Anyone who’s dug into the 2008 financial crisis knows the role that bundling and selling subprime housing loans played in bringing the world to the brink of economic collapse – out-of-control behaviors well-depicted in the movie “The Big Short.”
But one thing I hope “The Big Short” doesn’t do is further tarnish the image of subprime lending.
Despite their poor reputation, such loans remain a key tool in easing the housing affordability crisis and expanding the availability of mortgages to low-income Americans seeking to realize the dream of homeownership. They also can help policymakers cope with the growing ranks of the homeless.
I’ve been studying the world of subprime in recent years, and these are some of the lessons from my current and past research. First, we need to fix the subprime mortgage market, so that the ways in which it contributed to the financial crisis aren’t repeated.
Shocking levels of homelessness
Los Angeles, New York and other cities in America are struggling to cope with the problem of homelessness and the lack of affordable housing.
On a single night in January 2015, more than 560,000 people nationwide were homeless – meaning they slept outside, in an emergency shelter or in a transitional housing program. Almost a quarter were children. Meanwhile, homeownership is hovering at 20-year lows, while about half of renters struggle to pay their landlords.
Last fall, Los Angeles Mayor Eric Carcetti asked the City Council to declare “a state of emergency” on homelessness and committed US$100 million to solving the problem, suggesting that subsidies would play a role.
But a focus on rental subsidies to solve homelessness and other affordable housing issues has adverse consequences, as evidenced by New York’s experience.
Its cluster-site housing program, in which privately owned apartment buildings are used to house homeless families when the city’s shelters are full, relies on such subsidies. But because the city typically pays market rents (or more), many landlords responded by pushing out regular (and low-income) tenants in favor of this steady stream from the government.
Such programs reduce the overall supply of affordable units, crowding out other groups in need. As more affordable housing units are allotted to the homeless, there are fewer available for low-income residents who don’t qualify for those programs and are at risk of becoming homeless themselves.
Fortunately, Mayor Bill de Blasio aims to phase out the costly program over the next three years.
While there are many other approaches to tackling homelessness, they rely on addressing an important underlying problem: the housing affordability crisis. It may seem improbable, but subprime lending could help ease the housing affordability crisis.
The role of subprime lending
The relationship between homelessness and the strains in the housing rental market is well-known: when there are more rental vacancies available, homelessness decreases (I survey the academic findings on the topic here).
This suggests that if we reduce home affordability problems, we can effectively reduce homelessness.
A powerful tool to help ease the housing affordability crisis is subprime mortgage lending – defined as loans made to borrowers with credit scores below 640.
The idea is simple: by helping more low-income tenants qualified to take out a subprime mortgage become homeowners, there’ll be more affordable rental housing available for everyone else. More supply on the market helps reduce average rents, which in turns helps more of those pushed to the streets afford a roof over their heads with less government aid. Thus this makes the policies still based on rental subsidies more effective.
However, this idea cannot be implemented until we fix the subprime mortgage market. As you can see from the graph below, the market has not yet recovered from its collapse in 2008.
The subprime market has yet to recover from its collapse.Inside Mortgage Finance, Author provided
One of the reasons the market collapsed was that investors lost confidence in the ability of loan originators and regulators to use credit scoring models to accurately assess a borrower’s creditworthiness – remember the NINJA loans (no income, no job, no assets)?
This market won’t be back up and running at full strength – and able to help address the affordability crisis – until these credit-scoring models improve and mechanisms are put in place to ensure loan quality remains adequate.
The FHFA sets new goals
There has been some movement to get the subprime market moving again.
The Federal Housing Finance Agency (FHFA), an independent federal agency that regulates Fannie Mae, Freddie Mac and the 12 Federal Home Loan Banks, recently set goals for the next two years meant to expand the availability of mortgages to low-income buyers.
This policy will keep its focus on helping a small segment of borrowers with incomes no greater than 50 percent of their area’s median income to purchase or refinance a single-family home.
But many affordable housing advocates expressed concern that these targets do not go far enough. The Woodstock Institute – a leading research and policy nonprofit organization focused on fair lending, wealth creation and financial systems reform – for example, argued that the policy won’t do enough to promote affordable and sustainable home ownership for low-income families.
How to bring back subprime
Even with the FHFA embracing the idea of expanding the availability of subprime mortgages to low-income buyers, their perceived role in the 2008 crisis and bringing down the housing market may cause justifiable resistance from the general public as a means of tackling the affordability crisis.
And one cannot blame this reaction, as it was the average American taxpayer who bailed out the reckless financial system, brought down by greedy bankers and weak politicians and regulators.
So how we can encourage more subprime lending while avoiding a repeat of 2008? In my recent research, I suggest a few ways to do this.
One of the reasons subprime loans became such a problem in the run-up to the crisis is just the sheer volume (see the boom in subprime lending from 2001 to 2005 in the above graph). This expansion was fueled by the generous homeownership subsidies given to low-income households.
One way to help prevent this is to vary the size of the homeownership subsidy countercyclically to control the amount of credit flowing into the economy and prevent overborrowing during expansionary periods. It would be higher at times when the housing market contracts, and lower when it’s booming.
Another problem was that lenders had an incentive to originate mortgages to borrowers who couldn’t afford them because all the risk was passed along to banks and other investors through collateralized mortgage obligations (CMO) and other sophisticated financial instruments.
The Federal Reserve in conjunction with other regulators could reduce this risk by carefully monitoring how many mortgages lenders keep in their own portfolios. When the share lenders hold increases, they have more incentives to better screen borrowers and thus originate better mortgages.
