Follow the Money. Watch the Credit. Enjoy the BOOM! 

2nd of October, 2020

A step by step guide to how this cycle has developed and why the tide is turning 

Understanding the Credit Cycle is super important. It is credit that provides the atomic energy for the nuclear like Boom that ends in the inevitable Bust.

Follow the money. Watch the credit. Enjoy the BOOM!

The current cycle has been a bit of a bummer for our Aussie banks. Their ability to create credit has been limited due to the regulatory restrictions placed on them.

Last week this all changed!

We are now eleven years into this cycle, and it is important that we take a peek down memory lane to refresh our memories. Once we review what has happened you will see that the credit cycle is again playing out like clockwork.

Know the history, know the future, this is why we are so confident that things have just changed.

Once you reflect on what has transpired, I know you will be as confident as us and want to step on the gas with your investment endeavours.

Understanding how the credit cycle ebbs and flows is exactly what this Special Report will show you.

You will also understand how the recent changes announced by the Federal Government have resulted in providing a platform for the Aussie banks to create an abundance of credit for the second half of the investment cycle.

The result. “NOW is an excellent time to be looking to invest”.

When we talk about the “Property Cycle” or the “Investment Cycle” or the “Economic Cycle” we are really referring to the “CREDIT CYCLE” as the credit cycle underpins everything else. It is the driver of the Boom Bust cycle of assets.

This is why it is so important to understand.

In fact the concept of contracting and expanding credit is so important we have created not only this Free Special Report “Follow the Money. Watch the Credit. Enjoy the BOOM!” we have also dedicated the latest episode of our podcast Property Australia Favourite Obsession to this topic. Please visit www.pafo.com.au for more information and episodes.

Legislative restrictions are placed upon the Banks

First lets go back in time, back to the deep dark depths of the GFC lows when many thought that the financial system was “peering into the abyss of systemic failure”….

After a credit induced land bust (GFC) event the banks, the regulators and the public are all frightened of the stability and quality of our banking system to withstand another shock.

The mood is that action must be taken to avert another financial catastrophe. Fingers will be pointed and scape goats found.

Hence with their short investor memories, the regulators, must implement the kind of regulations that should have been employed BEFORE the bust. To kick off Australia’s current cycle the National Consumer Credit Protection Act June 2009 was passed and amongst other things it required the Banks to adhere to new-fangled “Responsible Lending Obligations”.

Seen as absolutely necessary at the time to protect consumers from the predatory banks and the economy from another potentially disastrous economic slump these regulations required two separate, but interlinked “responsible lending obligations” for lenders when assessing consumer credit applications:

1. make reasonable inquiries about the applicant’s requirements and objectives, and reasonable inquiries and verifications about their financial situation, and
2. not enter into a credit contract that is unsuitable for the applicant.

The concept was to ensure the banks applied more stringent assessment criteria. When lending money this raised the bar applicants had to jump to get funds. The result would be that the banks would only lend money to those who could afford it, hence ensuring loans in default would be kept to a minimum thus safeguarding the banks’ capital and preserving financial security.

Step one in ensuring there is never a repeat of the GFC – tick!

It wasn’t just Australian regulators looking to ensure the calamity of the GFC meltdown would never occur again. In November 2010 the good members of the international regulatory accord “Basel Committee on Banking Supervision” decided that in order to mitigate risk within the international banking sector, banks needed to maintain proper leverage ratios and hold minimum liquid assets there by eliminating the chance of a “run on the bank”.

The bankers gasped but given the events that unfolded during the GFC there was little they could argue against. They all agreed and an international move unfolded to increase the assets (capital adequacy) of the banks, Australia included.

Stated simply, a bank’s capital represents its ability to absorb losses. Boost the capital and you will be able to absorb greater losses.

The Basel Accord was scheduled to be implemented between 2013 and 2015. But as things worked out, this date was repeatedly rescheduled and now stands at 2022. I don’t want to give away the story just yet so we will come back to this a little later.

