Martin North – Page 1014 – Digital Finance Analytics (DFA) Blog

Policy Responses In A Falling Market

The IMF just published a discussion paper looking at what happened in Spain, Ireland, US and Iceland after the 2007 crash. In some countries, as house prices fell (some as much a 50%) creating an negative equity situation, the main response was a default sale, whereas elsewhere other strategies were tried, sometimes with government assistance or intervention. With the benefit of hindsight, it appears that loan modification or restructuring offered the best path to economic recovery and provided better outcomes for individual households. Worth noting when the Aussie housing market finally turns!

A number of interesting variations to loan modification were found in the research:

Trial modification – A trial period allows borrowers to showcase their debt service commitment and provides time to further calibrate the efficiency of the loan modification terms, in particular when the recovery is ongoing. In the US, HAMP requires borrowers to enter into a 90-day Trial Period Plan, during which a Net Present Value test is carried out to determine whether the borrower can be offered a permanent loan modification.

Split mortgage – A split mortgage divides the original principal into a part that continues to be serviced in full and a warehoused part that falls due at a later time. The warehoused part may be charged interest. At maturity, this portion may be refinanced, repaid if borrower circumstances allow, paid off from the sale of the home, or written off.

Shared appreciation – A shared appreciation modification reduces the outstanding balance on a mortgage until the borrower is no longer underwater, while entitling the lender to a portion of any home price gain once the home is sold.

Earned principal forgiveness – Arrears or principal forgiveness necessary to ensure long term sustainability may be granted to borrowers that remain in good standing on their mortgage payments. In Ireland and the US, earned principal forgiveness schemes forebear interest on a portion of the loan which may subsequently be forgiven if the borrowers remain current on all debt service obligations.

Negative equity transfer – Products allowing the transfer of negative equity to a new mortgage give mortgagees in negative equity the opportunity to benefit from refinancing at lower rates or move to smaller homes, which may improve their overall debt servicing capacity.

Debt overhang in the aftermath of a systemic housing crisis can cause a weak and protracted recovery. The effects of debt overhang from excessive debt payment burdens or declines in household wealth can create negative feedback effects that hamper the recovery and increase the cost of a crisis. As in other downturns, monetary policy and social safety nets provide a first line of defense. In addition, policies that temporarily allow forbearance of lenders vis-à-vis borrowers and facilitate the modification of distressed mortgages can help to contain the undershooting of house prices by reducing the extent of foreclosure and associated deadweight losses and social costs. Systemic crises can affect the trade-offs involved in these policy choices and warrant policies that deviate from “normal” times. However, different country circumstances suggest there cannot be a “one-size-fits-all” approach, and policy formulation should take into account important country specific factors as well as the stage of the recovery.

Temporary forbearance offers breathing space during a crisis, but should be selective and time-bound. Forbearance can reduce household financial distress in the short run, helping households to adjust their consumption more smoothly. However, temporary forbearance can induce free riding and should only be considered in cases of sufficiently strong prospects for a recovery of the borrower’s debt service capacity. While forbearance can help to act as a circuit breaker at the peak of the crisis, it is important that lenders remain selective in granting forbearance and reach formal forbearance agreements in order to avoid an erosion of the debt service culture and to ensure that borrowers remain engaged. Temporary forbearance can also tie in with loan modification by serving as a “trial modification” and bridging a period of elevated uncertainty about future incomes and house prices.

Systemic housing crises can tilt workout choices from foreclosure towards loan modification. Foreclosures are costly and can have negative externalities on house prices. Negative equity and prospects for the recovery of borrowers’ income suggest that loan modification becomes a net present value efficient solution for a larger share of delinquent borrowers. However, renegotiation cost and other obstacles often obstruct loan modification.

Policies can help to facilitate loan modification. Frameworks for orderly debt renegotiation in form of a code of conduct for lenders dealing with distressed borrowers, together with an efficient statutory framework for personal insolvency, can shape expectations and improve coordination, thereby facilitating timely loan modification. Prudential policies can set appropriate incentives to encourage loan modifications and facilitate the use of innovative modification techniques. A temporary tax exemption could help to enable loan principal relief. Depending on the availability of fiscal resources, support could be provided for mortgage counseling and targeted incentive payments could promote loan modifications. However, experience from Ireland and the US shows that even with such policies, a significant number of mortgages can remain unsustainable and require foreclosure.