Lastly, the so-called adverse selection problem on the part of the mortgage originator in the secondary market should also be taken into account. This problem occurs when the mortgage originator has more information about the quality of mortgages that are securitized than the secondary market investors who snap up the CMO. That allows the originator to keep the low-risk mortgages in its own portfolio while distributing the high-risk mortgages to investors.
Improving existing credit scoring models is crucial to ameliorating this problem. Also, the Fed should more carefully monitor the quality of mortgages that are sold to investors and share its information with them. At the very least, that would reduce the investors’ information disadvantage with respect to originators.
Accompanied by the right means to regulate the housing market, we can support subprime while avoiding the disastrous outcomes highlighted in “The Big Short.“ And we can create an environment in which making low-cost mortgages available to people helps resolve the problem of unaffordable housing and homelessness.
Author: Jaime Luque, Assistant Professor, Real Estate & Urban Land Economics, University of Wisconsin-Madison
There is much confusion about the effects of Labor’s tax proposals with respect to investors in rental housing. They propose to grandfather existing arrangements. But investors in the future can only negatively gear newly constructed housing, while the policy recommends the capital gains discount fall from 50% to 25%.
Claims by Prime Minister Malcolm Turnbull that house prices will collapse appear to be contradicted by his assistant treasurer Kelly O’Dwyer who claims that housing costs will soar. These puzzling assertions arise due to a failure to distinguish between the market in rental housing, where housing is leased, and the market in which investors and owner occupiers buy and sell housing. Critically these two markets are interrelated.
To see why, consider the first round effects of Labor’s proposals when we put the grandfathering arrangements to one side (for the moment). Some existing investors will sell up when leases come up for renewal. There are now more tenants seeking rental housing opportunities than there is supply to meet their demand. Rents will begin to rise.
But the houses which investors quit add to the properties available for sale; there are now more houses available for purchase than there are buyers. House prices will begin to fall.
These market signals trigger a second round of effects. Some tenants will elect to buy rather than rent. After all renting has become more expensive and home ownership has become cheaper. These second round effects help to put a floor under falls in house prices, and help cap rent rises.
By considering the inter-relationships between the two markets we can understand how the government has issued apparently contradictory statements. Rents will rise and so the housing costs of tenants will increase. But there will be falls in house prices (or more likely a slower growth in prices); while existing owners take a hit, first home buyers housing costs are lower and attainment of home ownership becomes more affordable.
The second round effects mean that impacts are likely to be muted. This is made even more likely by a grandfathering proposal that should prevent a stampede by existing investors seeking to relinquish their property investments.
A disappointing aspect of the debate so far has been its neglect of the longer term structural consequences of Labor’s suggested reforms. Our current arrangements encourage high tax bracket investors to take on debt in the “chase” for capital gains. Capital gains are leniently taxed as compared to ordinary sources of income, such as earnings and rents.
Only 50% of capital gains are added to assessable incomes. This is particularly attractive to high tax bracket investors. Moreover, they are taxed on realisation rather than as they accrue. The shrewd investor realises the gains when assessable income from other sources declines; for example, following retirement when the investor’s marginal tax rate commonly falls.
There are not enough high tax bracket investors willing and able to invest in all our private rental housing stock. They tend to cluster in those segments of the market where healthy capital growth is expected, but rental yields are lower. Low tax bracket investors tend to cluster in segments where capital growth is expected to be subdued. Typically these are areas with lower house prices. To ensure adequate returns rental yields have to be higher in these low house price segments.
We therefore get a distorted investment pattern that disadvantages the supply of affordable rental housing.
Labor’s proposals will curb these distortionary effects by reducing the capital gains discount. They will also reduce the tax incentives to leverage investments. Rising indebtedness is a threat to the resilience and stability of our housing market.
Many believe that repayment and investment risks carried by heavily indebted home buyers played a central role in precipitating the global financial crisis. Tax concessions that favour taking on debt exacerbate those risks. If Labor’s proposals succeed in attracting attention to these and other structural problems that plague Australian housing markets, they will have a much wider significance.
Author: Gavin Wood, Professor of Housing, RMIT University
Journalism is in an existential crisis: revenue to news organisations has fallen off a cliff over the past two decades and no clear business model is emerging to sustain news in the digital era.
In the latest in our series on business models for the news media, journalist and academic Jane Singer looks at the use of micropayments.
Once upon a time, the gap between the relatively low supply of something in high demand – timely and trustworthy information – generated enormous profits for news publishers. But over the past 15 years or so, the digital, social and mobile revolutions have all but obliterated that gap.
In response, publishers have scrambled for new revenue streams, and much recent attention has turned to “micropayments” – the payment of a very small amount to access a comparably small bit of content, such as a single story.
The traditional media world is one of bundled information, with a lot of diverse content in one package that aims to provide something for everyone. The digital world, though, is an unbundled one. It enables each individual to select one item at a time from among the billions of things on offer. Are we willing to pay for this content? Sometimes yes – see iTunes.
But the question for news outlets is whether personalised news can follow the lead of personalised entertainment in generating interest and – in their fondest dreams – income.
Blendle is poised to take on the US market.Blendle
So far, news micropayment initiatives are – at best – a work in progress. The most buzz has been around a Dutch service called Blendle, which claims half a million registered users in Europe and is poised to tackle the US market. Most items on Blendle, which come from diverse outlets, cost between 10 cents and 90 cents and come with a money-back guarantee: you only pay for stories you actually read – and if you then don’t like them, you can ask for your pennies back.
