Statement on Monetary Policy – May 2008 Domestic Financial Markets and Conditions

Money market and bond yields

As has been the case internationally, conditions within the domestic money market have been volatile in recent months. There have been two main factors driving the movements in money market rates: tensions in the money market embodied in the spread between bank bill rates and the expected cash rate (OIS) and changes in market expectations about the future course of monetary policy. While short-term rates rose throughout February and early March, reflecting expectations of further policy tightening, yields on bank bills rose by a greater amount than the expected cash rate. In early March, 90-day bill rates reached a peak of 8.10 per cent as the spread to OIS increased to as high as 80 basis points, up from 30 basis points in early February (Graph 49). The increase in the spread reflected strains in global money markets associated with the end of the March quarter, but appears to have been exacerbated by uncertainty surrounding the expiry of the benchmark March bill futures contract. As this was resolved, 90-day bill yields quickly fell back to around 7.80 per cent. The spread between the 90-day bill yield and OIS has since averaged around 50 basis points. Following the increase in the cash rate in March to 7.25 per cent, market expectations about future cash rate movements have fluctuated between expecting a further tightening and pricing in an easing by the end of the year. Currently, the market expects the cash rate to remain at its current level for the foreseeable future.

Since August last year, the Bank has responded to the pressures in the domestic money market by varying the supply of exchange settlement (ES) balances, dealing in a wider range of collateral and lengthening the term of its open market operations. Through March the aggregate volume of ES balances was increased from around $2 billion to a peak of more than $5 billion as the Bank acted to offset end-quarter funding pressures. As these pressures passed and with the general improvement in financial market sentiment, ES balances have been reduced to below $2 billion. Throughout this period, the primary objective of the Bank's money market operations has been to maintain the cash rate at the target set by the Reserve Bank Board and this has been achieved on all days in the period since the last Statement.

The average term of the Bank's repurchase agreements (‘repos’) with market participants increased from around 25 days prior to the market turmoil, to around 50 days late last year (Graph 50). This lengthening of maturity was aimed at addressing the greater tensions at longer maturities in money markets. In April, on several days of large dealing to offset private sector payments to the Government, the Bank dealt at maturities as long as 12 months. Some of these longer-term repo operations involved residential mortgage-backed securities (RMBS) as collateral and were aimed at improving the functioning of the secondary RMBS market (see below).

Long-term interest rates have risen since the last Statement, largely in line with movements in international yields but also reflecting revised domestic short-term interest rate expectations. The yield on the 10-year government bond has increased by about 25 basis points to be 6.35 per cent (Graph 51). Spreads between government bond yields and swap rates are little changed from the time of the last Statement, despite widening dramatically in early March. Although this pattern was evident in most other currencies, as has been the case since mid 2007, the movement in Australian dollar spreads was larger.


After rising more than other major indices over 2007, the ASX 200 has underperformed this year; it is down 10 per cent so far this year and 17 per cent from its peak late last year. There has been significant divergence across sectors – share prices of resource companies are around the levels seen in late 2007, while those of financial companies have fallen 30 per cent since the peak last year (Graph 52). Resource stocks have been supported by strong commodity prices and BHP's bid for Rio Tinto. Financial stocks were marked down with the global banking sector and following some increased provisions for bad and doubtful debts by Australian banks.

The ASX 200 has been volatile since the start of the financial turmoil, with daily movements averaging as much as 2 per cent (Graph 53). While the average daily change has been smaller than at the time of the 1987 stock market crash, the current episode is notable for the sustained period of volatility. Volatility returned to average levels about six months after the 1987 stock market crash. In contrast, in the current episode volatility has been well above its long-run average for nine months, with average daily changes exceeding 1 per cent since August.

Profits announced by listed Australian companies in the recent reporting period remain at a high level, though they were slightly lower than expected, putting some downward pressure on their share prices. Around one-half of companies that recently reported profits were below analyst expectations (with 10 per cent in line with expectations and 40 per cent above). Underlying profit – which excludes significant items and asset revaluations/sales – was 3 per cent lower than in the corresponding period in 2006.