Efficient foreclosure procedures provide a resolution of last resort and an important incentive for constructive borrower behavior. In cases where constructive cooperation between borrowers and lenders breaks down, or where no sustainable loan modification would be net present value optimal, foreclosure must remain as last resort. Delays in foreclosure procedures have been found to increase defaults and overall workout costs. Instead, a temporary increase in foreclosure costs through fees or taxes could reduce lenders’ reliance on foreclosure as workout tool. To avoid a deterioration of credit service culture, protections from foreclosure should only be extended to cases where other solutions are likely sustainable (with exceptions for hardship cases), and a foreclosure threat needs to remain present to deter strategic borrower behavior.

Across-the-board debt relief is costly and may require intrusive government intervention. Across-the-board debt relief is sometimes considered as crisis measure as it can be implemented quickly and provides immediate relief to many mortgagees. However, the macroeconomic benefit of a broad-based debt reduction tends to be small relative to its cost, and blanket debt reductions are not well targeted to address debt servicing difficulties. Implementing across-the-board debt relief can also have negative ramifications for the supply of mortgage credit in the long run.

Is Higher Market Volatility The New Normal?

Chris Salmon, Executive Director, Markets, Bank of England, gave a speech “Financial Market Volatility and Liquidity – a cautionary note”. He suggests that financial market conditions have changed quite noticeably over the past year or so, with significantly higher volatility. For example, on 15 October and 15 January the immediate intra-day reaction to the news was unprecedented. The intra-day change in 10-year US bond yields was 37 bps, with most of this move happening within just an hour of the data release. The intraday range represented nearly eight standard deviations, exceeding the price moves that happened immediately following the collapse of Lehman Brothers. On 15 January, the Swiss franc appreciated by 14%. The intraday range was several times that number, and market participants continue to debate the highest traded value of the franc on the day.

Could such events could imply that a number of major asset markets may have become more sensitive to news, so that a given shock causes greater volatility? Is this the new normal?

If so, what is the root cause? We know the macroeconomic outlook has changed and perhaps become less certain. Central banks have reacted, and in some cases pushed the innovation envelope further. Unsurprisingly these developments have been associated with more volatile financial markets. Given that policy-makers have previously been concerned that persistently tranquil financial markets could encourage excessive risk-taking, this development is not necessarily an unwelcome development. But recent months have also seen a number of short episodes of sharply-higher volatility which coincided with periods of much impaired market liquidity. There are good reasons to believe that the severity of these events was accentuated by structural change in the markets. There must be a risk that future shocks could have more persistent and more widespread impacts across financial markets than has been the case in the recent past.

Whilst market intelligence suggests that uncertainty surrounding the global outlook has been one factor; itself in no small part a consequence of the unexpected rough halving in the price of oil since last summer. This uncertainty can be seen in the recent increase in the dispersion of economists’ forecasts for inflation in the US, UK and euro area during 2015. Central banks themselves have reacted to the changed global outlook and monetary policy makers have been active in recent months. Indeed, so far this year 24 central banks have cut their policy rates. Moreover, the decisions by the ECB and three other central banks since last summer to set negative policy rates have raised questions about where the lower bound for monetary policy exists.

But he suggests there are two other factors in play, which may indicate a more fundamental change, and lead to continuing higher volatility.

First, market makers have become more reluctant to commit capital to warehousing risk. Some have suggested that this reflects a combination of reduced risk tolerance since the financial crisis, and the impact of regulation designed to improve the resilience of the financial system. This reduction in market making capacity has been associated with increased concentration in many markets, as firms have been more discriminating about the markets which they make, or the clients they serve. And this trend has gone hand-in-hand with a growth in assets under management by the buy-side community. The combination has served to amplify the implications of reduced risk warehousing capacity of the intermediary sector relative to the provision of liquidity from market makers during times of market stress relative to the past.