The slick interface appeals to fans, as does the lack of advertising (and advertising’s attendant clickbait). But others have flatly predicted the concept is doomed to fail. News consumers want to pay nothing, they say, and even a very small amount of money is not nothing.
Who pays the piper?
But perhaps the model here is not an “iTunes for journalism”, if by journalism we mean big-name branded content. Perhaps a crowdfunding site such as Kickstarter offers a better template – the ability for users to stack their coins behind ideas they want to see developed rather than existing stories they want to read.
Experiments with crowdfunded journalism have proliferated. One flavour is essentially a low-cost membership model that allows its member – or donors – to steer journalists to topics of interest. MinnPost, a non-profit site in Minnesota, has made good use of this approach. For instance, a New Americans beat, which covers the state’s immigrant and refugee communities, was launched last October based on pledges from interested donors.
In Scotland, a new investigative journalism site called The Ferret also pursues topics that its users say they want; fracking was an early example. And in the Netherlands, de Correspondent drew donations of more than a million euros in just eight days simply on the promise of delivering high-quality stories about important topics rather than “the latest hype”.
The other approach reverses the process, in a way, and is closer to the familiar crowdfunding concept – journalists propose ideas they would like to pursue and users back the ones they like. Stories that meet their funding target get written; those that don’t, don’t. Perhaps the most innovative example came from a British site called Contributoria, backed by the Guardian Media Group. Over a period of 21 months in 2014 and 2015, Contributoria published nearly 800 articles on topics from urban regeneration in Beirut to a day in the life of a bookie; its writers earned a total of £260,000 over that time, most of it built up from quite small individual payments.
Sustainability
However, such experiments have proved hard to sustain. Contributoria closed in October 2015, with its co-founder declaring that crowdfunding was just one piece of the puzzle. What the initiative really showed, he told journalism.co.uk, was that people have a “voracious appetite … to be part of the journalism process, including the way it gets financed”.
Perhaps that is, for now, the takeaway point on micropayments. The desire being given voice is less about paying for journalism than for having a stake in it. News organisations fervently hope that stake will be financial, but for users, “ownership” of the news seems more important than the payment involved.
As information proliferates wildly, consumers are saying they want a sense of control over it. Digital media gives them the ability to be reporters, but mostly, they seem to want to be editors: the gatekeepers who decide what news they will see by commissioning a freelance article, or steering an investigative team toward a topic, or engaging with this niche news app but not that one.
Getting the mix right
For news organisations, then, micropayments are just one option among many in a fragile and fractured digital ecosystem – something to add to the revenue mix if doing so requires only small investments of time, effort or money.
While experimentation is all to the good, the pay-off from this option seems inherently small. The vast majority of online users do not pay now for digital news and have no plans to change their ways. There’s no evidence of a massive demand from users for the ability to pay upfront to read news content – and, even if there were, the small amount of revenue generated on any given day would fluctuate considerably depending on what was on offer. This is not the most desirable funding model for organisations that need a stable financial base to support staff, infrastructure and the ongoing ability to hold the powerful to account.
The reverse option – enabling news consumers to steer the direction of journalistic investigations – seems more plausible and the various non-profit enterprises I’ve mentioned are among those offering examples of ways this might work.
But news users aren’t the only ones who like to be in control. Journalists tend to be fiercely committed to the notion of editorial independence – which is another way of saying that they like to decide for themselves what is and isn’t news. Whether they will be willing to share that control – and, if so, what they might be able to extract from users in exchange – remains to be seen.
Author: Jane B. Singer, Professor of Journalism Innovation , City University London
As part of its innovation agenda the Coalition government is offering a tax offset of 20 cents for every dollar invested into a startup, as well as an exemption from capital gains tax for up to 10 years. However, it has emerged that this incentive could be limited to only ‘sophisticated’ investors, defined as those earning more than $250,000 per annum or having a net worth of more than $2.5 million.
Placing this restriction on startup investment could potentially disadvantage a key group of seed capital providers namely family and friends or informal investors. Family and friends provided $66 billion of startup capital to emerging ventures in the United States This is about three times more than either venture capitalists or professional angel investors.
Many of today’s largest listed US companies took seed capital from informal investors. For example Whole Foods Market, a $10 billion American organic food company, was started with founder savings and capital provided by family and friends.
These investors each provide anywhere between $1,000 to $30,000 in seed funding, yet many of them would not qualify as sophisticated investors under the Australian government’s definition.
Australian startups face serious challenges in accessing capital at almost every stage in their growth cycle. In particular, difficulties in accessing seed capital, needed to help turn an idea into an operating business, appears to be a critical road block for many aspiring Australian entrepreneurs.
For example, one in five startups cite restricted access to capital as a major barrier to innovation.
So where can startups access very early stage capital? It appears the sources are limited. The latest data from the Australian Venture Capital Association shows that very few seed investments are made in Australia by venture capitalists.
Further, the angel and incubator community is only just emerging, with only about 12 active groups across the country. This further points to the important role that informal investors can play in filling the capital cap that occurs at a venture’s seed stage.
It is true that informal investors stand to lose a greater proportion of their wealth in comparison to high net worth individuals when investing in startups. However another important innovation agenda reform, equity crowdfunding whereby ordinary mum and dad investors can take an equity stake in a startup through an online portal, would allow them to diversify their risks across many ventures, beyond those in which they have personal connections.
With this in mind, there are several reasons to believe that encouraging, rather than penalising small unsophisticated investors, is an important step to help young Australian startups to grow.
