Credit Crunch No Excuse Not To Lift Interest Rates
Sydney Morning Herald
Wednesday November 7, 2007
THE CASE for the Reserve Bank leaving the cash rate unchanged today, despite a preponderance of local economic data that argues for an increase, rests on the argument that the debt crisis that has festered since the end of August is turning feral again.
But it is not completely there. One would not want to downplay the losses on securitised debt that are now emerging, including Citigroup's news this week that subprime mortgage-backed securities it holds have declined in value by between $US8 billion and $US11 billion ($8.7 billion and $11.9 billion) since September 30, and Merrill Lynch's earlier decision to write down the value of debt-backed securities it owns by $US7.9 billion. Nor should one dismiss the growing market belief that more losses are in the pipeline: there are more coming, they will be big, and they will involve some of the world's biggest players. It's difficult to see, however, how the Reserve's report to the central bank's board yesterday could have argued that the debt crunch overrides the local case for a rate rise. Two things are missing. The first is evidence that the new round of credit losses represents a worsening of the situation, rather than a more realistic appraisal of it. Debt spreads are not blowing out in response to the latest losses. The second thing is evidence that Wall Street's losses are spilling over into the real economy: US third quarter growth was surprisingly strong, at 3.9 per cent, household consumption in America is holding up despite the worst housing market downturn in a generation, and US corporate profits and share prices are solid everywhere except the financial sector. Australia is further insulated because its growth engine increasingly is China, which is sourcing half its growth these days from domestic demand. It will not have been a clear-cut call. The Reserve boosted the cash rate from 6.25 per cent to 6.5 per cent at the beginning of August, just as the debt crisis was flowering, and has sat on its hands since then, as it measured the effect of the credit squeeze. The squeeze manifested itself in higher short-term bank-to-bank lending rates and the emerging consensus is that the increase will settle at about a quarter of a percentage point. That is something the Reserve will have taken into account at its meeting yesterday. But it will also have noted that the wholesale funding cost increase has so far only been passed through to the economy at the margins, in some business lending, and through retail loans including home loans by non-bank home lenders that were raising their money directly from the debt securitisation markets most affected by the squeeze. The big banks have not yet passed the wholesale rate rise on to retail customers and the credit squeeze's impact on demand is accordingly filtered. The Reserve's board should also have been told that the big debt losses that are emerging are a sign that the system is coming to terms with the crisis. It is estimated that there are about $US200 billion of securitised mortgage debt losses in the global system and about $US100 billion of them will be taken by the big investment banks and integrated banks. After the Citigroup and Merrill writedowns, about a third of the total is accounted for, but there is more to come. One of the industry giants, Goldman Sachs, balances in November, and last reported on its August quarter, which did not reflect the full effect of the credit squeeze. Its next report will be crucial. Lehman Bros reports on the same November cycle and is also expected to disclose more losses. More will come from other US investment banks and there is speculation that Merrill and Citigroup have not yet cleared their decks - although it has to be said that the cut Citi has just taken is deep, at 20 per cent of the $US55 billion total value of its subprime and related exposure. The process is painful. Financials sector shares are being sold down, in the US particularly, where Merrill and Citi shares are down 40 and 36 per cent so far this year respectively, and the writedowns are causing balance sheet pressure. Citigroup, for example, targets its tier one capital base at 7.5 per cent of risk-weighted assets and, after this week's writedowns, the ratio has slipped below that, to 7.3 per cent. But as one banker remarked to me this week, it took Japan's politicians and bankers 15 years to face up to the bad debt problem sitting inside the Japanese banking system, and another five years to fix it. On the other hand, the markets are well on their way to amortising, or digesting, the subprime/collateralised debt losses within a year. And as the losses are booked, it is worth remembering that a billion bucks isn't what it used to be. Citi's $US11 billion writedown is a huge headline number but the group earned twice as much last year, and is a fully fledged bank, with a large deposit funding base. Its shareholders' funds stood at $US120 billion at the end of last year. Merrill's writedown of almost $US8 billion was proportionately larger, at about 20 per cent of shareholders' funds, and it is now vulnerable to takeover. There is of course another $US100 billion of subprime-related losses to be booked outside of the banking sector but it is spread around the world and held by various investment funds, including government and private sector pension funds and hedge funds. Lack of visibility in this case is a blessing. Losses in funds exposed to subprime are being declared but large chunks of the non-bank exposure will be privately digested. Hedge funds, for example, have low disclosure requirements.
© 2007 Sydney Morning Herald