Australia’s future; negative rates and quantitative easing, what are they good for? Part 1

by: Graham Andersen
Founder and Executive Director
Morgij Analytics

Official interest rates are heading negative everywhere that public and private debt levels are at record highs on every measure. Australia fits squarely at the top of the pile. No doubt influencing Australia’s central bank, the RBA, to reduce the official cash rate a further 25bps in August. Whilst lowering official rates to 1.5% was predictable, the explanation in the RBA minutes seems more confused than informed, more noise than signal.
Whilst the RBA seems to sweat on inflation, unemployment, income and growth numbers throwing in house prices, debt levels and what’s happening with the $A and in the rest of the world, so does every other central bank. Its central bank think. Figures like GDP, unemployment and inflation are constructed measures whose meaning is determined by the input, the algorithm and the interpretation. Things of beauty to any central bank bureaucrat and mostly weapons of obfuscation and deception.

This collective yet disciplined behaviour means that all central banks, no matter what narrative is portrayed ultimately do the same or similar things. It’s not a conspiracy but collective behaviour triggered by the same noise and motivations. But, behaviour is predictable if you look for the signals and remove the noise.

Forget central bank noise of manipulated statistical constructs, the signals for future interest rates are as follows:
• Global GDP growth for a very long time has been driven by credit growth which under current settings is maxing for governments and households.
• Much of the credit growth has been collateralised by non-productive assets which in turn have grown spectacularly in value with the risk concentrated into 4 very similar banks in Australia
• Australia’s 4 major banks are undercapitalised. They are not in the top quartile internationally. They are at best average and therefore vulnerable to capital flight and credit downturns
• Credit growth in both productive and non-productive assets creates new money and bank deposits, reduction in debt does the opposite
• If there’s too much debt there’s too much money but almost by definition the debt and the deposits are held in different and mostly generational hands, so the net of zero is irrelevant in assessing risk
• Australia is locked into the trifecta of budgetary, trade and current account deficits, ensuring that the AAA credit rating will be lost and downgrades continue. The caveat here is that rating agencies are not consistent and act in self-interest. But more importantly, offshore borrowing needs to continue to grow to fund the deficits, so at least in the short term the rating agencies may be kind.
• No central banker is going to deliberately crash asset prices to reset debt levels by causing losses on loans and a reduction of money in the system
• Currency wars prevail around the globe with exchange rates set just as much on capital account as on the trading account.
• Not to undermine the importance of the other signals but how about the fact that Australia has no means to pay back what it owes to the rest of the world ever, other than to sell the country, is some signal to be taken notice of and take action on.

Using that piece of wisdom that the herd will always act in immediate self-interest, the signals tell me that the politicians are not going to change deficit settings in any meaningful way so debt levels will not be reduced significantly, deliberately. Concentration of risk and liabilities means the markets overall do not want a crash and will avoid that by any means. Central bankers will take notice of the signals whilst generally denying them and do the only thing they can, keep cutting interest rates into negative territory.

Whilst the CB meme will be that rate cuts are for stimulatory purposes in encouraging businesses to borrow to invest, this is noise and false. In an environment where the signals say structural risk and debt cycles are maximising but lowering interest rates increases asset prices, why is any business incentivised to take the risk to invest in productivity rather than assets?

To understand what will happen as risks in the system are cranked to breaking point we need to come at things from a different angle. Throw out traditional thinking. Perhaps the whole notion of principal and interest needs a bit of a rethink. Maybe a concept of risk capital should be built into the balance of each loan and deposit and repaid or not based on macro criteria would make system management easier.

Negative interest rates are simply losses on capital over time whilst simultaneously increasing the real value or purchasing power of the currency unit. To put it another way, negative interest rates destroys the money that was over created by excess debt leaving the money remaining having a greater value per unit. So rather than CBs lowering rates into negative territory to be stimulative, they’re destructive of volume yet value creative of the unit.