Family and friend investors have a personal connection with the founder, and typically will invest out of loyalty, trust and a belief in the founder’s ability. Such relationship characteristics are difficult to replicate with professional investors, who will often price down a company’s value to account for the possibility of moral hazard or unscrupulous founder motives.
In fact, if a start-up can grow through family and friend investments, often venture capitalist and angels become more inclined to offer follow-on funding, because the fact that informal investors have put their trust (and money) in the founder is a strong signal of the entrepreneur’s integrity and ability.
Bringing on formal or sophisticated investors too early can also stifle innovation. Venture capitalists are certainly not patient. They look for an exit in five years. Angel investors are a little more patient, but still look at a 10 year time frame. Often developing an innovative business can take much longer. For example, Glenn Martin the founder of Martin Jetpack, a Kiwi startup that listed on the ASX last year, first started work on the jet pack in 1981.
Further, a slower start to a venture is often a safer start, where the entrepreneur can take a “try it, fix it” approach and has ample opportunity to correct errors from poor decisions. Informal investors are more likely to be hands-off in their investment approach and thus far more likely to tolerate such an uncertain environment.
On the other hand, professional investors are much more hands-on and may prefer the safe proven routes learnt from previous investments, when in fact an experimental try-it, fix-it approach may be more conducive to innovation.
In order to ensure that our taxation system creates incentives that promote a successful startup ecosystem, careful consideration should be given to how early stage ventures are developed in other successful startup environments.
The Australian government’s efforts to recently secure a “landing-pad” in San Francisco’s highly successful RocketSpace hub, is exactly the kind of initiative that will help Australians learn how to foster a more vibrant domestic startup ecosystem.
While this will not directly address the seed capital gap, helping founders to access valuable networks and to develop their ideas through co-working with others, will certainly enhance their future capital raising capabilities.
Author: Jason Zein, Associate Professor, UNSW Australia
In the United Kingdom, Transport for London (TfL) enables people to pay for their tube, train or tram journeys with a tap of their bank cards and this contactless payment now represents 25% of all (TfL) pay-as-you-go transactions. From 2018 New York subway and bus travellers are expected to be able to pay with their contactless bank cards or mobile phones.
And in Australia both the volume and value of cash withdrawals from the ATM network continue to fall from their peak in 2008, despite an ever-increasing number (now over 31,000) of available ATMs. Indeed figures released in February 2016 by the Reserve Bank of Australia (RBA) show consumers withdrew an average of A$11.7 billion a month from ATMs in 2015, down 1.7% from 2014.
Cash not done yet
And yet in other countries, cash is still king. Japan is still heavily reliant on cash for everyday purchases in retail outlets and restaurants. According to the Bank for International Settlements’ statistics on payments for 2014, there is US$6,429 of banknotes and coins in circulation per person in Japan, compared to US$2,459 for Australians and US$1,588 for the British.
Of further interest is that in Australia by 2014, the total volume of notes on issue was A$60.8 billion, with 92% of this total being in the high denomination A$50 and A$100 notes. According to data from Retail Banking Research, global ATM cash withdrawal volumes grew by 7% in 2014 and the upsurge in usage was most evident in the Asia-Pacific, Middle East and Africa regions.
So how to explain this seeming dichotomy between the holding and use of cash and the use of cards or mobile phones to make payments? Well as human beings we seem to have a psychological relationship with cash, that gives it an enduring appeal.
Cash is widely accepted; it is easy to carry; it is untraceable and it is reliable in times of crisis. People may be particularly attracted to notes because of the way they look and feel and because they want to store their wealth in physical objects, as the world around them becomes more unstable. This trust in “real currency” could explain the large increase in demand for cash during the global financial crisis, as people sought the “comfort” of a wad of banknotes.
Cash can also be used to avoid paying taxes; who amongst us has never used the words “Would that be cheaper for cash?”. The use of cash supports the “black” or “grey” economy, where tax evasion requires untraceable transactions. It is also more than useful where illegal activities produce wealth that needs to be kept secret from the authorities. Perhaps this helps to explain the proliferation of A$100 notes in circulation, but often rarely actually seen in circulation?
Despite the growth of card payments; the arrival of Android Pay, Apple Pay and Samsung Pay and the cryptocurrencies such as Bitcoin, cash is still here and here to stay.
Author: Steve Worthington, Adjunct Professor, Swinburne University of Technology
The first few months of a new year can be a stressful time financially. The Christmas holidays typically lead to depleted savings and higher credit card balances, while tax season is right around the corner.
Unfortunately for most us, this isn’t a seasonal dilemma but a chronic problem that brings anxiety throughout the year.
Indeed, as many as 44 percent of American households don’t have enough savings to cover basic expenses for even three months. Without a savings cushion, even regular seasonal expenses like holiday celebrations may end up feeling “unexpected” and lead households to turn to credit to cover costs.
U.S. consumers currently hold US$880 billion in revolving debt, with an average credit card balance of almost $6,000. The picture is even more dire for lower-income households.
So how can we turn this around? Many tacks have been tried but fallen short for one reason or another. Fortunately, behavioral science offers some useful insights, as our research shows.
What’s wrong with current approaches
Typical approaches to solving problematic finances are either to “educate” people about the need to save more or to “incentivize” savings with monetary rewards.
But when we look at traditional financial education and counseling programs, they have had virtually no long-term impact on behavior. Similarly, matched savings programs are expensive and have shown mixed results on savings rates. Furthermore, these approaches often prioritize the need for savings while treating debt repayment as a secondary concern.
