Tag Archives: australia

Standard variable rate mortgages

The last post looked at the increasing margins on Australian mortgages and small business loans. On the way is another post that tries to estimate how much the banks’ own margins have been increasing. Interesting though that may be, the real problem with Australian mortgages has nothing to do with whether bank margins are or are not going up. The problem is the product itself. This post explains why.

There was an article in the the Sydney Morning Herald today which explored exactly this issue, pointing out that Australia’s “standard variable rate” mortgage, which is the most common type of mortgage in Australia, is quite an unusual type of mortgage by international standards.

Banks tend to talk about “standard variable rate” mortgages, but a better term used in the industry is “discretionary variable rate”. The problem with Australian mortgages is encapsulated in that word “discretionary”. I can clearly remember almost 15 years ago trying to explain to European and US investors who were considering buying Australian mortgage-backed securities how a discretionary variable rate mortgage worked. The conversations went something like this:

INVESTOR: So, the bank can change the interest rate whenever they like to whatever they like?

ME: Yes.

INVESTOR: Why would anyone ever accept a mortgage under those terms?

ME: Well, it’s the standard product, so people are used to it and in practice the banks tend to just change the interest rates in line with the Reserve Bank cash rate.

INVESTOR: But they don’t have to do that?

ME: No.

Why were these investors so surprised by these sorts of mortgages? It’s certainly true that in many other countries, such as the US and France, the most common type of mortgages have fixed rates, but variable rate mortgages are found all over the world too. The difference is that most of these variable rate mortgages are pegged to some kind of indicator rate that the lender cannot control. Sometimes referred to as “tracker rates”, these mortgages would specify a fixed margin (say 2%) over a benchmark rate. This benchmark may be a central bank cash rate or some other kind of short-term market rate, but the important point is from then on that margin can never change. In contrast, with Australian mortgages, variable rates move up and down with market interest rates, but banks can also tweak the margin over market rates whenever they see fit.

Last year Westpac was pilloried when it tried to use the analogy of a banana smoothie to explain why mortgage rates were rising. It may not have worked for Westpac, but the analogy can help to highlight how strange discretionary variable rate mortgages are. Imagine that the cost of bananas goes up due to a cyclone-induced banana shortage. It may well be that the price of banana smoothies goes up (although it may also be that café owners take a portfolio view of their business, value their customers and absorb a bit of margin compression on their smoothies, but that’s another story). What certainly does not happen is that café owners go around to everyone who has bought a smoothie in the last year, explain to them that bananas are now more expensive and demand that their customer pays a bit more now for last year’s smoothie.

That is essentially what happens with discretionary rate mortgages. You might have taken out a mortgage a few months ago after doing extensive research comparing interest rates and deciding that the best value mortgage you could find was from the Commonwealth Bank as it was 0.1% cheaper than the next best offer (this may or may not have actually been the case). So far Commonwealth Bank is the only bank to have hiked their mortgage rate by 0.2% more than the Reserve Bank and now your “cheap” mortgage is 0.1% more expensive than the bank you turned down. So much for shopping around! Banks may argue that you are free to change to another bank if you are unhappy (although you can expect exit fees, particularly if you received any kind of rate or fee reduction when you first took on the loan). This does not change the fact that it is a rather unusual product that allows the seller to increase their margins after they have done the deal.

This hypothetical example highlights one of the real problems with the discretionary variable rate mortgage. It is inherently anti-competitive. There is little point shopping around for the cheapest mortgage when after next week it may not be the cheapest any more and you are locked in for 25 years. Is it any wonder that most people shrug their shoulders, say that the banks are all as bad as each other, hold their noses and just pick one almost at random?

There is another problem with discretionary variable rate mortgages, as one Mule reader pointed out in an email. It has the surprising effect of creating some credit risk for the borrower. Normally, depositors are exposed to the risk that the bank will fail, while banks are exposed to the risk that the borrower will fail. But, if you take out a discretionary variable rate mortgages, you may end up paying more if the credit quality of the lender deteriorates. The Herald article gave this hypothetical scenario:

Suppose one of our banks got downgraded from a AA to B. What would happen at the moment is they would just increase the margin on their mortgage rates to cover the extra costs they would face, whereas that risk should fall on the management and the shareholders.

