banks are short of the maximum Basel III requirement of 13.0% for markets in a credit bubble.

The problem, however, lies not only with CAR but with the definition of risk-weighted assets. Under RWA, loans and investments are not taken at face value but adjusted for perceived risk. These adjustments vary widely between banks in different countries. US banks still apply Basel I risk-weightings:

  • zero for cash and government debt (OECD Sovereigns);
  • 20 percent for (OECD) banks;
  • 50 percent for mortgages;
  • 100 percent for corporates.

Their counterparts in Asia and Europe apply Basel II risk-weightings, with more lenient mortgage risk weights, averaging 15 percent and 14 percent respectively.

Australia’s 4 major banks similarly apply risk-weightings (supervised by APRA) for residential mortgages as low as 15%, with an average of 17%. That means the big four hold less than 2% capital against residential mortgages. Even after mortgage insurance, Deep T pointed out earlier this year, leverage is close to 50 times capital.

Basel III introduces a minimum 3% leverage ratio which ignores risk-weighting and compares Tier 1 capital to total exposure — total assets plus derivative exposure and off-balance sheet assets. But this is a catch-all and allows banks with high quality assets to continue leveraging at 33 times capital. Fed guidelines are more conservative, requiring a minimum leverage ratio of 4% (“adequately capitalized“) with a recommended 5% minimum for well-capitalized banks. The ratio, however, excludes off-balance-sheet assets. None of Australia’s four majors appear to meet the Fed’s requirement at September 2011 — ranging between 3.9% and 4.8% of Tier 1 capital to tangible assets.

With household debt at a historic high of 150% of disposable income, 3 times higher than in the early 1990s, Australia shows classic symptoms of a credit bubble and cannot afford to be complacent. There are three areas of the banking system that require attention. Capital adequacy ratios need to be lifted as well as risk-weightings for residential mortgages. Improving these two measures should enable Australia’s four major banks to achieve a minimum (Basel III) leverage ratio of 5%.


Australia and the Endgame

John Mauldin: We wrote about Australia in a full chapter of Endgame. Their economy never really suffered in the recent debt crisis, in large part due to their growing housing market and their trade with China. If you talk to the average Aussie, they think that all is right with the world. They acknowledge a few issues but see nothing major like the rest of the world has experienced. Jonathan and I think otherwise. Their housing market is by recent standards in a clear bubble (which I know will get me a lot of email). Their banking system is dominated by foreign deposits (shades of Northern Rock, but not as bad as Iceland). They are vulnerable to a Chinese economic slowdown. I should note that Chinese GDP growth was “down” to 7.6% last quarter. That China might slow down should not come as a surprise. No country can grow at 10% forever. Eventually the laws of large numbers and compounding take over. All that being said, Australian government debt and deficits are under control. Any problems should be of the nature of “normal” business cycle recessions and accompanying issues.

Comment:~ Massive Chinese stimulus saved Australia from the GFC but that is no reason to become complacent. As Steve Keen recently pointed out, Australia is in a similar position to Spain in 2006. Spain was generating a fiscal surplus which it used to reduce government debt below 40% of GDP, but its banks were exposed to a large housing bubble funded by offshore deposits. Australian banks are similarly exposed to offshore funding and are leveraged 50 to 1 on residential mortgages (Macrobusiness May 4, 2012) — even after adjusting for mortgage insurance — leaving them highly vulnerable to a contraction. We also need to recognize that Australia is not exposed to a slowdown in China’s GDP growth, but to a slowdown in Chinese spending on infrastructure and housing. While GDP growth may fall to zero, the Chinese economy will still survive, but what are Australia’s chances if that is accompanied by say a 50 percent fall in new infrastructure and housing projects? The fall in iron ore and coking coal exports would have a far greater impact on the Australian economy.

Has the Chinese government given up on rebalancing already?

Zarathustra: As more and more evidence suggests that the Chinese economy is slowing rapidly, there is also more and more evidence that the Chinese central government has given up on real estate market curbs even though they say they will continue, and they have given up cleaning local government debts even though they said they were cleaning them up. And by giving these up, they have also unofficially given up on rebalancing the economy away from investment driven to consumption driven once more.

via Has the Chinese government given up on rebalancing already?.

Five Largest Banks ‘Should Be Broken Up’: Fed’s Fisher – CNBC

The five biggest banks in the United States are too powerful and should be broken up, Dallas Fed President Richard Fisher said on Wednesday.

The financial crisis has left the five biggest banks even more powerful than before, he said at an event in Mexico City……

“After the crisis, the five largest banks had a higher concentration of deposits than they did before the crisis,” he said. “I am of the belief personally that the power of the five largest banks is too concentrated.”

via Five Largest Banks ‘Should Be Broken Up’: Fed’s Fisher – US Business News – CNBC.

New Economic Perspectives: Banks Weren’t Meant to Be Like This. What Will their Future Be – and What is the Government’s Proper Financial Role?

So we are brought back to the question of what the proper role of banks should be. This issue was discussed exhaustively prior to World War I………

It was above all in Germany that long-term financing found its expression in the Reichsbank and other large industrial banks as part of the “holy trinity” of banking, industry and government planning under Bismarck’s “state socialism.” German banks made a virtue of necessity. British banks “derived the greater part of their funds from the depositors,” and steered these savings and business deposits into mercantile trade financing. This forced domestic firms to finance most new investment out of their own earnings. By contrast, Germany’s “lack of capital … forced industry to turn to the banks for assistance,” noted the financial historian George Edwards. “A considerable proportion of the funds of the German banks came not from the deposits of customers but from the capital subscribed by the proprietors themselves.[3] As a result, German banks “stressed investment operations and were formed not so much for receiving deposits and granting loans but rather for supplying the investment requirements of industry.”

via New Economic Perspectives: Banks Weren’t Meant to Be Like This. What Will their Future Be – and What is the Government’s Proper Financial Role?.

Comment:~ The author contrasts the short-term focus of modern banks with the long-term outlook of the early German banking system which was largely equity-funded, rather than deposit-based. The question is: could we ever successfully return to such a system?