Education and incentives haven’t worked because they are based on problematic assumptions about lower-income consumers that turn out to be false.
They also don’t need to be convinced of the value of saving. Many want to save but face additional obstacles to financial health.
For example, these households often face uncertainty about their cash flows, making planning for expenses even more difficult. More generally, they have little room for error in their budgets and the costs of small mistakes can compound rapidly.
Brain barriers
In this volatile context, psychological barriers common to all people exacerbate the problem.
People have difficulty thinking about the future. We treat our future, older selves as if they are strangers, decreasing motivation to make tradeoffs in the present. Additionally, we underpredict future expenses, leading us to spend more than precise budgeting can account for.
When we do focus on the future, people have a hard time figuring out which financial goals to tackle.
In research that we conducted with Rourke O’Brien of the University of Wisconsin, we found that consumers often focus either on saving money or on repaying debt. In reality, both actions simultaneously interact, contributing to overall financial health.
This can be problematic when people misguidedly take on high-interest debt while holding money in low-interest saving accounts at the same time. And, once people have identified building savings or repaying debt as an important goal, they have difficulty identifying how much should be put toward it each month. As a result, they rely on information in the environment to help determine this amount (like getting “anchored” on specific numbers that are presented as suggestions on credit card payment statements).
Unfortunately, the way current banking products are designed often makes these psychological realities worse.
For example, the information on many credit card payment systems nudges consumers toward paying the minimum balance rather than a higher amount. Budgeting tools assume income and expenses stay the same from month to month (not true for most lower-wage workers) and expect us to monitor spending against a long list of separate, complicated budget categories.
On a deeper level, the fact that banks offer credit and savings products separately exacerbates the psychological distance between paying down debt and building savings, even though these are linked behaviors.
Behavioral banking
The good news is that a range of simple, behaviorally informed solutions can easily be deployed to tackle these problems, from policy innovations to product redesign.
For instance, changing the “suggested payoff” in credit card statements for targeted segments (i.e., those who were already paying in full) could help consumers more effectively pay down debt, as could allowing tax refunds to be directly applied toward debt repayment. Well-designed budgeting tools that leverage financial technology could be integrated into government programs. The state of California, for example, is currently exploring ways to implement such technologies across a variety of platforms.
But the public and private sectors both need to play a role for these tools to be effective. Creating an integrated credit-and-saving product, for example, would require buy-in from regulators along with financial providers.
While these banking solutions may not close the economic inequality gap on their own, behaviorally informed design shifts can be the missing piece of the puzzle in these efforts to fix major problems.
Our research indicates that people already want to be doing a better job with their finances; we just need to make it a little less difficult for them. And making small changes to banking products can go a long way in helping people stabilize their finances so they can focus on other aspects of their lives.
Authors: Hal Hershfiel, Assistant Professor of Marketing, University of California, Los Angeles; Abigail Sussma, Assistant Professor of Marketing, University of Chicago.
Market volatility has affected banks internationally in the US, UK and Europe but even though Australian banks remain insulated from turbulence abroad it might not be all smooth sailing.
The MSCI index of global banks has fallen by 16% since the start of the year, while the S&P index for US banks has fallen by 20%. The chief executive of Deutsche Bank (one of the world’s largest banks) was forced to announce that his bank was “rock solid” after the share price had fallen more than 30% from the start of the year and rumours circulated of problems with contingent convertible (CoCo) bonds.
Bank stocks and the cost of CDS insuranceDatastream
The fall in international bank stocks has coincided with a perception of rising risk levels within the banking sector. The iTRAXX CDS index indicates the cost of insuring debt for a selection of global banks – the index increases as the cost of insurance becomes more expensive, indicating the market perceives that the debt is riskier. So far this year the index has risen 65% – the sharpest increase since the European sovereign debt crisis of 2011-12.
Falling commodity prices are the current focus
The main source of concern for financial markets at the moment is related to the commodity markets. Past high commodity prices encouraged many firms to invest heavily building huge new mines, liquefied natural gas (LNG) plants, and expanding production in shale oil. This investment required large amounts of borrowing, and banks have provided this directly (loans) and indirectly (purchasing bonds).
In the last year, crude oil prices have fallen 54%, LNG prices have fallen 32%, and iron ore prices are down around 30% (according to Datastream). The result is that many of the projects, some of which are still to come online, are not profitable – some may never be profitable – and the debt may not be repaid.
Credit ratings agencies such as Moody’s suggests that much of the debt issued by U.S. energy companies will be downgraded to junk in the near future, while Standard & Poor’s stated that debt at Chesapeake Energy (one of the largest US shale producers) is unsustainable.
Attempts by the Chinese government at intervening in the currency markets have also created volatility for banks. This has served to create a sense of uncertainty within the financial markets – and when this is the case there is often a reduction in the willingness to invest in “risky assets” such as stocks. Unlike in 2008, heavily indebted governments will have much less ammunition to bail out banks that fail this time around.
Longer term, the change in the regulatory environment is affecting the risk-taking ability of banks, and reducing profitability (even viability) of many areas. Increased capital requirements, particularly in areas that regulators deem to be too risky, mean that many banks are exiting equity, fixed income, and currency trading – divisions that have previously generated substantial profits for banks.
Of course, there is also ongoing regulatory investigation into a variety of cases of apparent financial market manipulation such as the recent LIBOR, and Foreign Exchange, fixing scandals that saw heavy fines imposed on US and European banks. This has even spread to Australia, where ANZ appears to be under investigation by ASIC for possible interest rate rigging.