But this sort of thing actually has happened! Many of the non-bank lenders like RAMS got into trouble during the global financial crisis and found funding through securitisation difficult, if not downright impossible. Some collapsed or turned to banks for support, but all of them suffered fast rising costs. Many borrowers who took out mortgages with these lenders saw their interest rates go up as a result. Some were able to refinance their mortgages with another lender, but those struggling the most to pay the higher interest rates would also be the ones least able to get refinancing approved.

In my view, abolishing discretionary variable rate mortgages, though unlikely to happen, would be a good thing for the Australian market. There’s certainly no guarantee that margins would drop. But it would change the stakes for banks considering raising rates to preserve their margins. Rather than being able simply to recoup that margin from their existing mortgage book, they would have to seriously consider the impact the move would have on new business, because it would only be new loans that would be paying the higher margins.

Getting caught in the traffic

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Guest author @pfh007 returns today to the Stubborn Mule. Staying on the theme of Sydney transport, but moving from train lines to motorways, he once again pulls out his beer coaster calculator (perhaps one day I’ll get him onto R).

QUICK SUMMARY: The proposal to widen the M2 motorway in Sydney recently received government in principle agreement. This post examines the risk that due to a provision in the original motorway deed the widening proposal may put at risk the completion a rail link to North West Sydney until after 2046!

UPDATE – 26 October 2010 – Government announces it has now signed the deal with the operators to widen the M2!

The recent post “Playing with trains” took a stab at a cost-benefit analysis for a North-West rail link in Sydney. In the comments on the post, the question arose as to whether the construction of a rail link would require compensation payments to be made to the operators of the Hills M2 motorway, since the original agreement to build the M2 included a provision that provided protection from any government action that undermined the viability of the toll road. In this post I will dig into this “no-prejudice” provision.

Naturally, any compensation payment(s) would be an additional cost in building and/or operating the North-West rail link and thus might be a factor in decisions to build it and where to locate it.

Last week the NSW government announced that an in-principle agreement had been reached with the operators of the M2 motorway to widen certain sections of the motorway. The ASX announcement by Transurban stated that the costs of widening the road were $550 million and provided for the extension of the original concession period by 4 years to 2046.

The announcement was, however, silent as to how the no-prejudice provision in the original M2 agreement would apply to the road-widening proposal. This was surprising as the no-prejudice provision had been very controversial when first revealed in the 1990’s and it seems relevant to the recent discussions about rail or metro links to the North West.

Time for some more Google-assisted beer coaster calculations!

First stop is to find out what the original M2 no-prejudice provision actually said. Google could not produce the actual deed but it did produce this interesting old report from the NSW Auditor General.

The M2 Deed and the “no-prejudice” provision.

The Auditor General report sets out the no-prejudice provision. In summary, the provision provides that if the NSW government takes action relating to the servicing of the transport requirements of the North West of Sydney which prejudices the operational results of the M2, then it will negotiate with the trustees so that the investors in the M2 will get the lower of the base-case equity return or the equity return they would have received if the prejudicial event had not occurred.

Of great interest to rail fans is the content of a letter from the Chairman of the Hills Motorway that the Auditor General included in the report. This “side letter”, which pre-dated the M2 deed, stated:

The Hills Motorway acknowledges the announcement of the New South Wales Government proposing a mass transit route connecting Parramatta to Hornsby via Epping, utilising the Carlingford line alignment in part.

The Hills Motorway proposes to execute the M2 Motorway Project Deed, having taken into account the above proposal and its likely impact on the M2 Motorway. As a consequence, the development of the Parramatta to Hornsby Mass Transit Route would not constitute grounds for negotiation under the M2 Motorway Project Deed.