The second is the evolution of the market micro-structure. Electronic platforms are now increasingly used across the various markets. In some cases regulation has been the cause but in others, such as foreign exchange markets, firms have over a number of years increasingly embraced electronic forms of trading. This includes using ‘request-for-quote’ platforms to automate processes previously carried out by phone. Electronic platforms are effective in pooling liquidity in ‘normal’ times but may have the potential, at least as currently calibrated and given today’s level of competition, to contribute to discontinuous pricing in periods of stress if circuit-breakers result in platforms shutting down. There has been much commentary about the temporary unavailability of a number of electronic trading platforms in the immediate aftermath of the removal of the Swiss franc peg.

Regulatory Changes And The Fixed Income Market

Guy Debelle, Assistant Governor (Financial Markets) gave a speech on “Global And Domestic Influences on the Australian Bond Market.” He covered some of the important up coming regulatory changes.

One global development that has garnered a large amount of comment of late is the effect of reduced market-making capacity in fixed income. The Bank for International Settlements (BIS) Committee on the Global Financial System (CGFS), issued a report on this topic late last year. That report documents the intended effect of regulation in bringing about this reduction. There is a debate as to whether the reduction has gone too far, but the fact that market-making activity is lower than it was pre-crisis is a desirable outcome given liquidity risk was under-priced pre-crisis.

Rather than describing it as a reduction in market-making, I think it is more useful to think of it as a reduction in the risk-absorption capacity of intermediaries. Their ability to warehouse portfolio adjustments of asset managers is curtailed. In the past, asset managers were dealing bilaterally with individual trading desks that each had their own limit. Now these limits are applied holistically across the trading desks so that selling one part of a portfolio to one desk will reduce the capacity to sell another part of the portfolio to another desk in the same institution. Asset managers need to take account of these changes in market dynamics in thinking about how they adjust their portfolios. Transactions costs are higher and, in particular, liquidity costs are higher. I am not sure that all market participants have fully appreciated this yet and are fully cognisant of the impact of the post-crisis changes.

The second development to note is in the asset-backed security space. As many of you know, as of 30 June this year, the Bank will introduce mandatory reporting requirements for repo-eligible asset-backed securities (ABS). The Bank continues to work with the industry to ensure the timely implementation of these requirements. The required information, which must also be made available to permitted users, will promote greater transparency in the market, supporting investor confidence in these assets. These requirements will also provide the Bank with standardised and detailed data on ABS, which are a major part of the collateral eligible to be used under the CLF.

In preparation for the introduction of these reporting requirements and to facilitate industry readiness, the reporting system for securitisations was made available for industry testing in November 2014, with voluntary reporting accepted from 31 December 2014. The Bank is currently working with a number of institutions undertaking test submissions, with some institutions expecting to commence regular reporting shortly. The industry is strongly encouraged to undertake testing early to ensure readiness for the commencement of mandatory reporting on 30 June 2015.

The third development is the proposed changes to the settlement convention to T+2 for over-the-counter (OTC) transactions in domestic fixed income securities. The Bank strongly encouraged this initiative. The current standard of T+3 settlement in the Australian market compares unfavourably with many other jurisdictions that have already progressed to shorter settlement cycles for OTC transactions in their domestic fixed income markets. A shorter settlement cycle will reduce the risks associated with settlement, in particular, counterparty risk. Market makers in OTC fixed income securities may particularly benefit from the reduced period of counterparty exposure, as any given trade will count towards internal credit limits for a shorter period of time. This could boost market turnover and trading capacity for participants. Further, moving to T+2 is likely to encourage straight-through processing, which could reduce the risk of an operational issue affecting the settlement of OTC fixed income securities. Ideally, this would be implemented by the end of 2015.

GE ANZ Consumer Lending Business Sold

GE Capital has sold its Australian and New Zealand consumer lending business to a consortium in a deal valued at US$6.3 billion. This transaction, which needs regulatory approval, will see its three million customers transferred to KKR (the lead bidder), Deutsche Bank and Varde Partners.

The GE business provides personal loans and credit cards to consumers in Australia and New Zealand, as well as interest-free financing for products sold by local retail partners including homewares and electrical-goods retailer Harvey Norman. GE Capital will keep its commercial-finance unit, which provides loans and leasing to midsize businesses in Australia and New Zealand.