By sector, the profits of resource companies were 10 per cent lower in the December half year than in the corresponding period of 2006, reflecting the effect of the appreciation of the Australian dollar and rising input costs. Underlying profits of financial institutions declined by 3 per cent. This mostly reflected a fall in investment income among insurance and diversified financial companies, with banks reporting moderate profit growth. For the several larger banks that have recently announced their financial results, aggregate underlying profits were 4 per cent higher than in the previous corresponding period. Net interest income rose strongly, with robust balance sheet growth more than offsetting a decline in the net interest margin. Higher earnings from trading operations boosted non-interest income. Banks' bad and doubtful debt expense increased, due to higher provisions on loans to several distressed broking and property companies. But overall asset quality remains strong, with total loan provisions still a low share of loans and advances. Profits in other sectors rose by 12 per cent, led by a few large companies.

Analysts have revised down their forecasts of earnings growth for 2007/08 (Graph 54). Earnings are expected to be broadly flat for resources in 2007/08 before increasing 37 per cent in 2008/09 (revised up from 33 per cent) as supply constraints ease and contract prices for bulk commodities increase substantially. Financial sector earnings growth is expected to be around 3 to 7 per cent over each of the next three years. The profits of other companies are expected to increase by 10 per cent next year after moderate growth in 2007/08.

Despite the volatility in markets, M&A activity continues to be strong, with around $93 billion of deals pending. Most of the activity reflects proposed consolidation among resource companies, including BHP's offer for Rio Tinto. The average deal size has increased, with a number of large deals announced in addition to BHP's offer for Rio Tinto. There is also significant proposed M&A activity in the insurance sector.

Financial intermediaries

The turbulence in capital markets continues to affect the cost and composition of financial intermediaries' funding. Institutions that rely heavily on capital markets, particularly securitisation, to fund their lending have been more affected than institutions that have sizeable deposit bases.

Bond issuance by the Australian banks has been very strong so far in 2008 (Graph 55). At around $45 billion, issuance in the March quarter was the largest on record and around three times the usual quarterly issuance. Issuance remained relatively strong in April, though it has slowed from the record levels reached in January and February.

In part, the increased bond issuance reflects the major banks undertaking a larger share of financing for the non-government sector (reintermediation) (Graph 56). Until recently, corporates have been borrowing almost exclusively through banks as bond markets have remained closed to them. Moreover, with almost no issuance of asset-backed securities, the major banks have been undertaking an increased share of housing lending and providing increased funding to non-bank lenders. In total, non-government bond issuance in the March quarter was around the quarterly levels of 2006 and the first half of 2007. A number of the banks have indicated that they are ahead on their funding plans for the financial year.

Much of the banks' bond issuance in the March quarter has been offshore, with a large share through extendible bonds in the US private placement market. These bonds have an initial maturity of 13 months and are extendible at the option of the investor with 12 months' notice, and a final maturity of five or six years. While they tend to be a little cheaper than an ordinary bond, there is a greater refinancing risk. In recent months, all of the majors have, for the first time, issued in the Samurai bond market (issuance in yen into the Japanese market by non-residents). This has not only diversified their source of funds, but has also enabled them to issue bonds at longer tenors (typically five years) than in the US market.

In the December and March quarters, the average tenor of bonds issued by the Australian banks declined, especially so if the extendible bonds are taken at their shortest possible maturity (Graph 57). However, in April, the banks have issued bonds at longer tenors (four years). This was due to longer tenors being issued domestically, with the first issuance of 5-year bonds by the major banks since September 2007, and the Samurai issuance. The current maturity of outstanding bonds has only declined a little, to 3 years from 3½ years prior to the recent disturbances.