The Auditor-General noted that the letter appeared to mitigate claims by the operators for at least the Parramatta-Epping section of any Chatswood to Parramatta rail link.

On the face of it, the no-prejudice provision would therefore appear to be directly relevant to action by the government to

introduce or increase bus services to the North West
build a heavy rail link to the North West
build a metro line to the North West
improve other roads servicing the North West

if those actions might reduce the number of toll payers using the M2 and thereby “prejudice the operating results from the M2 motorway”.

There is nothing really remarkable about having a provision like the no-prejudice provision. If you were an investor and had just stumped up a lot of money to build a toll road, you would not be too happy if the government then decided to undermine your business model by providing an alternative transport option to your potential toll payers.

The question is whether the current no-prejudice provision is too wide and should, for example, be limited to certain types of government action (such as selling another competing toll road concession) and whether, while negotiating to widen the M2, now is a good time to clip its wings.

Has the “no-prejudice” provision ever flapped its wings?

The 1994 letter concerning the Parramatta to Epping rail proposal suggests that both Hills Motorway and the government of the day considered the no-prejudice provision to be a serious issue, but I have been unable to locate any information that confirms whether the existence of the provision has been a significant factor in any government decision or in the resolution of any issue relating to the M2 motorway since then.

It would be interesting to know whether there was any correspondence or discussion between the government and Hills Motorway about the Chatswood to Epping rail link before it was completed as the Auditor General notes it does not appear to be covered by the 1994 side letter to the M2 deed.

I have a hazy recollection that the initial introduction of bus services on the M2 was not all plain sailing. I think there may have been an argument at some stage between the government, the M2 operator and Hills buses about the terms of commuter bus access to the M2. As that debate occurred in the era of human history now known as the pre-Googlassic, I was unable to locate any online references. It would be interesting to find out if, in the course of those negotiations, there were discussions about the extent to which public bus services might prejudice the operating results of the M2.

One immediate question that comes to mind is whether the public bus services that use the M2 pay a special toll or whether the government pays the M2 operator some sort of compensatory payment that reflects the fact that 17,000 public bus trips each day might be considered to result in a certain number of individual M2 car/toll trips avoided.

Presumably, there was some discussion about the provision before the Metro link was announced but as the link was initially only going as far as Rozelle perhaps not.

Missing in Action – The “no-prejudice” provision

Despite its relevance to both a proposal to widen the M2 and to building a metro line or heavy rail link to the North West of Sydney, the no-prejudice provision has been keeping a low profile lately.

I am more than happy to be directed to some information on discussion of the application of the no-prejudice provision to the M2 widening proposal, but I was unable to find any reference or discussion of it on the RTA website, the Hills Motorway website or the 277 page RTA “Submissions and Preferred Project Report (August 2010)”.

The closest I found were some submission questions on pages 123‒133 of that document, but the responses to those questions did not touch on the no-prejudice provisions in the original M2 Deed.

Does it really matter?

If you read the RTA Submissions and Preferred Project Report (August 2010), the impression given is that the North West region of Sydney is generating a swelling sea of cars and that buses and new rail links do not reduce the need to increase the capacity of the M2. This might suggest that we can sleep easily and not worry about dusty old provisions from 1994 that require the government to guarantee the returns of investors.

But it might also suggest that there is no good reason to retain the no-prejudice provision in its present form. At the very least, it might suggest that in coming to an in-principle agreement with the M2 operator to widen the current motorway, now is a good time to modify the provision to explicitly exclude the impact of new bus services, new rail links and other public transport options as events that may trigger the no-prejudice provision.

Finally, one last reason for caution. Traffic forecasting appears to be a very challenging science. The history of Sydney’s toll road projects has been remarkable in the regular disconnect between the estimates of traffic flow contained in the glossy prospectus documents and the number of toll payers who actually turn up when the red ribbon has been snipped and they have to start paying.

I am no expert in this area and the forecasts underpinning the M2 widening proposal may prove 100% accurate, but I would feel more comfortable if the tax payer was not exposed to the risk that they do not.

