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If at first you don't succeed, change the rules...

IF TRYING TO CLEAN UP toxic balance sheets fails, then simply change the rules, says Dan Denning in his Australian Daily Reckoning.

That seems to be the lesson from the G20 summit, the switch in US accounting standards, and the current action on the market. The Dow Jones in New York just capped its best four-week performance since 1933. And the ASX/200 across in Sydney is up a nifty 18% in the last three weeks alone.

So what changed? Nothing really, except the rules. The Financial Accounting Standards Board (FASB) in the United States suspended its rule number 157-e. That rule required that banks value their assets using a mark-to-market method. In other words, banks had to revise the value of their balance sheet assets based on the current market price for assets they held.

Banks complained that this rule distorted the price of assets for which there was currently no market, or which the banks intended to hold all the way to maturity, meaning the current price was largely irrelevant. It proved a clever argument.

Behind it is the assumption that if the market were normal, the price of the assets would be higher. Therefore, because the market is not normal, the pricing information is incorrect. But maybe the market isn't spewing out bogus price information after all. Maybe the price of the assets is what it is because they are what they are: deeply distressed and careening toward a larger write-down.

Either way, we've entered the age of Dr. Phil valuations. It's not about what the assets are actually worth. It's about your own feelings...

- How do you feel about your balance sheet?

- You know I feel pretty good.

- What is that? Have the default rates on your Alt-A loans gone down? Are fewer people behind on their mortgage payments than last week?

- C'mon man. You're bringing me down. You know it's not like that. I was just starting to get better...

- I'm sorry. Please continue. Just forget about reality for a moment. Examine your feelings. What do they tell you? Or what would you like them to tell you?

- Well, today I feel like I'm going to get 97 cents on the dollar back on my sub-prime CDOs. Don't ask me why. It's just this feeling I got eating breakfast. Yesterday, I didn't feel so flash. It felt like maybe the assets were only worth thirty cents on the dollar. But is great. I feel great. The assets feel great too. Everything is great...

Everything is not so great, mind you. Unemployment in the States just hit a 25-year high. The rate is now 8.5% with nearly 663,000 Americans losing their jobs in March. That will lead to higher default and foreclosure rates for those already facing falling home prices.

This is not just a problem in America. It's a problem here and now in Australia. "Given the poor growth outlook for Australia's two largest trading partners – Japan and China – Australia should be preparing contingency plans for unemployment to peak at 10 per cent," writes Kenneth Davidson in today's Age.

Won't rising unemployment imperil the Australian property market? It's possible. There is a new claim that rising unemployment is a big threat not just to home owners, but also renters.

"If unemployment rises to 9% next year, as many economists predict, the number of tenants facing eviction rises to 216,000 nationally," reports the Sunday Telegraph, citing a report by Fujitsu Consulting. We have no idea who these guys at Fujitsu are. But they are definitely flying their housing crash/rental crisis flag on a regular basis. In this case, the logic of the argument seems sound.

Rental vacancies are low. Landlords have to pay mortgages on properties and know there are plenty of other tenants around. The squeeze begins. Over the weekend, the Federal government stepped in to try and relieve the squeeze, but only for mortgage owners. It amounts to the construction of a mortgage prison for the unemployed, if you ask us. And it's not exactly new. The Prime Minister has taken credit for a move announced by Commonwealth Bank chief Ralph Norris three weeks earlier. That move allows mortgage holders who've lost their job to defer payments on the mortgage for up to twelve months.

So what's the story? Well, the short story is that his move keeps Australian house prices high and more Australians in mortgage debt for longer.

Don't get us wrong. What the bank and its customers choose to agree to is between them. That's the spirit of capitalism! Voluntary exchange, enforceable contract, no compulsion or coercion. You signs your mortgage and you pays your money. But have you ever known a bank to do something out of the kindness of its heart?

Banks don't want to foreclose on a homeowner. It's expensive. And the bank doesn't want to own the home outright anyway. That's complicated. It has to then carry it on the balance sheet and value it while it tries to resell it.
The bank would rather keep you in the home, where you think you own it. And most importantly it wants to keep you paying on the mortgage. The longer you're in debt, slaving away at the mortgage, the more regular bank earnings will be (which isn't so bad if you're a shareholder collecting dividends.)

In its current form, the various banks' plans allow mortgage owners to either capitalize interest or choose an interest-only option. Capitalising the interest means the value of the monthly interest payment is added to the principal. The loan grows larger over time. This threatens to put the mortgage owner in negative equity.

The interest only option is more likely. Hmm. Interest-only mortgages. Sound familiar? The mortgage owner doesn't pay down the principal at all for up to twelve months. Blah blah blah. We could go on with the details. But you see the basic problem.

This is a move designed to keep people in their homes because it "feels" bad when people lose their homes. We're certainly not making light of it. It does feel bad. And once you get beyond how you feel about it, it IS bad. But policy made to make people feel better doesn't do anyone a real financial favor.

The problem is that there are already too many people in Australia who shouldn't, financially speaking, have mortgages at all. They have not prepared for rising interest rates or the possibility of a job loss, both of which can throw the worst-laid housing plans into complete disarray. Rates may be cut tomorrow by the RBA. But joblessness is definitely on the rise.

The banks are hereby also trying to prop up property prices to support their own loan books. By keeping marginal buyers in their homes during a recession, it prevents a flood of new inventory which might depress prices (especially since demand for housing finance should be expected to fall in a recession, although we'll know more about this later in the week when the numbers from the ABS come out).

The bottom line is that any effort by the bank or the government to keep the marginal buyer in a house he can't afford just keeps housing more expensive for everyone else. Property prices are already too high. Keeping people in homes with huge mortgages just keeps them in debt for longer. What Australia needs is a good property price correction to correct the inflationary excess of the credit boom that pumped up prices so much in the first place. The two-decade credit boom and investment in residential property hasn't made the country wealthier if it's put hundreds of thousands of people into debt they can't repay. It's made the country poorer.

And don't forget the unintended consequences. So far, the mortgage moratorium applies only to the Big Four and their customers. Smaller banks, building societies, and credit unions aren't part of the plan yet. Will this cause an exodus of borrowers from these smaller firms? Will they refinance with the Big Four in order to have access to the leniency terms? It certainly can't hurt business for the Big Four. They manage to grow their loan book at the expense of smaller non-traditional firms.

This might not work out exactly the way they plan, though. Many of these smaller firms are the ones extending credit to marginal first home buyers. So perhaps the banks will end up bringing on to their balance sheet the single riskiest mortgage assets in the Aussie market. Keep the subprime plague at bay from the front door, and open up the back door for a house warming party.

Good plan!

Best-selling author of The Bull Hunter (Wiley & Sons) and formerly analyzing equities and publishing investment ideas from Baltimore, Paris, London and then Melbourne, Dan Denning is now co-author of The Bill Bonner Letter from Bonner & Partners.

See our full archive of Dan Denning articles

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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