Spreads at issuance on the Australian banks' domestic bonds have continued to rise (Graph 58). The 5-year bonds were priced at an average spread of 124 basis points over swap, well above the average spread of 42 basis points in September 2007 and the average spread of 15 basis points prior to July 2007. The banks issued 3-year bonds in April at spreads of around 90 basis points, double the spreads in January. Offshore spreads also rose in the March quarter.

In contrast, banks' credit default swap (CDS) premia have decreased significantly from the peak in mid March following the rescue of Bear Stearns (Graph 59). Australian banks' CDS premia have fallen by 95 basis points, though are still elevated at around 55 basis points. Though CDS premia have increased more for US banks since the onset of the strains in markets, premia across commercial banks worldwide have moved together closely, suggesting that investors are not greatly differentiating between banks globally.

In contrast to banks' on-balance sheet capital market funding, the volume of securitisation remains very low. There have been no public RMBS this year and only two private placements although there are a number of new issues in the pipeline. Secondary market spreads on RMBS rose sharply in early 2008, reportedly on forced selling of RMBS by distressed leveraged offshore investors, mainly structured investment vehicles (SIVs, which bought around one-third of Australian RMBS prior to the credit crisis) and, to a lesser extent, foreign banks. While there has been little distressed selling in the past two months, spreads have remained elevated amidst very illiquid conditions. With few transactions observed, and wide bid-ask spreads, it is difficult to gauge current spreads. Most estimates suggest that spreads on AAA-rated prime RMBS are around 150–200 basis points.

The elevated RMBS spreads reflect investor caution toward securitisation, and the general credit conditions, rather than concerns about losses on Australian RMBS. Investors in rated tranches in Australia have never suffered any loss of principal – any losses on the underlying loans after the sale of the property have been covered by lenders' mortgage insurance, the profits of the securitisation vehicles, and to a lesser extent unrated tranches. Although losses on prime loans increased in 2007, they are still extremely low as a share of loans outstanding at 4 basis points.

A number of banks have recently converted some mortgages on their balance sheet into RMBS to be retained on balance sheet. These RMBS are able to be used in the RBA's domestic market operations, providing the banks with an additional source of liquidity should they need it. This follows the RBA's widening of the list of securities eligible for repurchase agreements in October 2007 to include highly rated RMBS and asset-backed commercial paper (ABCP) backed by prime mortgages.

During April, S&P downgraded the Australian mortgage insurance operations of PMI to AA− from AA. PMI's Australian operations, which provide mortgage insurance to around 45 per cent of securitised mortgages, remain on credit watch negative due to the two notch downgrade of the parent (to A+ from AA). While PMI Group suffered losses this year, the Australian operations remained profitable and PMI has indicated that it intends to ‘quarantine’ PMI Australia so that it maintains its rating. Following the downgrade of PMI's Australian operations, S&P downgraded around 175 subordinated RMBS tranches to AA– from AA. Subordinated tranches make up only a few percentage points of the value of an RMBS and so this action has little practical consequence for the RMBS market. The ratings of almost all senior tranches (AAA) were affirmed as they have sufficient protection from subordination.

In contrast to the absence of issuance in the RMBS market, there have been two auto loan securitisations in 2008. The AAA tranches priced at 150–170 basis points, well above the spread for issues prior to 2008.

Conditions also continue to be strained in the ABCP market, with the spread to the bank bill rate remaining elevated at over 50 basis points compared to only a few basis points prior to the turbulence. Liaison suggests that some programs are only able to issue at maturities as short as 14 days. However, two of the major banks have recently set up additional ABCP programs; these programs will have greater than usual transparency in terms of disclosure of the underlying assets and sellers of the assets. Three small ABCP programs were placed on credit watch negative as a result of the PMI downgrade (the programs are currently rated A1+).

The amount of ABCP outstanding continued to decline in February, falling by $5 billion to $53 billion, 26 per cent below the peak in July 2007 (Graph 60). Around half of the decline in February was due to the full repayment of RHG's (formerly RAMS) program, which was refinanced through other means. The majority of Australian ABCP has now been issued onshore, with market participants indicating that the offshore market remains largely closed to Australian issuers, with only a small amount of ABCP able to be rolled over.