Other bidders who missed out, included Apollo Global Management which was a consortium that included Macquarie Group and Pepper Australia and a syndicate headed by TPG Capital, which industry observers had viewed as the most likely winner.

GE is focusing on its industrial businesses in Australia & New Zealand.

The WSJ commented

“the sale of the Australian unit also follows a trend of global banks looking to sell down their consumer-finance businesses as they focus on core operations and free up capital. Standard Chartered PLC in December agreed to sell its consumer-finance units in Hong Kong and Shenzhen as part of its strategy to dispose of noncore businesses, as the Asia-focused lender battles with declining profits and slower growth.

Earlier this month, Citigroup Inc. agreed to sell consumer-finance unit OneMain Financial for $4.25 billion to Springleaf Holdings, as the sprawling global bank continues to pare its operations in the wake of the financial crisis.”

Latest Lending Data Investment Boom

The ABS released their Lending Data to January 2015. The recent trends continue, with a growing investment housing lending sector, at the expense of other commercial lending. In trend terms, The total value of owner occupied housing commitments excluding alterations and additions rose 0.8%. The trend series for the value of total personal finance commitments fell 0.1%. Revolving credit commitments rose 0.2%, while fixed lending commitments fell 0.3%. The trend series for the value of total commercial finance commitments rose 1.1%. Revolving credit commitments rose 6.6%, while fixed lending commitments fell 1.0%. The trend series for the value of total lease finance commitments fell 2.5% in January 2015.

We see a slight fall in relative terms in commercial lending, (and in this data. lending for investment housing is included in the commercial category. )

But, splitting out the investment housing we see that more than 31% of all commercial lending is for investment housing – and note the consistent trend up from 19% in 2011.

Turning to housing lending, we see investment loan flows were more than 51% of all new loans written (excluding refinance).

In other words, more investment loans than owner occupied loans were written in January 2015.

Finally, looking across all housing categories, we see that investment loans made up 41%.

This momentum in investment lending continues to distort the market. We need proactive intervention, like the recently announced initiatives in New Zealand. I have to say I think APRA is just not cutting the mustard.

US Rates To Stay Low, Thanks To Dollar – Moody’s

According to Moody’s latest, conceivably, dollar exchange rate appreciation might substitute for a fed funds rate hike. All else the same, the need for a higher fed funds rate recedes as the dollar exchange rate strengthens. A persistently strong dollar is likely to weaken the pricing power of US businesses and labor. Since bottoming in the summer of 2011, the US dollar has soared higher by a cumulative 29% against a basket of major foreign currencies. In the context of an economic upturn, the dollar’s ongoing ascent is the steepest vis-a-vis major foreign currencies since the cumulative 31% surge of the five years ended 2000, or when core PCE price index inflation grew by merely 1.6% annualized, on average, notwithstanding real GDP’s comparably measured growth rate of a scintillating 4.3%.

Lately, the strong dollar has put downward pressure on the prices of US exports and imports. February 2015’s -5.9% annual plunge by the US export price index was the deepest such setback on record for a mature US economic recovery. The dollar’s earlier surge of the five-years-ended 2000 saw the US export price index slide by -0.8% annualized, on average. Moreover, February’s price index for US imports excluding petroleum products fell by -1.8% annually. Expect more of the same according to the -1.3% average annualized drop by the US core import price index during the five-years-ended 2000.

Is Low Inflation Good Or Bad?

Mark Carney, Governor, Bank of England, gave a speech on Inflation. I have summarised his arguments in this post because the current low inflation rates around the world have profound implications, and current inflation targets and assumptions reflect earlier responses to hyper inflation, which may not be so relevant now. That said, low inflation appears to carry significant risks, and low interest rates do not help.

16 of 18 inflation targeting economies had inflation below target in January 2015. These include US, UK, Canada, euro area, Norway, Sweden, Switzerland, Australia, China, India, Indonesia, Malaysia, New Zealand, Philippines, South Korea, Taiwan, Thailand and Brazil. 11 of those countries have inflation rates below 1%.