By lowering rates, driving credit growth and inflating asset prices, CBs have created an allusion of sovereign wealth creation when all they’ve done is rearrange the deck chairs on the Titanic. Creating excess money from unrepayable debt is a can kicking exercise of mammoth proportions but to the man in the street I suppose it seems like CB magic and for a time it feels great. Its only as time marches does the realisation hit that its nothing more than screwing those left holding massive debts for the benefit of the privileged. All orchestrated by CBs and their political masters in order to look good.

That’s because the holders of excess debt (the victims) and excess deposits (the privileged) are in different hands and reducing both debt and deposits together is a political land mine. Whilst there’s a real sting in the tail most mortgage holders would be happy about repaying less than they borrow. Personal entitlement by the privileged screams that their deposits are untouchable. Negative rates are a way of making the pain more acceptable or more to the point, realigning investment in unproductive assets into a position where it’s more attractive to invest in productive assets.

Sounds like a pretty neat solution, but is it? Certainly explaining how we’ll be better off by making losses on capital is something of a challenge.
The questions that come to mind are; what level of negative rate will do the trick? How do you get there and what damage will the movement down do before things start to reset to the positive?

The movement of interest rates down into negative territory is necessary in the absence of a short term bust. However, it will drive asset prices up and this movement distorts investment decisions and incentives, but, it is likely to drive credit growth and therefore support CB statistical constructs that make them look good whilst actually making the problem worse. Its only when the interest rates have unequivocally hit bottom that the rebalancing will take hold and reality bites. That bottom must be significantly negative. Zero or close just won’t cut it…….

To be continued in PART 2

Strong industrial strategy has many benefits

The argument should be about the best way the state can help drive growth, writes Mariana Mazzucato

Almost every technology behind the iPhone was government-funded.

In a brief moment after the financial crisis, policymakers set their sights on something higher than mere growth: not a return to the consumption and (private) debt-driven growth that had created the trouble, but investment-led growth. Time passed, however. The obsession with austerity set in and that interesting debate dwindled away.

Now, British prime minister Theresa May’s revival of industrial strategy is an opportunity to engage in the conversation again. Certainly, the concept of having such a strategy has not lost its power to shock. Commentators have been swift to denounce its revival as misguided and protectionist, a 1970s’ tribute to failed attempts to revive zombie companies. But the idea that the choice is one between protectionist policies and the elimination of any strategic role for the state is false.

In South Korea, China, Finland, Israel and the US, for example, the state has played an active role in increasing innovation and the productive capacity of the economy. Almost every technology that makes the iPhone smart was funded by government. This was not just about basic research but rather engagement across the whole innovation chain, including demand-side procurement policies.

Today the argument ought not be about whether the state should or should not be involved in driving growth but how it can do this in the best way. There are, for example, legitimate concerns that certain approaches to industrial strategy can lead to incumbent companies and sectors winning unwarranted favours from governments through persistent lobbying. Sectoral approaches sometimes increase these risks.

Much better to look to the lessons of innovation policies that have focused on getting companies to find ways around social and technological problems by working together across sectors and with public agencies. The Apollo mission to put a man of the moon, for example, required collaboration between sectors from textiles and aerospace.

Such an approach demands new types of public-private partnerships, targeting real co-investments rather than concessions and subsidies . In the past, this led in the US to the likes of Bell Labs and Xerox Parc, engines of future innovation, and in the UK to chip designer Arm, through spillovers from BBC investments.

By increasing business expectations about growth areas, mission-oriented investments encourage private sector investment. Unlike indirect measures such as tax credits, these policies create animal spirits rather than assume them. They also allow greater synergy between macroeconomic stimulus, financial market reform and innovation. This can lead to bigger multipliers than “infrastructure spending,” the policymaker’s default panacea.

On the finance side, the problem is not quantity but quality: industrial and innovation policies require long-term, strategic finance, while the UK continues to reward short-term finance. The few attempts at building sources of patient public finance have been neglected, with the successful Green Investment Bank , for instance, in the process of being privatised.

Indeed, just as the debate should not be industrial strategy versus free market, at the organisational level it should also not be about public versus private. There is no reason for the government to sell its entire stake in the GIB. It could retain a significant share, ensuring that it is neither fully public nor wholly private, and use the public share to direct green innovation in the long term.