Remember how the Credit Cycle changes

Before we move on, I’d like to remind you how the Credit Cycle changes as it’s important that we remember its ever changing ebb and flow throughout this report.

At the bottom, after the “Great Crash”, the economy suffers at first with growing bankruptcies and a deepening economic contraction. Eventually, it will start to recover and soon there will be a return to economic normality. Now with the economy growing and asset prices rising in response to the renewed profitability and protected by new financial and banking regulations life is feeling pretty good.

As the mood of the masses improves and investor psychology switches from the fear of the crash to now overall general bullishness the banks attitude to lending becomes more relaxed.

Remember a bank makes money when it borrows money from depositors then extends credit to others, that’s their business model. The banks DO want to and need to create loans. However, after the crash they too are scared and implement very difficult lending standards. Borrowers must be able to jump the highest of hurdles to obtain their cash.

But as the banks become less scared of the potential for either a crash or run on their deposits, they typically start to again become more cavalier in their lending standards.

2009 – Can you remember what happened in Australia?

Does anyone recall how Australia dodged the Banking and Housing debacle that most of the developed world endured C2009. With a special thanks to China and the continued-up swing in the commodity cycle our housing market stayed afloat. As a result, our banks faired relatively well.

Even though this blessed our banks with the rare opportunity to continue extending credit into a buoyant housing market they ran into some other serious head winds.

Remember they had to meet their damn responsible lending obligations. Further to that the Reserve Bank of Australia (RBA) and Australian Prudential Regulatory Authority (APRA) the banking regulator, were terrified that the Australian Housing Market was in bubble territory.

This bubble fear was fuelled by spruikers like Harry S Dent doing book promotion tours first in 2014 with “The Demographic Cliff: How to Survive and Prosper During the Great Deflation of 2014-2019” and then Harry and others have followed up every year warning us about the impending crash. The one thing these people have in common is that they understand the time honoured premise that “Bad news Sells”. If they keep predicting a crash every year they will eventually (actually every 15 -20 years) get it right and then remind you about it for another twenty years.

The regulators stepped in again in December 2014 and made the banks Christmas a complete misery by announcing that the banks growth in loans to property investors could not exceed 10 per cent.

To add insult to injury they also required the banks to use a minimum 2 per cent interest rate buffer and a “floor” lending rate of 7 per cent when assessing borrowers’ ability to service their loans. In addition, they further required the banks to actually take the time to assess the applicants true spending habits in determining if they could afford the loan. How many bus trips do you take? How many pizzas do you eat?…. When you consider this with the backdrop of the Responsible Lending Obligations, the banks backs were getting pushed harder and harder against the wall.

See the banks typically prefer to use a matrix like the HEM Method (Household Expenditure Measure) that just approximates what your living costs are to determine your cost of living for lending purposes thus allowing them to make no allowance for the actual lifestyle you live.

Using a matrix is much quicker than actually confirming what each applicant actually spends. It doesn’t however distinguish between the costs of living for a Porsche driving lawyer in Toorak and a janitor living in Mt Druitt.

An example of a HEM method matrix is:

Not happy with the response they got from the housing market and the banks, APRA was prepared to play the bully and on 20 July 2015 announced “an increase in the amount of capital required for Australian residential mortgage exposures by authorised deposit-taking institutions (ADIs)”.

This was a result of that damn Basel Accord and it was not good news for the banks, nor would it be the last time APRA pulled this stunt.

This meant that the banks were required to hold higher levels of cash, and cash like assets on their balance sheet to continue extending credit. If they couldn’t get more cash (ie increase their deposits), then they would have to reduce their loan books. So, cap in hand the banks went to the market to try and raise further funds.

But then it got even worse and APRA, those nasty banking regulators, imposed further restrictions in March 2017 forcing lenders to limit new interest-only lending to 30 per cent of the new home loans that they issued. This meant that the growth in new business had to be 70% principal and interest loans applying more restrictions on the banks ability to satisfy the market and create credit.