Meanwhile in Australia
In Australia, banks have performed very well over the course of the last five years. At one point in 2012 Australian banks were worth more than the whole of the European banking sector! Record levels of profitability in Australian banks have supported large dividend payments to shareholders and helped push share prices to all-time highs in 2015.
Earlier this week, CBA announced another rise in earnings for the first half of the year – to A$4.8 billion. Much of this profitability is a result of increasing interest margins. As the Reserve Bank of Australia cash rate has fallen, banks have been quick to cut the rates offered to savers, but slow to pass on the rate decrease to borrowers (if they have done so at all). Even a small increase in this margin can boost profits if total assets are measured in the hundreds of billions of dollars.
Interest marginsrba.gov.au
However, this profitability may not last as margins are under pressure on two counts. First, tighter lending standards, particularly for investors, have slowed lending in the housing market. The housing market appears to be slowing and this may increase bad debts in the future.
Australian banks are not totally immune to the impact of falling commodity prices, and CBA with ownership of Bankwest may be particularly exposed to a slowdown in Western Australia.
On the other side of the coin, funding is becoming more expensive for banks at the same time that increased capital requirements require them to hold more. Funding through international sources is particularly scarce (the CDS index indicates this is becoming more expensive), and this matters because Australian banks require a substantial amount of offshore funding.
Author: Lee Smales, Senior Lecturer, Finance, Curtin University
Greg Medcraft, chairman of the corporate regulator ASIC, is a distinguished banker who worked for 27 years in the obscure world of asset securitisation with the large French bank Societe Generale. He helped to set up the American Securitisation Forum (ASF) and is also chairman of the international securities industry body, IOSCO, which bills itself as “the global standard setter for securities markets regulation”.
Mr Medcraft then is probably as well placed as anyone in Australia to understand the complexities of the financial markets that gave rise to the interest rate benchmark manipulation scandals, which are grouped under the general term LIBOR but include other benchmarks such as EURIBOR, TIBOR and the local variant, BBSW (Bank Bill Swap Rate).
The fallout from these scandals rolls on but according to reporting by Adele Ferguson (a one-woman regulator) it will soon be the turn of BBSW to take the spotlight.
The reasons that manipulation of interest rate benchmarks took place are complicated, caused by an explosion of financial trading in the last 20 years, especially in so-called Interest Rate Swaps (IRS), and the failure of regulators to handle the flood of new types of securities.
[For an academic explanation of the phenomenon, see here and here and for a general overview see here.]
The initial reaction to the revelations that Australian banks just might be involved with manipulating BBSW was outrage, especially from AFMA, the investment bankers’ industry body. This stance was however undermined when, in January 2014, ASIC accepted an “enforceable undertaking” from BNP Paribas (BNP) in relation to potential misconduct involving BBSW.
Since then, however, there has been little information about other possible instances of BBSW manipulation other than ASIC’s investigations were ongoing and ongoing and ongoing.
It is strongly rumoured that ANZ will be in the firing line when ASIC eventually decides to take regulatory action, long after other jurisdictions have done so. This is, in part to do with the salacious revelations emerging from a civil case brought by ANZ traders against the bank for wrongful dismissal related to possible manipulation of BBSW.
ASIC is in the spotlight and it really has to put up or shut up.
Many of the big birds have already flown. With the recent departure of Mike Smith from ANZ, all of the CEOs of the big Australian banks who were in charge when the BBSW investigation was started have gone. ASIC’s inquires have taken so long that the chances of getting any “clawback” of bonuses if serious misconduct is proven have disappeared.
Unfortunately, Mr Medcraft is an accountant rather than a lawyer and ASIC faces a real legal quandary – whether to prosecute the individuals involved, the banks they worked for, or both. All of these paths are fraught with possible dangers.
Going after individuals is difficult. Although the UK Serious Fraud Office had a win against Tom Hayes, the Libor Mastermind, it had a spectacular loss against six brokers who had been accused of supporting Hayes. The failure to convict the brokers resulted in the ridiculous situation where Hayes was convicted but his alleged co-conspirators walked free.
A UK legal expert, Alison McHaffie noted that
“Apart from being acutely embarrassing to the SFO, these verdicts show how difficult it is to demonstrate criminal activity by individuals for this type of market misconduct
It is always easier to bring regulatory action rather than criminal prosecution.”
Which brings us to the second option, going after the banks.
If the reports are correct, ASIC may be considering prosecuting ANZ, although it is difficult to see under which statute. In the past, Mr Medcraft has pointed to Section 12.2 of the Commonwealth Criminal Code, which he argued would allow
“companies to be charged with being an accessory to a crime if the company’s culture encouraged or tolerated breaches of law.”
It would be a brave (and probably foolhardy) regulator who would take on a single bank alone, hoping to prove conclusively in court that the bank’s culture was responsible for fraud and misconduct. That is only a bonanza for lawyers for the next decade.
So what to do?
History has shown that a single regulator can do very little on their own, especially one whose mandate is so diffuse and its staff so overstretched.
Overseas experience has shown that when multiple regulators get together, share information, skills and most importantly purpose they can succeed in jointly fining multiple banks. Singly, regulators can get picked off – as a pack they can be successful.
In the Australian context, what this means is that, while ASIC might be the spearhead, the real firepower should be provided by the Council of Financial Regulators, comprising ASIC, APRA and the RBA. When ASIC finally decides to prosecute someone for manipulating the market, the other members of the CFR should not only come out in unequivocal support of ASIC but also announce how they will use their powers to support ASIC, such as, for example in the case of APRA, additional operational risk capital charges for misconduct.