Similarly, there is no compelling reason for Channel 4, the British public service broadcaster, to be privatised. It can continue to offer opportunities for private sector broadcasting activity, through procurement; so far it has done this successfully with a good return for the taxpayer.

Why should the public sector not get some return on successful investments, sharing the risks and rewards, precisely so that it can cover the failures that inevitably come with innovation? This also entails seeing intellectual property (patents) not as “rights” but as contracts to be negotiated between government and business so that innovation is nurtured rather than stifled. We need the interesting conversation about investment-led growth but the last time it began it was cut short before it really started. This time, we must do better.

We do not need false or ideological choices between market and state. This time we need a real debate about the social missions that can drive public and private investment to claim the opportunities of the future.
The writer is a professor at the University of Sussex, author of ‘The Entrepreneurial State’ and co-author of ‘Rethinking Capitalism’

Half of big banks unprepared for accounting shake-up

Published by the Financial Times 14 Aug 2016
Caroline Binham and Emma Dunkley in London

Nearly half of big banks around the world are unprepared for an international accounting standard due to take force in less than two years, even as they expect provisions for bad loans to soar as a result of the new rules.

A poll of 91 banks across the globe — excluding US banks that are governed by their own rules — has found that 46 per cent of those surveyed do not believe they have enough resources to deliver changes by the 2018 implementation date, with a significant minority going on to say there were not enough skilled candidates in the market to hire.

With less than 18 months to go before the change, nearly two-thirds of banks are unsure how the rules might impact their balance sheets, according to Deloitte, which undertook the global survey.

The rules force banks to have a provision on their balance sheets for expected losses in the future rather than actual losses already suffered.

Those banks that have made the calculations reckon the rules will result in a surge of at least 25 per cent in total impairment provisions across all asset classes.

Banks are also forecasting that the rules, dubbed IFRS 9, will cause their capital ratios to deteriorate: they are expecting core tier one capital — one of the most keenly watched metrics of the health of a bank’s balance sheet — to decrease on average by half a per cent as a result of moving to the new standard, according to Deloitte.

Uncertainty is not limited to the banking industry: 99 per cent of respondents said their local financial regulator had yet to say how they might incorporate IFRS 9 numbers into regulatory capital requirements.

IFRS 9 is part of a suite of measures by the International Accounting Standards Board to overhaul accounting since the financial crisis. The reform package is an attempt to increase regulatory co-operation between the US and international standard setters. Converging the different corporate reporting frameworks has been fraught.

By moving from an “incurred loss” to an “expected loss” model in 2018, under IFRS 9 the regulators hope to avoid the problems that occurred during the crisis, when banks could not book accounting losses until they happened, even though they could see them coming. This should help to keep banks properly capitalised for the loans they have made.
UK banks have experienced historically low impairments recently because of the record low interest rate.
However, there are some concerns that if economic growth were to stall following the Brexit vote, impairments could go up even without the new rules.
Steven Hall at KPMG said the estimated increase in provisions as a result of IFRS 9 was actually “cautious”.
“IFRS 9 will be almost as difficult to implement as it is to say,” he said. “Firms need to consider a range of future scenarios, and in today’s uncertain economic environment assessing the impact of that is not an easy task.”
Mr Hall has called for a grace period during which the new systems might be tested and embedded.

The Founder’s Mentality: How to Overcome the Predictable Crises of Growth

Extract from an interview with the author:….

Knowledge@Wharton: This founder’s mentality is more toward the thoughts of the company than the actual bottom line. Does the bottom line come as a by product of it?

Zook: Yes, it’s really about the inner health of companies. I remember reading that the best-selling sports book of all time was The Inner Game of Tennis. This is a little bit the inner game of business. We found three elements that we referred to as the elements of the founder’s mentality, which we felt were the best measures of health inside of a company. Boards of directors don’t typically ask as many questions or track these, although we found they are 85% to 94% of the reasons companies break down on the outside.