Some of the (non-major) banks who are significant participants in the Australian ABCP market have announced that they intend to scale back their programs, some of which are used to provide warehouses for mortgages prior to securitisation. As a result, some mortgage originators will need to find a new source of funding for their warehouses. Liaison suggests that other banks are likely to provide replacement warehouses for some of this funding, but at a higher price. Some originators are being squeezed between the closure of the securitisation market and this higher cost of warehouse funding and have consequently scaled back their new loan growth.

Strains in securitisation and wholesale funding markets are affecting the ratings of smaller institutions who rely on these markets. Standard & Poor's recently affirmed the ratings of most Australian financial institutions, though they downgraded two building societies, and reduced the outlook for several other small lenders that rely heavily on securitisation.

In summary, banks, which supply about 85 per cent of intermediated finance, continue to have access to funding, albeit at a higher cost than prior to the capital market turbulence. Over the March quarter, their deposits and foreign liabilities grew at a solid pace, though their domestic capital market liabilities were little changed after growing very strongly in late 2007. The share of household and business debt that is funded by financial intermediaries has risen noticeably since the onset of the market turbulence in mid 2007, as asset-backed securities markets have been effectively closed, and corporates have found it difficult and expensive to issue bonds (see ‘Box C: Trends in Intermediation’).

Credit growth has slowed in the March quarter, with monthly growth in total credit averaging 0.8 per cent, down from 1.3 per cent over 2007 (Graph 61, Table 9). While the monthly credit figures can be quite volatile, the most recent data are consistent with other signs discussed in the ‘Domestic Economic Conditions’ chapter that demand slowed in the March quarter. Growth in broad money has also slowed in recent months from the rapid rates seen over 2007 (for further details see ‘Box D: Recent Developments in Broad Money’).

Household financing

Over the past three months, the interest rates on loans to households have continued to rise, reflecting both increases in the cash rate and the higher cost of funds faced by financial intermediaries.

Variable indicator rates on prime full-doc housing loans have risen by an average of 74 basis points since the end of January 2008, 24 basis points more than the increase in the cash rate (Table 10). Mortgage originators have increased their rates by about 12 basis points more than banks. The average variable rate on prime, full-doc housing loans is now 8.83 per cent, 139 basis points higher than at the end of July 2007. Interest rates on riskier housing loans have also continued to rise. The average variable rates on prime low-doc loans (7 per cent of outstanding housing loans) and non-conforming loans (1 per cent of outstanding loans) have increased by more than 75 basis points since the end of January 2008.

The five largest banks' average 3-year fixed rate on prime full-doc housing loans is currently 8.97 per cent, 50 basis points higher than at the end of January 2008, slightly above the variable rate and the highest level since 1996 (Graph 62). The share of owner-occupier loan approvals at fixed rates remained at about double its decade average.

Overall, we estimate that the average interest rate on outstanding household loans has risen by about 60 basis points since the previous Statement, to be around 90 basis points above the post-1993 average.

Reflecting the increase in borrowing costs and some tightening of lending standards, particularly for riskier borrowers, the value of new housing loans written has fallen over the second half of 2007 and early 2008. The share of loans approved by the banks has increased by 7 percentage points to just over 85 per cent, while mortgage originators' share has halved to 6 per cent (Graph 63).

Housing credit growth has slowed over the past year from an annual pace of around 14 per cent in early 2007 to 11 per cent over the year to March. The decline in loan approvals suggests that credit growth may slow further.

Interest rates on personal loans have risen over recent months. Average variable interest rates on margin loans, unsecured personal loans and credit cards have increased by 75–80 basis points since the end of January 2008. Partly reflecting this, personal credit growth has slowed noticeably during the first quarter of 2008, but is still 10 per cent higher over the year. A 14 per cent fall in margin lending accounted for much of the slowing in personal credit growth in the March quarter (Graph 64). Declining equity prices and increased investor risk aversion have seen borrowers pay down their existing margin loans.