On page 129 of the RTA document, response (b) notes that the tolls from the increase in usage after widening would not be sufficient to fund the project and that is why the widening deal involves an increase in the toll of 8% and an extension of the concession period by 4 years. That suggests that a failure to hit usage targets will readily prejudice the operating results of the M2.

Finally, it is also worth noting that a large chunk of the Auditor General report on the M2 that I referred to earlier was concerned with the forecasts of traffic numbers contained in the original prospectus. More on that below.

Calculating the Prejudice

Leaving to one side what a flock of lawyers and judges might decide the words of the no-prejudice provision actually mean, how might we go about calculating the prejudice?

Time to turn over the beer coaster!

According to the RTA, approximately 100,000 vehicles currently use the M2 every day. That is an interesting figure because the Auditor-General’s report in 2000 set out the original base case projection of traffic numbers by 2010 to be 94,659, but only 76,289 under the then proposed financial restructuring. Transurban’s figures report that in the Sept 2010 quarter 96,983 trips per day were made on average, or 105,068 trips on the average workday.

The vehicle figures (whichever you prefer) suggest that the M2 is currently going gang-busters and exceeding the traffic projections made when the original deed was entered in 1994. That, of course, is entirely consistent with a proposal to widen the roadway.

If the M2 is currently at or exceeding capacity, minor government action would seem unlikely to prejudice the operating results of the M2. A few additional bus services to the North West are unlikely to trigger the no-prejudice provision.

The Transurban ASX announcement states that one of the objectives of the M2 widening project return is to achieve by 2016 an increase in average daily trips of 17,300.

Current toll revenue

Currently the toll on the M2 is $4.95 for a Class 2 vehicle (cars and motorcycles) and $14.50 for everything else (trucks, etc) for the full route, or less to Pennant Hills Road ($2.20 and $7.10 respectively).

According to Transurban figures for the Sept 2010 quarter they earned approximately $36.7 million net of GST which is about $40.37 million inclusive of GST.

That equals $161.48 million per annum including GST.

Their daily average figure of approximately 97,000 trips amounts to about about 35.4 million trips per annum.

That suggests an average toll per trip inclusive of GST of $4.56.

Toll revenue in 2016

Assuming that an 8% increase in toll is applied, the average toll per trip stays constant (plus the 8%) and the 17,300 extra trips are occurring by 2016, then the toll revenue figures will have increased substantially.

114,300 car trips per day at $4.92 (the average toll per trip $4.56 + 8%) = $562,356 per day or $205.3 million per year.

That’s a tidy revenue increase of $43.8 million per annum (inclusive of GST) per year for the remainder of the now longer concession period (2016 to 2046, 30 years) for the $550 million investment to widen the road.

Needless to say the above figures are beer coaster calculations.

Could the M2 experience train pain?

How much pain could a heavy rail link to the North West cause?

As beer coaster fanciers would recall from the “Playing with trains” post, a modestly efficient heavy rail link to the North West with 15 train stations could move approximately 30,000 passengers on 25 services (at 6 minute intervals) during the morning peak period of 6.15 am‒8.45 am, or 60,000 trips assuming every person returned to their home each night.

Assuming that only 10 of the stations proposed are likely to compete with the M2, that would mean that competing stations on the North West rail link could service 40,520 commuter trips each day (once again assuming that the stations have equal passenger loads of 2,026 people per morning peak period).

As discussed in the rail post, securing that many commuters will not be easy and may require substantial re-zoning to increase population densities and perhaps other policies to build patronage on the new rail link, such as building extensive commuter car parks and connecting bus services throughout the catchment. The actions are also likely to decrease the appeal of a daily return trip on the M2.

Let’s assume that the rail link was built (and, conveniently for this exercise, that it is done by 2016—yes, optimism is good for the soul) and succeeded in achieving only 66% of capacity—attracting only 20,000 passengers each morning peak period to its 25 comfortable air-conditioned Waratah carriage (only a few months away now, fingers crossed) equipped services.