Number one is what we called an insurgent mission. Every founder is either at war against their industry standards because they are frustrated with it or trying to create something new, like Elon Musk is doing with SpaceX — creating a vehicle potentially to put people on Mars or Google is doing to organize information. Yet over time, companies can become just another company. We found that only 13% of people in the world now say they have any emotional commitment to the company that they spend probably half of their waking lives with.
The second element of the founder’s mentality is what we called frontline obsession. A great image for me was a description from Vikram Oberoi, the CEO of Oberoi Hotels, which were voted for a number of years as the best luxury hotels in the world. He would describe how on Sunday mornings he would visit his father, who was a poor villager who began this story in this incredible, humble beginning. Even at the age of 94, he would be holding customer comment cards in front of his eyes when he could barely see, scratching notes about the temperature of the tea for customer complaints. To me, that gets lost often in big companies.

The third is what we called the owner’s mindset, which is an aversion to bureaucracy and a desire to jump on problems, take responsibility right away, which often gets lost in big companies. It’s the essence of private equity’s success, in a way.

Chris Zook is a partner at Bain & Co., a management consultant firm, and served as co-head of its Global Strategy Practice for 20 years. In his new book with James Allen, The Founder’s Mentality: How to Overcome the Predictable Crises of Growth, he draws on his decades of experience to demystify the secrets of companies that push themselves past a slump.

Australia headed for recession next year, Professor Steve Keen says

http://www.abc.net.au/news/2016-07-29/australia-headed-for-recession-next-year,-professor-keen-says/7674154

Australia headed for recession next year, Professor Steve Keen says
By The Business presenter Elysse Morgan

Australia’s credit binge will lead to a bust as soon as next year, with house prices to fall between 40 and 70 per cent and unemployment to rise sharply, Professor Steve Keen says.
The professor famously lost a bet when he predicted a catastrophic crash in Australian house prices following the GFC and had to walk from Canberra to Mount Kosciusko as a result.
But he says, this time, he is right and does not have his hiking boots at the ready.
“We have borrowed ourselves so much to the hilt that we are now dependent on that continuing to rise over time and it simply won’t,” he told the ABC’s The Business.
Many believe the Reserve Bank has been a steady guiding hand to the Australian economy in the years since the GFC, but Professor Keen believes it has guided the economy “straight toward the shoals” by encouraging households to borrow with low rates which has led to asset bubbles.
“They don’t know what they’re doing,” he said.
“Our debt level according to the Bank of International Settlements, private debt level, has gone from 150 per cent of GDP to 210 per cent of GDP.”
He argued that means a large part of the growth that Australia has enjoyed since the GFC, while many other countries plunged into recession, has been fuelled by a 60 per cent rise in household debt.
“Ireland did the same thing when they called themselves the Celtic Tiger and they don’t call themselves that anymore,” he said.
“Spain was doing the same thing during its housing bubble and we’ve replicated the same mistakes.
“It is even worse for us, we are the last idiot on the block.”
He believes the Reserve Bank will be forced to take rates down to zero from their current level of 1.75 per cent as the economy continues to slow, but that will not stop the collapse of the credit binge that has kept the country afloat until now.
“[Lower rates] will suck more people in, it will suck more people in for a while and the [Reserve Bank] can delay this for a while by cutting the rates,” he said.
Government deficit worries overblown, Keen says
He said the catalysts for the recession were the declining terms of trade, the continued fall in investment into the economy and the Federal Government’s “stupid” pursuit of a budget surplus.
“The Government is frankly stupid about the economy and is obsessed about running surpluses when it is bad economics.”
A major round of government stimulus that takes the deficit to 10 or 15 per cent of GDP and a massive uptick in foreign investment, especially into housing, would allow the country to avoid a big recession, according to Professor Keen.
But he said neither options were politically palatable.
He said worries about huge government deficits were overblown.
“The Government is not like a household. A government is like a bank. And a government running a balanced budget is like a bank that simply lends back as much as it gets in repayments, therefore the money supply never grows and without that, you don’t have a growing economy,” he said.
Professor Keen, who was formerly an associate professor of economics at the University of Western Sydney and is now at Kingston University in London, says economists and governments around the world have their thinking completely wrong on the issue of budget deficits.
He said the best way to prepare for the coming recession was to sell assets and reduce debts, but he admitted that was the type of behaviour which could set off a credit crunch.

