You and your debt... the banks best asset!!!

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Todays' missive on the banks selling (and profiting) on selling us debt was particularly good.

Enjoy...

--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. The main one is the point we made 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.

--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, "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. What's left unsaid because it's assumed is that the borrower will have an income. That's a basic assumption, it's true. But is full time employment over the life of the 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.

--But what's left unsaid is that the bank is obviously happy for the borrower to maximise the amount of his income that goes to service the loan. After all, the bank is getting paid. What does it care how much stress it puts 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.

--For the bank, the borrower is a kind of fixed income investment. Mortgagees are literally a cash crop to be planted, farmed, rotated, and reaped cyclically. The bank only really risks a loss if the cost of servicing the loan breaks the back of the borrower. The banks allow for that in their loan loss and bad debt provisions. But generally, if you break your financial back it's your problem, not the banks.

--We're not bashing on the banks, mind you. They sell money. It's a valuable service. But we are showing 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. They're in the business of selling you debt. What else would you expect them to say?

--Eslake adds, that "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."

--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 behaviour 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. And 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, which is bad enough. 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.