Let’s also assume that 40% of those 20,000 passengers are car users who have been attracted by the thought of relaxing and reading their iPads on the train rather than listening to honking horns and breakfast radio on the M2. Those 8,000 train converts represent 16,000 lost trips each day on the M2.

The value each day of those lost trips is 16,000 × $4.92 = $78,700 per day or $18.1 million per annum (assuming they work 230 = 46 × 5 days per year) .

Considering that the business case for the widening of the M2 has a target of 17,300 extra trips by 2016, there could be some unhappiness if the majority of those 17,300 exciting motorway trips vanished into a railway tunnel.

That unhappiness would only increase if the railway hit its target capacity of 30,000 passengers per peak period (60,000 trips) and 50% of them were lost trips on the M2. A loss of 30,000 $4.92 toll payments per day would represent an annual loss of toll revenue on the M2 of $33.95 million per annum (again assuming those train commuters only turn up to work 230 days per year).

OUCH!

That would mean that the tidy toll revenue increase of $43.8 million per year under the widening proposal might shrink to $9.85 million if there was a North West rail link that could attract 15,000 people who would otherwise be paying a toll to travel on the M2.

DOUBLE OUCH!!

As the estimated ticket revenue in my train post from approx 30,000 people paying $50 for a weekly ticket was only $70 million, it would be a nasty sting if $33.95 million of that had to be handed over to the M2 operators as compensation for loss of toll revenue.

It seems highly likely that a moderately well-patronised and well-designed new rail link to the North West (that interconnects with the Chatswood-Parramatta railway) would have the potential to prejudice, perhaps significantly, the operating results of an M2 that is widened and has a daily trip capacity increase from 97,000 trips to 114,300 trips per day. It is even possible that a well-designed and run North-West rail link could prejudice the operating results of the M2 without any widening taking place, but that is less likely as the M2 is already exceeding the capacity that formed part of the original base case for the road.

Summary

The absence of any substantial public discussion of the application of the no-prejudice provision in 1994 Deed to the M2 widening proposal and a North-West rail link and the potential for possible compensation payments to the operators of the M2 is surprising.

No doubt people with much bigger beer coasters than I have available will have performed much more sophisticated modeling of the potential impact of governments actions like a North West rail line or significantly expanded public bus services on the number of vehicles using the M2 per day. But even with my little beer coaster, it seems that there is real potential for government action servicing the transport requirements of North West Sydney to prejudice the operating results of a widened M2.

The problem is clear.

If the agreement to widen the M2 is likely to expose the government (and therefore the residents of NSW) to even greater risk of compensation should a North-West rail link go ahead, then the likelihood of a North-West rail link being approved for construction is reduced as those compensation costs would weigh heavily on the decision. Furthermore, every action taken to improve patronage by creating bus links to train stations, or commuter parking or expanding the number of services will only worsen the problem and understandably meet some resistance from the M2 operator.

Of course if the sophisticated modeling, that I am sure is on a laptop somewhere in Sydney, shows that future public transport by rail and bus to the North West will not prejudice the operating results of the M2, because the M2 when widened will have no trouble attracting 114,300 trips per day, then the agreement to widen the M2 should include a modification of the original no-prejudice provision to exclude future public transport services to North West Sydney as potential triggers for the operation of the provision.

At the very least there can be no harm in releasing the modeling that has been done on this issue so that the context of the in-principle agreement to widen the M2 and its potential implications on future public transport to North West Sydney can be fully understood by the community.

Playing with trains – a North-West rail link

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Not content with scrutinising the plan for a National Broadband Network in Australia, guest contributor @pfh007 has now turned his analytical beer coaster to a network of a different sort: a railway network.

There is a Ph.D. for the taking by any researcher who is able to unlock the evolutionary origins of the propensity of young children (and many older people) to be mesmerised by trains, even the generic suburban variety. You can see the rush of endorphins on the faces of weary commuters as an express service roars past within a metre or two of their aching feet. People seem to have a railway gene.