The curtain is about to go up on the second act of the BBSW tragedy (or is it farce), and we await the entry of the villain(s) with keen expectancy. But will the show close on its first night, with no prospect of a revival?
Author: Pat McConnell, Honorary Fellow, Macquarie University Applied Finance Centre, Macquarie University
To see Australia’s shortage of affordable housing as a failure of government is to misunderstand the politics that underpin housing. The vast proportion of government money spent on housing directly benefits the well-off at the expense of private renters and public housing tenants.
Government policy has not, on the whole, failed. It has been a huge success insofar as protecting the opportunities for speculative investment and profit for homeowners and private landlords.
If the government was serious in wanting to end the housing crisis it would need to invest in new social housing and pursue measures that choke off, via tax reform, the opportunities for profiteering currently enjoyed by landlords and homeowners.
The pursuit of these options would be bitterly opposed – not least by many homeowners and property investors, as it would lead to a fall in house prices.
Why this misdiagnosis persists
The government’s current housing response can be viewed as a charade. Ministers have been able to convince many that the government is working hard to put in place measures to fix the problems faced by low-income households.
There are two discernible ways that the government has maintained this charade. The first is by permeating an impression that action will be forthcoming. Social Services Minister Christian Porter recently announced that he would be establishing a working group to explore ways to improve the availability of affordable housing.
Porter’s working party should come as no surprise. Over many years, governments have undertaken many reviewsandenquiries.
Second is the recycling of a set of myths. Among these is that public housing is a failed policy that reinforces welfare dependency and that state and territory planners impose arbitrary rules and regulations that impede new housing development.
Public housing and planning regulation are framed as dysfunctional. We are told that affordable housing would be built quickly if the commercial sector were not impeded by bureaucratic demands.
Should we discard statements from the government that effective reforms are underway and recognise that the prospects for low-income Australians will deteriorate over the coming years? Already there are as many as 105,000 people who are without a home and 160,000 households on public housing waiting lists. The overall stock of public housing had fallen from 331,000 units in 2007-08 to 317,000 in 2013-14.
The Productivity Commission estimated that the proportion of low-income households in housing stress – that is, those that pay more than 30% of their income on housing-related costs – increased from 35% in 2007-08 to 42% in 2013-14.
In its 2012 report, the former National Housing Supply Council highlighted that between 2002 and 2012 rents increased in nominal terms by 76% for houses and 92% for flats. And the median value of a home in Australia is now A$576,100.
Sticking to the script
There are already signs in 2016 that the government intends on sticking to the usual script – one that frames the affordability crisis as stemming from a shortage of land, excessive red tape, and high labour costs within the building industry.
Three critical elements that require government attention. One – land release. Two – the cost of building – and this is in particular in relation to the inner city apartments where there is an urban infill. The third is bureaucracy.
Hunt’s attribution of the causes of the housing affordability crisis are broadly in line with the pronouncements of finance, developer and real estate lobbyists. All have made similar claims and work tirelessly to safeguard the opportunities for profit-making that exist when housing is in short supply.
It is no coincidence that supply-side interventions, such as sustained investment in public housing, have been eschewed in favour of demand-based subsidies. The latter includes initiatives such as Commonwealth Rental Assistance and inputted tax subsidies that enable landlords to boost their profits, alongside first homeowner grants and the exemption of capital gains tax for owner-occupiers when they sell their home. This amounted to A$54 billion of revenue forgone in 2016.
For those who wish to reap profits from their housing investment, there are good reasons to maintain the status quo; for a shortage of supply to continue and for public housing to remain a stigmatised tenure only available for those without any recourse elsewhere.
Stressing land release as a significant cause of the affordability crisis is misleading but not surprising. This is the claim repeated by developers who wish to increase their profits. It is not uncommon for developers to delay development plans on land they have acquired on the expectation that the opportunity to secure greater profits will accrue when the land value increases at a later stage.
It is disappointing that Hunt offered such a myopic explanation of the housing affordability crisis. A more insightful analysis would attend to the failure to invest in public housing, the subsidies that distort the private rental market such as negative gearing, and the tax privileges that are extended to homeowners.
The housing problems experienced by low-income households are a symptom of entrenched inequality within Australia. Public and private tenants remain disadvantaged and have to endure problematic tenancies that are increasingly insecure. Unless this inequality is addressed, Australia’s housing problems will endure.
Author: Keith Jacobs, Professor of Sociology and ARC Future Fellow, University of Tasmania
The move, first announced last year, follows an aggressive campaign to get the largest private employer in the U.S. to lift worker wages and coincides with a nationwide push to raise federal and state minimum wages and a prolonged period of little growth in pay.
While Walmart’s decision is at least in part a result of that pressure, it’s still the action of a private company to revamp its own wage policies, as opposed to the result of a government forcing it to lift worker pay. Proponents of requiring just that argue raising the minimum helps reduce inequality. Critics contend it can actually worsen it by driving up unemployment and weakening economy-wide labor market flexibility by raising the costs firms face.
So what does the economic research say about the impact of minimum wages on income inequality and is there a better way to reduce it?
Minimum wage fallacies
Many of the articles in the mainstream press promoting minimum wages are incompatible with basic economic principles.
The first fallacy is that changes in the minimum wage do not affect the behavioral response among firms and individuals. The second fallacy is that higher wages will force companies to innovate in order to reduce costs. Both these arguments overlook some very basic, but informative, economic principles.