Financial difficulties at several small brokers that offered margin loans have also emerged. These margin lenders did not restrict their lending to just the larger listed companies but lent against a wide range of smaller, less liquid listed equities, often at high loan to valuation ratios. Further, some of their clients had substantial holdings in some small companies. The volatility in the Australian share market in the March 2008 quarter has caused margin calls to rise sharply to an average of four calls per day per 1,000 clients. This is the highest frequency since the share market trough in March 2003.

Business financing

Total business debt expanded by a rapid 15 per cent over the year to March. This masks divergent trends in intermediated and non-intermediated borrowing. Business credit grew by 21 per cent over the year, while difficulties in issuing directly into turbulent capital markets have resulted in the stock of outstanding bonds falling over the year (Graph 65).

Growth in business credit eased noticeably in February and March partly due to higher borrowing interest rates, but also reflecting some slowing in the pace of reintermediation. This slowdown was most evident for large borrowers, who had recorded very strong growth in borrowing over the second half of 2007. Variable rates on large business loans, which are largely priced off bank bill rates, have increased by about 65 basis points since the end of January. Variable indicator rates on small business loans have risen by 81 basis points, and 3-year small business fixed rates have increased by 82 basis points over the same period. Overall, the average interest rate on outstanding business loans at the end of April was around 75 basis points above its long-run average (Graph 66).

In contrast, there have been some signs of improvement in the corporate bond market, with around $3 billion of bonds issued in April, all offshore. The four issuers are all large well-known companies that find it easier to tap wholesale funding than many other corporates. The spreads at issuance on these bonds were well above the levels these companies issued at prior to the credit crisis and the terms were not all as long as initially planned. The large spread on the Wesfarmers issue has led it to cancel plans to issue more debt and instead use equity and bank loans to refinance existing debt.

The corporate bond market was also affected by Fitch's downgrade of bond insurer MBIA to AA from AAA. Around 7 per cent of non-government Australian bonds are insured, and MBIA has just under half of this market. Consequently, Fitch also downgraded bonds insured by MBIA to AA.

In secondary markets, yields on corporate bonds have remained at elevated levels over the past couple of months after increasing sharply since late last year (Graph 67). Swap and CGS yields have come down a little, resulting in spreads widening.

Net equity raisings were low in the March quarter at around $5 billion, well below the quarterly average over the past year of $12 billion, and a number of floats were deferred amidst the volatility in equity markets. Share buybacks were also at a low level, probably reflecting companies taking a conservative approach to retaining cash in the current environment.

Overall, Australian businesses are in a strong position, with high levels of profits and continued access to debt and equity funding, despite the turmoil in financial markets. Measures of gearing – the ratio of debt to shareholders' equity – and the share of short-term debt confirm the healthy position of the aggregate business sector.

The market value measure of gearing – which incorporates expectations about future profits that can be used to service debt – was broadly unchanged in the December half year, with the increase in share prices offsetting the rise in debt. Falls in equity prices and continued strong growth in debt this year will have pushed the market value gearing measure up. In contrast, on a book value basis, the gearing ratio of listed non-financial companies rose by around 20 percentage points to 85 per cent in the December half year 2007, to be at the highest level in almost 20 years. However, the increase was mostly a result of Rio Tinto's debt funded takeover of Alcan. Rio Tinto intends to pay down its debt over the next two years through asset sales and its strong cash flows. Excluding Rio Tinto, gearing increased to be a little above the long-run average, but well below the levels reached in the late 1980s. Most of the highly leveraged companies are utilities and industrial companies that typically have fairly stable cash flows.

On average, companies' reliance on short-term debt at the end of December 2007 was moderate with around 20 per cent of gross debt due to mature within 12 months. Companies with high reliance on short-term debt do not tend to be highly geared. Although there may be further cases of corporates running into difficulties rolling over their short-term debt, overall this does not appear to be a large risk to the Australian non-financial corporate sector.