How Banking Works

Home-buyers are a cash crop to be planted, farmed, rotated, and reaped...

NOT ALL DIVIDEND YIELDS are created equal, writes Dan Denning in his Daily Reckoning Australia.

Yet there is an assumption among today's investors, bred by complacency, that higher yield is always available if you're prepared to take the risk. The way some of those income streams are manufactured, however – and the way the funds are structured – is, if not misleading, certainly not safe.

Not that you're going to retire rich on bank interest. But be wary of funds promising safe yields with no risk. They don't exist. In fact, we'd be wary of nearly the entire universe of financial investments at the moment. We'll leave why to another day. Because for now, you can't blame investors for chasing yield.

With real incomes falling in the Western World – as a result of a corporatist policy to off-shore high-wage jobs – the only way most people can achieve a standard of living that matches cultural expectations is to borrow money from the bank. Debt is just a means to an end. And that end is social respectability.

Perhaps that is why bankers have become so blasé about how they risk shareholder money. We're referring to the response of former banker Saul Eslake to the news, commented on by Terry Barnes in The Age on the 13th, that Australian households have $1.2 trillion in debt – or 112% of GDP according to the ABS. That's $56,000 for every man, woman, and little nipper in the country.

In today's Age, Eslake says debt won't "roon" us and that the debt-to-GDP numbers don't convey anything significant. The important numbers, he says, are the debt-to-asset ratio and the debt payment as a percentage of disposable income. By both measures, Eslake says there's nothing much to worry about.

To prove his point, he uses a hypothetical example where a customer walks into the bank with $100,000 in cash, annual after tax income of $100,000 and a request to the bank manager to borrow $200,000 for the purchase of $300,000 home. Elsake says:

"The manager would not reject the customer's request for a loan on the grounds that he or she would then have a debt-to-income ratio of 200 percent...

"Rather, the manger would look at the customer's debt-to-assets ratio, which in this hypothetical example would be 67 percent [a $200k mortgage as % of a $300k house]. Banks will normally lend for owner occupied housing up to 80 per cent of the value of the property (or up to 90 per cent with mortgage insurance).

"No problem there."

No problem there? We can think of at least one...a point we've made countless times before – the value of the property.

The assumption embedded in Eslake's risk assessment is that that the loan-to-value ratio can be that high because house prices generally go up. The borrower is getting an appreciating asset in exchange for his debt. That's a good trade as long as asset prices rise. But it's just worth pointing out the nonchalant assumption.

Of course if house prices don't rise, or if they fall, the debt-to-asset ratio would get closer to parity. In practical terms, the mortgagee has a debt that doesn't change and an asset whose value does. During certain phases of the real estate and credit cycle, that is a formula for indentured servitude to the bank.

But what about the ability to service the debt? Eslake says that, when meeting the would-be debtor:

"The manager would also consider the customer's capacity to service the loan out of his or her income. Assuming a mortgage rate of, say 7 per cent, interest payments would be absorbing 14 per cent of his or her disposable income, plus a little more for principal repayment. Banks will typically lend amounts requiring up to 25 or even 30 per cent of a customer's disposable income before becoming seriously concerned about his capacity to service the mortgage."

What's left unsaid here is just as important as what's assumed. And what's left unsaid (because it's assumed) is that the borrower will have an income.

That's a basic assumption when any loan is made. But is full-time employment over the life of a loan something you can take for granted in an economy like this? Perhaps these kinds of assumptions explain the track record of global bankers in making good loan decisions over the last ten years.

What's also left unsaid is that the bank is obviously happy for the borrower to maximize the proportion of his income that goes to service the loan each month. After all, the bank is getting paid. What does it care how much stress the repayments (and interest costs) put on the borrower?

For the bank, the borrower and his stressed-out mortgage payments are just as much an asset as the collateral itself, the house. Indeed, for the bank, the borrower is a kind of fixed-income investment – just like a bond. Mortgagees are literally a cash crop to be planted, farmed, rotated, and reaped cyclically. The bank only risks a loss if the cost of servicing the loan breaks the back of the borrower, and the banks allow for that in their loan loss and bad debt provisions. And in the main, if you break your financial back it's your problem, not the bank's.

We're not bashing on the banks, mind you. They sell money. It's a valuable service. But we are trying to show that if the underlying assumptions behind their lending practices are faulty, or not in your interests, you should be very cautious when they tell you it's okay to go into debt.

Banks are in the business of selling you debt. What else would you expect them to say?

Eslake adds that, given the request outlined above, "Not only would the customer's request be approved more or less on the spot, but mindful of the 'cross-selling' targets, the manger would have had, he or she would have probably also offered a further $100,000 loan for a geared investment in the share market." And to give him the benefit of the doubt, we detect a note of irony in Eslake's telling of this anecdote.

He's not endorsing or approving of the scenario. But we think he is saying that under common practices, this is how a bank would behave and that this behavior is reasonable, prudent, and ultimately, wildly profitable for the bank.

That tells you a lot about the banking sector. It shows you why the financial services industry has every incentive to load you up with debt so you can buy houses and stocks. In boom times, that strategy appears to make people richer. But when the cost of capital goes up and debt deflation sets in, both banks and their borrowers will regret the debt – and not just in a financial way.

Debt is not inherently evil. But it is a burden. And a society that loads itself up with obligations it strains to pay the interest on, much less the principal, is a very unhappy, heavily burdened society.

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