The first overlooks the fact that wages are designed to compensate workers for productivity. When wages are distorted, they affect the profit-maximizing decisions that businesses make. The textbook prediction, which is generally supported in the data, is that higher minimum wages reduce employment since companies restrict the number of workers they will hire. These adverse effects are especially likely given the pace of technological change and automation.
The second overlooks the fact that there are effective and ineffective ways to stimulate innovation among businesses. The idea that making hiring more costly will spur innovation is tantamount to requiring companies to reduce the size of their physical presence so they become more productive. While these types of distortions may prompt a small fraction of companies to innovate, misallocation more generally is a major factor behind cross-country differences in productivity.
Protests like these may have helped persuade Walmart to raise wages.Reuters
Minimum wage and inequality
Nonetheless, economists themselves have debated how minimum wages affect employer decisions for many years.
In 1994, economists David Card and Alan Krueger were the first to provide some evidence that such effects may be small. But more recently, a consensus has generally emerged that changes to minimum wages have strong effects on jobs growth.
How minimum wages affect inequality, however, remains controversial. Detecting it with standard statistical methods is very challenging because their full effects are constantly changing and require data on both individuals and companies.
Back in 1999, Princeton economist David Lee used the Consumer Population Survey (CPS) from 1979 to 1989 to argue that the declining purchasing power of the minimum wage largely explains why inequality surged in the 1980s.
Other new research, however, has put that conclusion in doubt. Perhaps the most conclusive reassessment comes from economists David Autor, Alan Manning and Christopher Smith earlier this year. Using many more years of microdata from the CPS, as well as a different statistical approach, they found that the minimum wage explains at most 30 percent to 40 percent of the rise in wage inequality among the lowest earners.
Since economists had thought that changes in the minimum wage could explain as much as 90 percent of the shift in inequality, these new estimates are important.
How wages affect worker behavior
While the extent is still uncertain, it’s clear that the minimum wage and other wage-setting forces such as tax rates and union bargaining power do in fact affect inequality and the labor market.
My own ongoing research, which focuses on the link between such wage-setting mechanisms and company behavior, suggests labor-market distortions like raising the minimum wage can have other negative effects on workers, businesses and inequality beyond the overall impact on employment.
The first adverse effect concerns how much people work. If, for example, worker wages rise due to a government mandate, the employer may reduce the number of hours staff work, leading to lower paychecks even after the raise. That’s part of the reason why we’ve seen companies like McDonald’s increasingly try to automate tasks that were once held by people.
In addition, my research suggests one of the major ways people acquire new skills is by spending more time at work. Thus policies that lead to fewer hours could lower employees’ ability to improve their long-run earnings potential.
The second is an indirect effect on the way businesses invest in workers and design compensation and organizational policies. When companies are forced to pay higher wages, they may offset the cost by reducing how much they invest in workers. There is evidence that minimum wage laws have this effect.
This can result in weaker compensation contracts (e.g., purely salary-based), which provide employees with fewer incentives to accumulate skills. As a result, workers paid fixed wages suffer greater long-run earnings volatility than those receiving performance-based pay.
Put simply, if a recession comes and an individual loses his or her job, having more skills makes it easier to find a new position and return to the previous income level.
Minimal impact on inequality
Even setting aside all the plausible economic arguments against the minimum wage, under the best case scenario, what does it really achieve?
If the average full-time employee works 1,700 hours per year, then moving from $7.25 an hour to $9 an hour produces only about $2,975 in additional annual earnings. While some may argue that something is better than nothing, this would be at best a marginal solution to inequality.
Taking a look at the most recent 2015 Current Population Survey data and restrict the sample to full-time earners with over $10,000 earnings per year, Americans at the 90th income percentile (they earn more than 90 percent of their compatriots, or $80,000 a year) make 5.6 times as much, on average, as those at the 10th percentile ($14,200). Increasing the minimum wage to $9 an hour would put the ratio around 4.65.
In other words, even in the best of worlds – where the minimum wage has no unintended side effects – it appears to only marginally reduce inequality.
Alternatives to raising the minimum wage
Where does this leave us in trying to reduce inequality?
First, companies are welcome to raise wages at any time they want. And letting them do so may be more effective at reducing inequality than when they’re forced to because it avoids the adverse consequences such as reducing hours.
Businesses are well aware of their marginal costs and benefits – how much it costs to produce an additional unit of output versus the incremental gain. When governments set uniform wage regulations, they require all companies – each with their own and distinct marginal costs and benefits – to abide by the same rules. In contrast, when companies decide to change their own pay practices – as Walmart is doing – they do so in a more efficient way.
Second, as Stanford economist John Cochrane has remarked, instead of addressing the short-term problem of low wages, governments and companies can address the more structural problem: a lack of skills.
Companies and local governments can provide training programs and support for additional education, such as through community colleges, in order to equip workers with additional skills that translate into meaningful value for their companies. Investing in worker skills can lead to increased employee productivity and creativity, which in turn translates into sustained higher wages. And these benefits have broad spillover effects throughout the labor market and make sustainable gains in narrowing the gap between the richest and the poorest.
While the economic effects of minimum wage laws are very complex and a subject of scrutiny within the economics community, there are much better ways to deal with systematic challenges in the labor market. Getting more people to work, reducing the barriers for businesses to hire and encouraging the accumulation of new skills are all strategies for promoting sustainable long-term growth in wages.
Author: Christos Makridis, Ph.D. Candidate in Macroeconomics and Public Finance, Stanford University