During the 1970s and early 1980s, the annual model train exhibition held in the Willoughby Town Hall in Chatswood was a highlight for the local kids. It took a full day to observe every detail of the elaborate models complete with green fuzz trees, fields of tiny cows and platforms full of frozen people and Hornby OO gauge recreations of famous rolling stock clattering around and around. Although remarkable as demonstrations of what can be achieved in a backyard shed, those models and their kin were probably responsible for turning large measures of the population into armchair rail network designers.

Consider this a contribution from one such Backyard Bradfield.

One of the striking features of the recent federal election was the ferocious response to the promise to complete the Epping to Parramatta section of the Chatswood to Parramatta line even though new (or finally completed) rail should be of immense appeal to residents of the area. It seems clear that the strength of the reaction was largely due to the failed rail promises of recent NSW political history. In short people were tired of having their railway gene tweaked for short term political advantage.

At one level it is hard to understand why building a new railway in Sydney is so difficult. Unlike the technological challenges facing the early railway builders in Sydney (see the ponies and pick axes in the photos at Museum Station) we have access to marvellous mole-like machines that can bore tunnels right through the Sydney sandstone. We also have advanced administrative systems for compensating people whose houses must give way to new surface track. Shanghai has been laying a new subway at a great rate over the last 15 years, so why can’t Sydney?

Could the problem be cost, even though modern technology and construction methods should have caused construction costs to fall over the last 100 years? Perhaps it is not so much the cost as the complexity of the financing arrangements, which have become too ‘elegant’. The Waratah train deal seems remarkably ‘elegant’ and yet, according to the press, it is poised for implosion.

I think the real problem is that these days we are spending too much time thinking about what we want rather than what a railway needs to be viable. That is we should decide to build a railway and then shape that part of the city to suit the railway. After all, if the majority of Sydney’s suburbs were designed around the car it is highly unlikely that they will be suited to a rail line without substantial modifications.

As the National Broadbank Network (NBN) has established back of the beer coaster calculations as a valid method of policy analysis, I will adopt that technique for some rough calculations of the North-West rail line viewed from the perspective of the needs of the railway.

Route

Using Google Maps, the following route seems reasonable in terms of not going too close to existing rail lines. The precise route is not critical as the demographics and structure of the suburbs will change to suit the new rail line by way of changes to zoning requirements.

Number of Stations: 15

Balmain, Drummoyne, Gladesville, Top Ryde, Denistone East, Eastwood (interchange with Northern Line), Carlingford (interchange with Chatswood-Parramatta Line), North Rocks, West Pennant Hills, Castle Hill, Kellyville, Rousehill, Box Hill, McGrath’s Hill and ending at Windsor.

Train Capacity

Capacity of the new Waratah trains is 896 seated (8 carriages) and, say, another 320 standing (20 in each vestibule) = 1,216 people in total per train

Peak Hour Capacity

The beer coaster is not very big so I will stick with peak hour only and peak “hour” is taken to extend from 6.15 am to 8.45 am, so 2.5 hours. We want a well-signaled, well-designed speedy network that can handle trains at 6 minute intervals. This means we can run 10 trains per hour. Thus the number of peak hour trains is limited to 25 trains.

25 trains in 2.5 hours can carry between 22,400 people (all seated) and 30,400 people (40 standing in each carriage) into the CBD.

I have assumed that during peak hour everyone gets on and travels to the city and everyone comes home by train at the end of the day. I have also assumed that every train going in the opposite direction during peak hour is empty

Station Capacity at Peak Hour

With a capacity at 30,400 people between 6.15 and 8.45 am and assuming that the load is spread equally between all 15 stations, each station will process 2,026 passengers during peak hour. Assuming they all arrive evenly spaced during peak hour, there would be no more than about 80 people on the platform at any one time.

Ticket revenue generated by Peak Hour Capacity

Assuming that everyone works about 46 weeks per year and no one uses the train for any other purpose the revenue generated by the new line (at $50 per week for a weekly ticket) is 30,400 × 46 × 50 = $69,920,000 (roughly $70 million per year)

Certainly people will use the rail line outside of peak hour, but as they will often be concession fares, etc. it is probably safer to do the sums on the basis of the peak hour capacity.