For example, the Reserve Bank of New Zealand, said yesterday:

“Annual CPI inflation is expected to fall to around zero in the March quarter and remain low over 2015, reflecting the high exchange rate, low global inflation, and the recent falls in petrol prices. Inflation expectations appear to have fallen recently, and we will be closely monitoring the impact of this trend on wage and price setting behaviour, especially in the non-traded sector.”

There are some significant implications of this low inflation environment, especially bearing in mind that these countries are using central bank monetary policy to try and wrangle inflation above 2%. This 2% inflation seems to reflects the lessons of the past, including the fight against high inflation in the 1970s and 1980s, as well as the deflationary disasters that have followed past financial crises. The target is set by government, but managed by the central bank. Indeed, the banks have to explain to the politicians if inflation falls outside the target band. Mark Carney has just written an open letter to the UK Chancellor addressing the current low inflation there.

Whilst high inflation damages growth, in part, because high inflation also tends to be volatile, generating uncertainty that makes important economic decisions more difficult. In contrast, a little inflation ‘greases the wheels’ of the economy, helping it to absorb shocks. A positive average inflation rate also gives monetary policy space to respond to negative shocks by cutting interest rates. Persistently low inflation can be difficult. Deflation proper is potentially dangerous. During the Great Depression, sharp falls in prices reinforced collapsing output and skyrocketing unemployment.

A commonly cited reason is that falling prices prompt households and firms to delay spending and investment. The subsequent reduction in demand causes further reductions in prices through higher unemployment. That further reduces incomes and spending, drawing the economy into the vortex. But there is a more clear and present danger arising from the balance sheets of households and firms should deflation persist. When a household takes out a mortgage or a firm secures a loan, the amount owed is denominated in cash terms – that is, not adjusted for inflation. Unexpected, generalised, and persistently falling prices then mean the real value of debt increases: the same amount of money is owed, but that money now buys more goods and services. As a result, more consumption or investment needs to be foregone to service the debt. This debt-deflation dynamic was at the core of the Great Depression and in the Japanese malaise following the collapse of the asset bubbles of the 1980s. It would be a particular concern if the pace of wage growth were to follow prices down.

Whilst falling oil prices have impacted inflation, even “core inflation” which strips out such volatile factors continues to fall.

In some major economies there are additional disinflationary forces. For example, in the euro area, a series of necessary internal devaluations are weighing on wages and prices. In China, a rebalancing of investment and consumption risks generating further disinflation. The producer price inflation rate has been negative for 35 months in a row, reflecting long-standing overcapacity in industries such as concrete and steel, while the more recent weakness in the property market could further increase excess capacity in related sectors. All this suggests a persistent period of low inflation globally is a possibility, and could itself create a self-fulfilling fear of a bad outcome. Concerns that household or government debt will weigh on demand could cause firms to delay further their already weak investment spending. Such rational corporate caution is consistent with the behaviour of many financial asset prices, which appear to be pricing the possibility of material downside tail risks, such as that economic weakness and persistently low global inflation become mutually reinforcing. Those expectations matter as they feed into the wage and price setting processes that ultimately determine inflation.

Protracted global weakness could heighten the challenge of returning inflation quickly to target. That’s because weak global conditions would tend to push down on the equilibrium interest rate that would maintain demand in line with supply and inflation at the target. This equilibrium rate has likely been falling for the last three decades and turned sharply negative in the downturn. This meant central banks had to turn to unconventional policy tools to stimulate their economies in order to return inflation to target. In the cases of the UK and the US, these measures have been effective in supporting domestically generated inflation. Inflation is likely still to be negative in many countries, reflecting an excess of saving over investment.

RBNZ Left Rate Unchanged

The NZ Reserve Bank left the Official Cash Rate unchanged at 3.5 percent.

Global financial conditions remain very accommodative, and are reflected in high equity prices and record low interest rates. However, volatility in financial markets has increased since late-2014 following the sharp drop in oil prices, continued uncertainty about the global outlook and US monetary policy, and policy easings by a number of central banks.

Trading partner growth in 2015 is expected to continue at a similar pace to 2014. Growth remains robust in the US, but has slowed recently in China.