The Prince and The Fintech

Nicolo Machiavelli’s The Prince has been lauded for centuries for the wisdom it imparts about the actions and motivations of men and women in establishing and managing enterprises. Machiavelli sets the book in the form of how a Prince should manage or acquire a….. Principality of course. There is an argument that The Prince was written as satire and not meant to be taken seriously. The fact that Machiavelli dedicated the book and gifted it to a member of the Medici family after they sacked him from his important and well paid job would seem to add a little weight to this view. Let’s go with conventional wisdom that there’s usually more truth to satire than in a “how to” instruction book.
What’s a book written by an Italian in Venice in the 16th century about a satirised prince got to do with building a fintech? Everything and nothing as they say, but the reader can make up their own mind. I’m selecting some of Machiavelli’s more revealing quotes from The Prince and putting them in a modern context. Let’s see if we can make the connection, firstly from Chapter 6.

“A wise man (The Prince) ought always to follow the paths beaten by great men, and to imitate those who have been supreme, so that if his ability does not equal theirs, at least it will savour of it”

Nicolo is imparting his wisdom. When starting your fintech the smart founder should not just head-out blindly, stand on the shoulders of greatness. This does not mean that the fintech product should be only a marginal improvement on existing technology as true valuable innovation comes in leaps and bounds. Rather, look around for advice from those who have been through the process successfully and not so successfully. Get the value of their experience and not their opinions and put that solidly in the innovators plans.

From Chapter 6: “Let him (The Prince) act like the clever archers who, designing to hit the mark which yet appears too far distant, and knowing the limits to which their bow attains, take aim much higher than the mark, not to reach by their strength or arrow to such a great height, but to be able with the aid of so high an aim to hit the mark they wish to reach”

A bit of an inelegant description by Machiavelli but it was around 100 years before Newton’s theory of gravity was first published, so we should forgive him for not reaching for that analogy. The aim of our fintech should not only be to have lofty goals for her product and business but those goals should be fashioned to the limit of your ability and resources and beyond. By hitching a ride on existing systems which can extend your reach you can make these goals a reality. Use networks, existing sales infrastructure (but be careful), whatever tax incentives or government assistance is available but most of all where ever and whenever you can hitch a ride on anything that can catapult your business forward get on it, it’s way too hard to do it on your own.

From Chapter 6: “And it ought to be remembered that there is nothing more difficult to take in hand or more uncertain in its success, than to take the lead in a new order of things. Because the innovator has for enemies all those who have done well under the old conditions, and lukewarm defenders in those who may do well under the new……….Thus it happens that whenever those who are hostile have the opportunity to attack they do it like partisans, whilst the others defend lukewarmly..”

Machiavelli tempers the enthusiasm of aiming high with, perhaps his most famous quote, by pointing out how difficult a mission any fintech may take on. A fintech has no friends in the market you are trying to disrupt whether it’s good, bad or indifferent for the participants. Be prepared to be attacked and to have to deal with those attacks without support. A fintech must be resilient as well as all those who reside within her. On the positive side, all true innovation has to deal with a total lack of support and indifference and if this is not the case, perhaps the truth of the innovation should be questioned.

From Chapter 6: “It is necessary, therefore, if we desire to discuss the matter thoroughly, to inquire whether these innovators can rely on themselves or have to depend on others: that is to say, whether, to consummate their enterprise, have they to use prayers or can they use force? In the first instance they always succeed badly, and never encompass anything, but when they can rely on themselves and use force, then they are rarely endangered. Hence it is that all armed prophets have conquered, and the unarmed ones are destroyed”

This quote from The Prince is the immediate follow up to the oft quoted “innovator has for enemies” and is the real guts of the issue. Whilst understanding that all innovators face the same battles may make them feel a little warm inside and not alone, what do you do about it? Machiavelli lays it on the line here. Hope is not an option nor is a reliance on co-operation. The innovator must fight for herself and use every option to crush both opposition and indifference. There is no other way. So all innovators need to have right on their side. The right to provide a better deal to customers, the right given by the law to provide a product that improves society or the right to compete and crush the established rent seekers. All innovators must be prepared to fight and show no mercy.