Out of that $70 million you will need to remove operating costs (say $25 million) leaving you with $45 million to pay down the debt used to construct the rail line. As $45 million would only produce a 6% return on $750 million worth of bonds and building the line would cost a lot more than that, there is quite a large shortfall to be found.

To give you an idea of how much that shortfall might be, the price tag for completing the Epping–Parramatta line is estimated at $2 billion. It seems likely that the cost for the full North-Western rail line would be well in excess of $5 billion. How do we cover the shortfall?

Remodeling the suburbs along the route

The beer coaster calculations make it quite clear that the finances of our beloved new railway are marginal even if we squeeze 1,200 people on trains running every 6 minutes non-stop between 6.15 am and 8.45 am.

That means we need a nice steady supply of warm bodies arriving at the station. Where will they come from? This is what demands the remodeling of the suburbs along the route. Unless there are sufficient people who can use the rail line we will not even get to the stage of trying to convince them to use it.

Finding 30,400 people in a Sydney of 4 million during peak hour can’t be that hard, can it?

Well yes it can.

It is worth keeping in mind that, currently, the inner West line in Sydney only runs about 4 services per hour in peak time and you can usually get a seat at Petersham, which is one of the closer stops to the city. That means that, even in the relatively densely-populated inner Western suburbs of Sydney, it would be a struggle to get anywhere near 30,400 people.

Walkers are unlikely to want to walk more than 15 minutes to the station. It may be that most people will only be willing to walk a shorter distance. A 15 minute walk at a brisk pace is only 1.5 km. That means that the walker catchment for each railway station will be a circle of radius 1.5 km.

Bus links and commuter car parks can help extend the catchment for each station, but when you are trying to get an average of 2,026 people to each station during the peak hour, that means a lot of buses or a rather large commuter car park for each station.

The only practical solution is to permit or, better still, encourage medium-high density housing for a 1.5 km radius around each of the 15 stations. Ideally this would be mixed office/housing/retail construction so that the inhabitants of the 1.5 km zone might get away without having a car at all.

On the assumption that only 20% of the people living in the 1.5 km radius will be daily commuters, we will need about 10,000 inhabitants in each 1.5 km radius to generate the 2026 passengers. That is quite a lot of houses or, more likely, apartments (say 5,000–2 people per dwelling).

The re-modeling will not require an army of town planners. Simply change the zoning rules for the 1.5 km radius around each station to allow medium-to-high density construction of approximately 5,000 dwellings and let the builders and developers of Sydney do the rest.

If this approach was applied to the other rail lines in Sydney we may find that we can deliver an enormous supply of new dwellings (apartments) over the years ahead without any increase in the area occupied by Sydney. This would allow the preservation of the market gardens on the outskirts, which currently supply much of Sydney’s vegetables.

Needless to say, an increased supply of dwellings where people want to live will go a long way to making housing more affordable in Sydney.

What about the shortfall between construction costs and ticket revenue?

It might be possible to increase the weekly ticket price, but I think $50 is probably a price that will not cause too much “sticker shock”.

It is hard to justify making people outside the railway catchment pay the cost as they will probably have their own rail link developments to fund. It seems reasonable that the shortfall between ticket revenue and paying the construction cost should be recovered from all the property owners in the railway catchment as the rail line will increase the value of their properties.

This could be done by imposing an annual State “infrastructure” tax on houses in the catchment for as long as it takes to retire the bonds issued to raise the construction capital (perhaps 20 years). The rate of the tax could vary depending on the benefit to the taxed property of the rail line.

For example: the 75,000 dwellings (15 × 5,000) within the 1.5 km radius of each of the 15 stations might pay $3,000 per year for 20 years and the 300,000 dwellings (I have no idea how many there are!) outside the 1.5km radius but still within the railway catchment might pay $750 per year for 20 years. This ‘infrastructure’ tax would raise $450 million per year. Add in the $45 million from ticket sales and the annual total of $495 million would pay 6% interest on about $8.2 billion worth of government bonds (or less for a non-government borrower). Taking into account repayment of principal as well over, say, a 20 year period, the debt $450 million could support would be closer to $5 billion.

