The 2008 Global Financial Crisis, Housing Bubble & Survival of Australian Banks
So Why did Australian banks fare better than many of their overseas counterparts?
Before I answer this, I’m going to talk a little about what caused the global financial crisis in the first place; as it is integral to understanding why Australia fared so well. The crisis evolved as a result of the US housing bubble.
What is a housing bubble?
A bubble is where prices in a particular market are forced to rise in a continuous upward spiral. An upward trend in the housing sector caused first time home buyers to decide buy up before prices rose even higher.
On top of this, investors were greatly attracted by all-time low interest rates.
This caused demand-pull inflation and therefore, a somewhat self-fulfilling prophecy. The demand caused a massive boom in the housing sector to compensate for it. Then all it took were a few over excited people to overpay for houses within the bubble to cause massive cost-push inflation.
For example, let’s say family a buys a house for $100,000 in 1995. In 2005 they sell their house at auction for one million. Now families B, C and D think “my house must be worth 1mil also” and so, this becomes the new market price.
Now the home owners within the bubble have massive equity on their house. Supposedly the best thing to do is take out a home equity loan of say, $500,000 to invest elsewhere. However, many of them foolishly re-invested in fixtures for their home or needless consumption.
When the bubble popped, house prices very quickly dropped to below the initial value most owners paid for them. All of a sudden, home owners found themselves with a mortgage value higher than their home. The $500,000 they borrowed from the bank to invest has mostly disappeared, as anything which was re-invested in the house has almost instantaneously depreciated to nothing. With nowhere to borrow money from, they defaulted on their loans in the masses.
Now the banks are in the shit. They do, of course, gain the houses as compensation as owners filed for bankruptcy, but now instead of $1mil they are worth say, $250,000. So for each loan they gave out, they have lost $250,000.
2.Add Equity loan assets
3.House equity rises
5.House equity drops
6.Equity loan value is essentially crushed into nothing as the house value drops below the value of both the mortgage and the equity loan.
7.Owners file for bankruptcy
8.Banks loose money
So why did the rest of the world compared to Australia fair so badly?
Well, there were three things in particular:
· High risk lending
· Poor regulation and;
· Poor credit rating.
Australia fared well because it was sitting in almost the opposite position.
According to the Reserve bank of Australia, the success of Australian banks is mainly due to an unusually low bad debt experience. Throughout the world; banks went way too far in relaxing the conditions required to qualify for a loan. New “low documentation loans” were being handed out frequently to consumers who had no real proof of a clean credit history, “Low-deposit loans” were being handed out to new home buyers who didn’t possess the cash required for a full deposit, and “high loan to valuation ratio loans” allowed for lending 80% or more of the value of the bought property.
Australian banks offered out some of the high risk loans mentioned, but for the most part they remained carefully conservative. Whereas in the US for example; High risk loans were being thrown at anyone who walked into a bank. No small part of this was because in some cases, managers gained a percentage of the short term profits, and couldn’t care less about the long term sustainability. So they cashed in for their own benefit. In short; Australia entered the GFC with relatively low exposure to high risk assets.
According to the International Monetary Fund;
“Australia’s approach to prudential and market conduct regulation is sound overall. There is a generally high level of compliance with international standards and in a number of areas, including transparency; Australia is at the forefront of best practices.”
The regulatory system of the US certainly lacked the same level of transparency. Though it should have been easy for anyone who actually looked to realise something was seriously wrong with the growing housing bubble; it seems anyone who did couldn’t care less. Those who were in authority within the Australian financial system obviously took their responsibility somewhat more seriously.
It would also be prudent of me to mention that with all banks adhering to their capital adequacy requirements, Australia had the reserves required for a very healthy buffer against market risk.
Australia has a heavy reliance on international funds, and during a crisis it’s important that this doesn’t become a problem. Of the top 19 highest rated banks in the world for credit rating, Australia has four. Each of them has been given a double a rating by Standard & Poor’s and the rating of some other Australian banks have actually been upgraded since the crisis. These rating ensured that
Australia had the availability to credit required to prevent disaster. Not a single dollar of taxpayer money went to bank funding during the GBF with only a 2% drop in profits in 2008.
Everything I have mentioned so far boils down to one thing; liquidity. When a bank’s cash flow drops to dangerous levels, things go tits-up. Combining high liquidity with low risk taking prior to the crisis is ultimately what saved Australia’s banks from the pit of despair experienced by banks across the northern hemisphere, who somehow managed to combine low liquidity with extremely high risk taking.