Could banking get any harder?

Then just for those who thought it couldn’t get any worse, the Government finally backflipped and decided that a Royal Commission into Banking was not really just a “populist whinge” but actually in our national interest.

Oh, the pain to be a banker!

14 December 2017 marked the establishment of the “Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry” – even the name told everyone how guilty the banks were.

With the Honourable Kenneth Madison “Attack-Dog” Hayne AC QC in charge, if banking wasn’t such a lucrative pastime, I’m sure most bankers would have just packed it in and start selling telco plans.

We heard all about predatory lending, money laundering, impropriety in foreign exchange trading and a host of other shenanigans that went on via the 10,323 submissions and endless public hearings. In the end seventy six recommendations were made and the government made a steadfast promise to implement “Every single One”.

As this video shows not everyone was happy with the outcome.

It was a horrendous time for the banks, although they did get a little glimpse of blue sky when during the Royal Commission APRA announced on the 26th of April 2018 the removal of its 10% annual cap on investor loan book growth.

This was the first bit of good news our beloved banks had received in yonks.

The good news did not last long because on the 3rd of August 2018 – The Productivity Commission released its report into “Competition in the Australian Financial System”

This “Blueprint for Change” wacked the banks again accusing them amongst other things of exercising their market power over their competitors and consumers and providing poor advice and complex and confusing information.

Then on the 8th of November 2018, more regulations were piled onto our poor banks with APRA again wanting the banks to increase their balance sheets by forcing them to add additional capital.

Crikey! Will it ever stop thought the bankers…

Later that year though the banks had another win when finally on the 18^th of December 2018 the removal of the 30% interest-only lending cap was announced. Behind closed doors the bankers cheered as this was another very important win for the banks!

The crucial shift

Over the last eleven years, from 2009 onwards, the Australian Banking Regulators have been trying to constrict the rate at which the banks can grow.

More importantly the banking regulators have been forcing the banks to diligently build their capital within an environment of continual restrictions. Our Aussie banking sector is now robust and flush with lazy assets. Assets that they have not been able to leverage as quickly as they would have liked.

A bank’s ability to create credit is NOT just a function of their balance sheet! As important is their willingness to lend (i.e. risk appetite) and ability (i.e. legislative environment) to convert their assets into loans and for the first time in this cycle we have ALL these drivers working together in Australia.

The result will be EVER EXPANDING credit creation which is sure to send asset prices sky-high.

But what happened to all the regulations?

Great question…

Well when it comes to “Attack Dog” Hayne and the implementation of his seventy six recommendations from the Royal Commission. Lets just say its reminiscent of Paul Keating’s “L-A-W law” quote when he legislated promised tax cuts into “L-A-W law” only to repeal them after the next election instead announcing that the money would be put into superannuation.

The Morrison government has legislated twenty-four of the seventy-six recommendations and claims it has “substantially progressed” thirty-five others. No mention of the other seventeen recommendations that have obviously found their way into a trash can.

However in May 2020 the government cited Corona Virus as the reason that it had again delayed key deadlines for financial services reform…

So how has the Basel Accord panned out? Well as I hinted at earlier their implementation has been pushed out from the original 2013 expectation to now Jan 2022. I doubt we will ever see them implemented…

In fact if you want further support for my thoughts on this one you just need to refer to APRA’s March 2020 announcement where they reversed their rock solid position for the requirement of stronger and more substantial capital buffers to ensure our banks are regarded internationally as unquestionably strong. They were now allowing them to eat into their buffers under the guise of a Covid-19 response.

In reality, the mood for easier credit is upon us and as long as the virus remains a “health crisis and NOT a credit crisis” the banks will most likely sail through completely unscathed, but with less regulation, lower capital requirements and of course more lenient credit assessments policies.

