Like you and I, banks have equity…
It’s interesting that this statement about banks being “wiped out” keeps getting bandied around with no actual substance behind it.
Just to re-cap, as with all companies, a bank’s shareholder equity comprises its share capital, its reserves and its retained profits.
A balance sheet – as the name implies – balances! That’s why it is called a balance sheet, right? The balancing figure on the top half of the balance sheet is the sum of the banks’ assets less its liabilities.
A bank has many assets – its cash, property, plant and equipment, intangible assets, derivatives, its many investments and so on.
A bank’s biggest asset is usually its receivables balances, comprising loans, bills and other receivables. Our major banks in Australia are rather top heavy in residential property loans, so this is typically the largest asset balance of all.
Making up the bottom half of the bank’s balance sheet are its liabilities, such as payables to creditors, tax liabilities, provisions, debt issues and so on.
For a bank, however, the biggest liability balance is likely to be deposits and other public borrowings.
Simplified balance sheet
In fact, you could simplify a bank’s balance for the purpose of this discussion as being: bank’s equity = loans, bills and other receivables, less deposits and other borrowings.
Now here’s the thing: a fall in residential property prices does not change the value of assets on a bank’s balance sheet, and therefore nor does its lessen the bank’s equity.
Under generally accepted accounting principles (GAAP), a loan is just that, and is valued as such.
Actually that’s not quite true. Loans are valued under International Accounting Standard 39 (IAS 39) at amortized cost under the effective interest method net of provisions for impairment which are taken to profit and loss…but let’s not go there today, eh?![sam id=40 codes=’true’]
(Strewth, and youse were all wondering why I gave my accountancy career the flick…).
Now, loans can indeed become impaired as implied above, but it is not a fall in residential property values which is the trigger point per se.
A loan becomes impaired when a mortgagee is in default, and particularly, when the bank is unable to sell the property at market value in order to recover the value of its loan.
A bank will make an assessment of whether there is any objective evidence of an impairment on its loans at each balance sheet date. Where the bank estimates there to be objective evidence of an impairment on a loan the value of the asset less the expected future cash flows to be recovered is written off or a provision is made (taken as a loss to the profit and loss account).
So, in summary, it’s not quite as simple as is often made out.
For our bank’s to be cast into negative balance sheet positions, property prices would likely have to first fall very substantially so that borrowers were in severe negative equity, and then the borrowers would also have to default on their mortgages.
The trigger for non-repayment of a mortgage would normally be a prolonged period of unemployment, given that we have full recourse loans in Australia.
This was an issue during the US sub-prime crisis when first non-banks and then commercial banks foolishly attempted to maximise their profits by lending to people with poor or non-existent credit history.
Unfortunately when the poor borrowers inevitably defaulted on mortgages they could never afford in the first place, the ensuing market crash meant that the red-handed banks had no real estate market worthy of the name to sell the properties into, and found themselves staring down monster asset impairments and write-downs.
Britain, too, had its problems when property prices away from London fell by between 20-40% in many cases. With unemployment also spiking this resulted in banks having a proliferation of non-performing loans.
In Australia, we did not have a property crash during the financial crisis, and nor have we had a spike in unemployment. Prices fell by around 7-8% from peak to trough, which was a useful but not painful correction, and most importantly of all, unemployment stayed relatively low.
Mercifully, lending standards as a general rule have also been reasonably robust since the financial crisis, with a few exceptions as always.
Aussies are miles ahead on mortgage repayments – bravo!
In fact, with interest rates at generational lows, Aussies are billions of dollars ahead on their mortgages rather than in arrears. In 2013, Aussies broke a new Antipodean record by becoming an amazing 14% ahead or $160 billion on their loan repayments.
Australians in 2013 had a little more than $1 trillion of mortgage debt in aggregate. It sounds like a big number, but in fact Australia’s residential properties are said to be worth around $4 trillion in aggregate.
That’s because more than a third of homes in the two most populous states – as well in South Australia and Tasmania – have no mortgage debt at all against them, and are owned unencumbered.
We should not become complacent, however, because unemployment may always rise. But while it certain quarters people misguidedly continue to hope for mass unemployment and an Australian recession, unemployment remains doggedly low in international terms at 5.8%, and business conditions have returned to near 3 year highs.
The net result of all of this is that our banks have had an ongoing very low share of non-performing loans which actually fell last year, and long may that continue.