From Chapter 17: ‘Mercenaries and auxiliaries are useless and dangerous; if one holds his state based on these arms he will stand neither firm nor safe; for they are disunited, ambitious and without discipline, cowardly before enemies, they have neither the fear of god nor fidelity to men, and destruction is deferred only so long as attack is; for in peace one is robbed by them, and in war by the enemy. The fact is, they have no other attraction or reason for keeping the field than a trifle of stipend, which is not sufficient to make them willing to die for you”

So what do you really think Nicolo? No time for mercenaries then? If the fintech innovator is going to fight she needs her soldiers, her employees, but they must be bought in and motivated. Without that they will be useless when the going gets tough. Every fintech is a target and every fintech needs to fight for its existence and future. Without employees with serious skin in the game these battles will be lost and employees will flee when the real pressure is applied and they have to step up and give the extra yard. Reliable employees, no matter how skilful, are those who have equity in the business and serious incentives to perform and be successful. No mercenaries, hangers on or employees and directors with free options and no accountability, because with that sort of back-up the fintech will fail.

Back to Chapter 6: “Therefore such as these (innovators) have great difficulties in consummating their enterprise, for all their dangers are in ascent, yet with ability they will overcome them; but when these are overcome, and those who envied them their success are exterminated, they will begin to be respected, and they will continue afterwards powerful, secure, honoured and happy”

Now the good news, whilst the fintech has many enemies, no support and has to fight every step of the way, with ability and motivated employees, these things can be overcome. Once overcome however, the fintech becomes entrenched with great rewards to the innovator and her employees. It’s much tougher to get to the top than one can imagine but once there the fintech is in a highly defensible position and therefore equally tough to be displaced. It’s a truism or existing systems would be in a constant state of chaos and unworkable.
So unleash the innovators, follow The Prince and fight to the top with those heavily motivated soldiers and you’ll never look back.

Graham Andersen
Founder and Executive Director

Level 3 | 10 Bond Street | Sydney | NSW 2000 | Australia
[P] +612 8197 1826 | [M] +61 438 696 600
graham.andersen@morgij.com.au | www.morgij.com.au | www.marqservices.com.

Half of big banks unprepared for accounting shake-up

Published by the Financial Times 14 Aug 2016
Caroline Binham and Emma Dunkley in London

Nearly half of big banks around the world are unprepared for an international accounting standard due to take force in less than two years, even as they expect provisions for bad loans to soar as a result of the new rules.

A poll of 91 banks across the globe — excluding US banks that are governed by their own rules — has found that 46 per cent of those surveyed do not believe they have enough resources to deliver changes by the 2018 implementation date, with a significant minority going on to say there were not enough skilled candidates in the market to hire.

With less than 18 months to go before the change, nearly two-thirds of banks are unsure how the rules might impact their balance sheets, according to Deloitte, which undertook the global survey.

The rules force banks to have a provision on their balance sheets for expected losses in the future rather than actual losses already suffered.

Those banks that have made the calculations reckon the rules will result in a surge of at least 25 per cent in total impairment provisions across all asset classes.

Banks are also forecasting that the rules, dubbed IFRS 9, will cause their capital ratios to deteriorate: they are expecting core tier one capital — one of the most keenly watched metrics of the health of a bank’s balance sheet — to decrease on average by half a per cent as a result of moving to the new standard, according to Deloitte.

Uncertainty is not limited to the banking industry: 99 per cent of respondents said their local financial regulator had yet to say how they might incorporate IFRS 9 numbers into regulatory capital requirements.