Something else to note is the Morrison governments supportive view of FinTechs and the NanoBanks. Since May 2017 there has been a string of announcements and support packages aimed directly at the establishment and support of the tech sector. Recently the government has announced an $800 million digital technology plan for business as part of the October 2020 budget.

This is important as each cycle needs new entrants. New business models and of course CEO’s that either have never experienced a cycle or now believe that their technology or business model will protect them from any possible future credit crash.

How wrong they will be. Now its time to experience the lending boom from this new tech sector.

To understand just how seriously the government takes all this banking stuff you only need to refer to the new Banking Code Compliance Committee (BCCC) set up in the aftermath of the Financial Services Royal Commission.

The BCCC showed it was a toothless tiger when in late September 2020 it officially sanctioned Bendigo and Adelaide Bank for “systemic breaches of the Banking Code” when it was found to have not acted “fairly and reasonably” over the space of four years.

The BCCC was so upset with these serious breaches that they decided that the bank would face no fines or repercussions but it “named and shamed” them and asked them to promise not to do it again…

Meanwhile back in the USA

The US Credit cycle has been similar, but a little different, so it’s worth spending some time thinking about what happened on Trumps home turf.

Back in July 2010 the banks, who were still licking their financial wounds, were wanting to ensure the security of their few precious remaining assets. Although they adopted more stringent lending standards (that would have saved a bucket of money and a lot of heartache if they had been in place before the crash) it was the rock star President Obama who was really the financial sectors saviour.

See it was on his watch that saw the passing of the Dodd–Frank Wall Street Reform and Consumer Protection Act which amongst other things provided protection to consumers against abuses related to credit cards, mortgages, and other financial products. They went further than that as it also provided an environment that promoted sustainability and stability for the financial sector.

The world was saved. Thank you, Mr Obama.

In America the mood was changing, and the industrious nation of the star-spangled banner wanted to borrow money and buy stuff again. Inevitably what the people want the people get.

The Dodd–Frank Act was considered by many to be the most significant piece of legislation passed during Obama’s presidency. However, most of Barack’s beautifully scripted masterpiece was repealed in June 2017 with the passing of Trumps Financial Choice Act. Then basically whatever regulation was left was washed away in May 2018 with the Economic Growth, Regulatory Relief and Consumer Protection Act paving the way for the US Banking sector to ensure they can again wreak havoc by creating copious amounts of credit that will end in tears once again Circa 2026.

What else could you expect from America while under the rule of a real-estate speculator!

Our story does not quite end there as something else very important happened on March 2020 when the US Fed made a somewhat astounding announcement.

“The Board has reduced reserve requirement ratios to zero percent effective on March 26, the beginning of the next reserve maintenance period. This action eliminates reserve requirements for thousands of depository institutions and will help to support lending to households and businesses.” RBA Press Release March 15^th 2020

This completely runs against the Basel Accord! Astounding really….

In effect US consumers without any protection from the Frank Dodd Regulations, are again able to trouble the American banks for money. The banks in turn are free to create unvetted amounts of credit for willing banking consumers.

Lets get on with Investing. NOW!

This is how the credit cycle ebbs and flows and how although interest rates can have an effect other factors including

• the size of a bank’s balance sheet
• their statutory reserve requirements
• their appetite for risk and extending credit
• their legislative and consumer protection requirements

all go into determining how much money (credit) a bank will create!

Now is an excellent time to be looking to invest.

The changes in the Australian Government’s position will result in the Aussie banks obliging and becoming more liberal with their lending procedures. It happens every cycle.

Will the boom start tomorrow? I’m not saying that – but it will come.

APRA, by forcing the banks to build their balance sheets and Josh, by telling the banks they can now start to lend “Irresponsibly”, have ensured this will occur.

The scene is set for the second half of the investment cycle. Don’t miss out. If you want some assistance, Calnan Flack and our team would love to help.

Either way – get ready, the fun is about to start.