World oil prices are about 50 percent below their June-2014 peak, more reflecting increased supply than demand factors. The fall in oil prices is net positive for global economic growth, but will further reduce inflation in the near term, at a time when global inflation is already very low.

The domestic economy remains strong. The fall in petrol prices has increased households’ purchasing power and lowered the cost of doing business. Employment and construction activity are strong. Net immigration remains high, and monetary policy continues to be supportive. The housing market is showing signs of picking up, particularly in Auckland. However, there are a number of factors weighing on domestic growth, including drought conditions in parts of the country, fiscal consolidation, reduced dairy incomes, and the high exchange rate.

On a trade-weighted basis, the New Zealand dollar remains unjustifiably high and unsustainable in terms of New Zealand’s long-term economic fundamentals. A substantial downward correction in the real exchange rate is needed to put New Zealand’s external accounts on a more sustainable footing.

Annual CPI inflation is expected to fall to around zero in the March quarter and remain low over 2015, reflecting the high exchange rate, low global inflation, and the recent falls in petrol prices. Inflation expectations appear to have fallen recently, and we will be closely monitoring the impact of this trend on wage and price setting behaviour, especially in the non-traded sector.

Monetary policy remains focused on ensuring inflation settles at 2 percent over the medium term. As the economy expands, inflation returns gradually towards the midpoint of the target range.

Our central projection is consistent with a period of stability in the OCR. However, future interest rate adjustments, either up or down, will depend on the emerging flow of economic data.

Reforms To Offshore Banking Units

On 6 November 2013, the Government announced that it would proceed with certain reforms to the Offshore Banking Unit (OBU) regime.These reforms address a number of integrity concerns with the existing regime while ensuring the OBU regime targets mobile financial sector activity. They are now seeking input on proposed changes. Consultation closes for submissions on Wednesday, 8 April 2015

By way of background, an OBU is a notional division or business unit of an Australian entity that conducts OBU activities. To be considered as an OBU, an entity must be declared by the Treasurer as an OBU. An OBU receives concessional tax treatment in respect of eligible OB activities, provided additional criteria are met. One kind of eligible OB activity is a trading activity. Amongst other things, trading activity includes trading with an offshore person in shares, securities and units of an offshore entity, as well as options or rights in respect of these shares, securities and units. As a result, trading in the shares, securities or units (or the associated options or rights) of an offshore subsidiary may constitute an eligible OB activity. This has the effect of allowing the conversion of ineligible non-OB activities to eligible OB activities. That is, the offshore subsidiary may undertake ineligible activities and the OBU may claim the same economic benefit as assessable OB income by trading in the shares it owns in the subsidiary.

Potential activities which could be included:

Unfunded lending activities (Unfunded lending is where an OBU makes funds available to an offshore person but the funds are not drawn down, or are yet to be drawn down. Income in the form of fees for making the credit available is mobile income and will be treated accordingly as assessable OB income.)
Syndicated lending activities (A syndicated lending arrangement involves a number of financial institutions lending to a borrower. Syndicated arrangements are common in large capital raisings. In addition to committing to lend their own capital, an OBU may be involved in arranging contributions from a syndicate of other lenders. The OBU may also be involved in underwriting some of the credit risk. The OBU will earn a fee for these services.)
Guarantee activities and connections with Australia
Trading in commodities
Securities lending and repurchase agreements
Non-deliverable forward foreign currency contracts
Portfolio investment asset percentages
Advice on disposal of investments
Leasing activities

The proposed amendments in the draft Bill are:

limit the availability of the OBU concession in certain circumstances where it could otherwise be used to convert ineligible activity into eligible activity by trading in a subsidiary;
codify the ‘choice principle’ to remove uncertainty for taxpayers;
introduce a new method of allocating certain expenses between the operations of a taxpayer’s domestic banking unit and the OBU;
modernise the list of eligible activities; and
treat internal financial dealings (for example, between an Australian bank and its offshore branch) as if they were on an arm’s length basis.

The proposals are likely to lead to greater transparency and clarity, and will offer less wriggle room for financial engineering. Though the changes are mainly technical in nature there could be some implications for banks in Australia.