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To balance out the multiplicity of sarcasm in my last post, I thought I’d add a link to the government’s press release which stated why they were investing in Residential Mortgage-Backed Securities. http://www.alp.org.au/media/1009/mstres110.php

The policy is not as absurd as I previously stated. The government is investing in the mortgage market to tackle the major problem facing Australia’s economy right now, which is competition in the banking sector. The financial crisis has basically crippled or killed most of the smaller financial institutions, since they had less ability to withstand this sudden credit crisis than the Big 4 banks (for various reasons, mostly to do with size and reputation).The Big 4 banks: the Commonwealth Bank, NAB, ANZ and Westpac, on the other hand were wounded but not crippled by any means. (See my last post for a few examples of how they are expanding internationally and domestically).

The Big 4 are now actively stealing market share from these smaller financial institutions. That has obvious negative effects on competition in the long run. Already, we can see the Big 4 banks trying to increase interest rates over and above the interest rates set by the Reserve Bank. They tried it earlier this year, and they look like they’re trying to do it again now. They argue that this is because of the increased cost of borrowing that the banks face. Their argument is based on truth, but they would never have passed them on if the market were as competitive as before. They would have borne the costs themselves rather than passing them on to consumers. They can afford to do it, given their record profits this year. To show you what I mean by a competitive market, look at the interest rates for businesses. They rise with the RBA’s interest rates and no higher. The banks simply absorbed the extra costs.

What the government wants to do is strengthen the smaller financial institutions that used to compete with the Big 4. They often do not source their money from international markets because they lack the reach of the big banks. Instead, they rely on the domestic securitisation market. (Securitisation is where the company which lends you money in the form of a mortgage, packages (or securitises) the rights to collect your mortgage and a lot of other mortgages, then sells that package on the securitisation market). During the credit crisis, all US private label securitisation (ie everything not issued by the semi-government Fannie Mae and Freddie Mac) stopped, and to my knowledge it still has not started up. It was a huge market, and its gone. I imagine that the Australian market has been hit just as hard, though there’s not much public information about it. This being the case, small mortgage lenders like RAMS can no longer afford to package mortgages and have effectively turned into mortgage agents for the big banks. This is the government’s attempt to restart that market. Hopefully it works.

I should add of course, that I still do not agree with this policy. It does not address the various structural problems with the securitisation model identified by the subprime crisis – namely information asymmetries and lack of information flow that allows us to model the worth of mortgages. We rely wholly on credit agencies, which have yet to earn back our trust. Furthermore, even though this is a short-term government investment, it is always dangerous to have your government investing in the market.

Furthermore, this policy alone is not enough to restore competition in the banking sector. The only participants left in the mortgage market are banks and credit unions. They had retail deposits (ie the money you put into the bank) to keep lending out. Companies like RAMS (whose only business was mortgages) are all gone because they did not have those retail deposits to keep them afloat. Measures have to be taken to allow those companies to return (without over-subsidising them and creating another mortgage bubble or creating more unsustainable mortgage lending companies). Other companies exist which do not rely as heavily on the securitised market. For example, the Mirvac AQUA fund is an investor in securitised mortgages. It is being squeezed out by the government (since they are now both competing to buy these mortgages). But AQUA is exactly the sort of institution that the government should be promoting in the long run. It merely cannot buy more mortgages because its share price has collapsed along with the rest of the ASX. Its lower share price means it can sustain less risk, so it can’t buy more mortgages. The government also needs to bring into effect policies which support these kinds of investors (along with supporting smaller banks, credit unions and mortgage originators).

In summary, I think investing in the mortgage market is a good idea, but a dangerous one. It encourages complacency in thinking we have done enough to revive competition in the banking sector. It makes us conveniently forget lessons we should have learned from the American mortgage market, and encourages us to not regulate. We should regulate. That is the best way to reduce systemic risk in the mortgage sector, to restore investor confidence in the industry and it should (if implemented correctly) increase the share prices of all the companies I’ve mentioned. That is restoring competition in the banking sector.

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