IFRS 9 is part of a suite of measures by the International Accounting Standards Board to overhaul accounting since the financial crisis. The reform package is an attempt to increase regulatory co-operation between the US and international standard setters. Converging the different corporate reporting frameworks has been fraught.

By moving from an “incurred loss” to an “expected loss” model in 2018, under IFRS 9 the regulators hope to avoid the problems that occurred during the crisis, when banks could not book accounting losses until they happened, even though they could see them coming. This should help to keep banks properly capitalised for the loans they have made.
UK banks have experienced historically low impairments recently because of the record low interest rate.
However, there are some concerns that if economic growth were to stall following the Brexit vote, impairments could go up even without the new rules.
Steven Hall at KPMG said the estimated increase in provisions as a result of IFRS 9 was actually “cautious”.
“IFRS 9 will be almost as difficult to implement as it is to say,” he said. “Firms need to consider a range of future scenarios, and in today’s uncertain economic environment assessing the impact of that is not an easy task.”
Mr Hall has called for a grace period during which the new systems might be tested and embedded.

Asymmetry of Information and Moral Hazard – a tale of securitisation past

A Review of “WORKING DOCUMENT”

“on Common rules on securitisation and creating a European framework for simple, transparent and standardised securitisation” – Committee on Economic and Monetary Affairs – European Parliament

Rapporteur: Paul Tang, 19.5.2016

Document link: http://www.europarl.europa.eu

The “Working Document” is a review of securitisation in Europe and the European Commission’s framework for reactivating the securitisation market through the creation of simple, transparent, standard securitisations (“STS”) by rapporteur, Paul Tang.

Mr Tang’s document provides a thorough analysis of the history of the structure of European securitisation, what went wrong and how to fix the weaknesses. Morgij Analytics is primarily interested in transparency failures, issues and fixes, so what does the Rapporteur have to say about securitisation and transparency?

What went wrong in the past was the creation of an asymmetry of information and a moral hazard that favoured issuers due to a lack of provision of detailed loan information in a standard format and from an easy to access portal.

Not only does the issuer know much more about the security itself, but also the credit quality of the underlying loans, the profile of the credit receivers, and the relative quality of the different tranches. By contrast, the buyer may not employ the resources to perform a detailed analysis of the underlying loans and of the structure, in particular for complex securitisation deals.

So what’s wrong with that scenario?

Securitisation incentives are very different for each market participant, which raises potential problems of conflicts of interests between parties(1). It has widely been recognised that the misalignment of interests can lead to “self-reinforcing dynamic between demand and supply” (ECB-BoE, 2014) that are not sustainable. Indeed, ample examples of moral hazard and misalignment of interests materialised before the crisis. It seemed that what could go wrong went wrong.

Clearly the evidence is that asymmetry of information between buyers and sellers leads to bad outcomes. So what role did the credit rating agencies play and surely these organisations were there to rebalance the asymmetry?

…investors relied on credit rating agencies (CRAs). Ratings by those agencies could have contributed to solving the asymmetry problem, but they did not. Overreliance led to failures on due diligences on the part of investors. Meanwhile issuers and rating agencies had aligned commercial incentives to ensure by all means that those products would be rated AAA.

Mr Tang’s findings reflect badly on the market operation at the time which relied almost exclusively on credit rating opinions with investors doing very little to no risk analysis of their own on securitised loan portfolios.

To further point to the effect of credit rating agency opinions on securitisations, security tranching whereby securities are issued according to different payment priorities, is also seen as being a high risk not assessed by investors due to a lack of data and information.

Tranches of different risk profiles are created in order to satisfy different risk appetites by investors. However, there is a clear trade-off involved with tranching a securitised asset portfolio. Tranching encourages reliance on ratings, stresses the robustness of modelling and exposes investors to human errors of judgement. In particular, tranching creates greater risk of modelling error, potentially with high impact for the smallest of errors(2),

Tranching of securitisations generates cliff edge risks since weakness at the bottom of a tranching structure can result in downgrades higher up the credit rating tranches which in turn can result in a fire sale of securities by investors. Unintended consequences for sure but a clear result of how a lack of transparency and asymmetry of information results in rated tranching structures to support high rated (AAA) securities which themselves are full of risk for investors even when no default occurs.

So how have regulators used these lessons of the crisis to improve securitisation markets? Unsurprisingly transparency initiatives figure highly in the STS initiative.

Key is to tackle the twin problem of asymmetric information and moral hazard. This requires transparency for each market participant, including supervisors, combined with clear responsibilities to give and/or acquire information.

And to this should be added “The asymmetry of information on the securitisation market will be better addressed through a due diligence regime, giving a clear responsibility to investors”

At this point we at Morgij Analytics were starting to despair at the lack of a practical solution. Very good statements of intent but most securitisation investors are not set up to deal with and analyse reams of data and information let alone dealing with the problems of collecting and storing such data. But Mr Tang does go further and recommends measures ignored in the original STS paper.

Your rapporteur believes that transparency on the securitisations and their underlying assets should be improved, for the benefits of supervisors, potential market participants and other stakeholders like academics, through a public register. That approach would reduce compliance costs and monitoring costs. A data repository would capture and aggregate information for markets to extract and analyse

A public register to collect and distribute data and information is an important recommendation which not only benefits those investors and market participants but also opens the door widely for financial technology companies to develop easy to use analytic tools which will provide interpretation of the data for those market participants that do not have the resources to develop tools themselves. Morgij Analytics, MARQ platform, is just such an easy to use tool, accessible through the internet, that analyses the risk of mortgages used as collateral in a securitisation.

Standardised, easily accessible data is the life blood for developing innovative solutions. Solutions, like MARQ, can greatly improve the confidence in and therefore the liquidity of securitisation markets.

In a number of jurisdictions, there are initiatives to make data available but these do not go far enough or the requirements to access the data make it both very difficult and restrictive.

The ECB has the European Data Warehouse but our rapporteur believes that this portal does not provide enough data being only loan and security level data. In Australia as per the UK, securitisation data is to be collected directly from the issuers. However, contractual and due diligence requirements mean that it’s very difficult or impossible for most market participants to get access to the data. Not only does that not instil confidence in the securitisation markets it stifles innovative fintechs from accessing the data to develop market solutions.

A big improvement for data access in Australia would be to have a one stop shop central registry and database where all market participants could have a single engagement point for all securitisations. Perhaps the RBA itself could create or mandate a not for profit entity to undertake this task? It would be simple enough now as the RBA collects all securitisation data which could be transferred to an accessible data base, just add other standard information and documentation and a solution presents itself.

Under the Government’s productivity policies it may be that the RBA already has an obligation to make the securitisation data it collects available to the market. Currently traditional credit rating agencies are in a favoured position because the RBA’s rules on repo eligibility ensure that only traditional ratings are accepted by the RBA. Those rating agencies collect data on all securitisations whether public or held internally and so enjoy a cosy government supported oligopoly at the expense of new innovative locally owned organisations that may be able to provide a new or better alternate solution.

So what does our rapporteur recommend in relation to credit rating agencies?

The CRAs will stay instrumental in determining the credit ratings of the tranches of a securitisation. Reinforcing the clarity of rating methodologies for securitisation and the disclosure of ex post performance of ratings should be the main goal in order to foster competition. Requirements to rotate for issuers should be strictly enforced and smaller CRAs should be systematically included in the multi-rating processes.

For the RBA to allow free and open access to alternate rating methodologies would certainly go a long way to allowing smaller rating agencies, exactly like Morgij Analytics, to be systematically included in the multi rating process.

Easy access to securitisation data and information by not only investors but alternate analytic service providers such as the MARQ platform, is key to overcoming asymmetry of information and moral hazard. A central, not for profit, registry is the recommended solution for accessing data and information.

Graham Andersen
Founder & Executive Director

 

(1) Report on asset securitisation incentives, The Joint Forum BCBS-IOSCO-IAIS, July 2011
(2) 
Securitisations: tranching concentrates uncertainty“, Adonis Antoniades & Nikola Tarashev, BIS Quarterly Review, December 2014