Not quite there, as the construction cost is probably a lot more than $5 billion but at least in the ball park!

Is it all too hard?

The numbers above are all beer coaster figures, but they do suggest that better public transport has a real cost and involves changes that cannot be imagined away.

Survey after survey reports that Sydney is sick of congestion and wants better public transport, and yet I cannot recall too many attempts by our politicians (of any shades of the political rainbow) to lead the debate as to what better public transport may require of us in terms of contributing to its cost and accepting some changes to the car-flavoured landscape of Sydney.

Perhaps that is the real obstacle to improving public transport in Sydney.

Conclusions

If we want new rail lines, we need to think more about what they require of us rather than what we require of them.
If we are serious about better public transport, we need to be serious about increasing the density of Sydney’s population (although not necessarily increasing the total population).
The main obstacle to building new rail lines in Sydney is low population density.
Building a new rail line will require substantial remodelling/re-zoning of the areas within a 1.5 km radius of each station, preferably a mix of medium-high density housing/offices and retail.
One way of funding the cost of better public transport is a state infrastructure tax on the properties that benefit from better public transport services.
The next time you catch a train in Sydney, take along a beer coaster and count the people on the platform, the density of housing around the station, the frequency of services and the price of the ticket and then start designing your own preferred extension to the City Rail network
Some suggestions—Bondi Junction to Cronulla via Kurnell (tunnel under the mouth of Botany Bay), Northern Beaches, Parramatta to Hurstville, Chatswood to Dee Why, Hornsby to Mona Vale.
It the context of the above discussion, it is perhaps unsurprising that people are raising questions about the rationale for an expenditure of $43 billion on the NBN.

Photo credit: coverling (copyright Creative Commons)

Will the Reserve Bank hike rates next week?

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Over the last few months, the Reserve Bank of Australia (RBA) board meetings have not provided any real surprises, but coming up next week is the most interesting meeting in a while. The cash rate is currently 4.5%, but there have been enough noises from the bank’s governor and other RBA board members about the strength of the Australian economy, that consensus is leaning towards a rate hike next week. Financial market pricing is currently indicating a 62% probability of a 0.25% rate rise. Interestingly, the online betting agency Sportsbet offers bets on possible RBA actions (somewhat controversially) and its odds are indicating an even higher chance of a rate hike.

Reserve Bank move	Payout	Probability
Rise Between 0.01 and 0.25%	1.33	75%
Stay The Same	3.40	29%
Rise Between 0.26 and 0.5%	4.50	22%
Rise 0.51% or More	21.00	5%
Any Decrease	101.00	1%

Sportsbet Odds (as at 1 October 2010)

My own contacts in the markets (you know who you are) tell me that the HSBC economist Paul Bloxham, who recently joined the firm after 12 years at the RBA, is calling for no move until November. So, perhaps a hike is not as sure a thing as Sportsbet punters believe.

What do you think? Here is another chance to pit the collective wisdom of Stubborn Mule readers against both the financial markets and online gamblers!

If you need more information to help you make up your mind, you could read Christopher Joye’s arguments as to why the RBA should just be getting a move on in the fight against inflation. It might help tame property prices in the process. Then again, perhaps not.

UPDATE: there was an error with the calculation of probabilities, which has been corrected. By the way, the fact that the probabilities add up to well over 100% gives an insight into Sportzbet’s profit margin, which looks to be around 25%.

FURTHER UPDATE: Sportsbet’s pages of financial markets bets are down…I wonder if ASIC are on to them now.

Is this the stupidest provision of the U.S. Tax Code?

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Two guest posts in one week! On this occasion, the Mule is yielding the soapbox to an anonymous and unqualified cynic who wants to talk about tax (his own words).

“Decline in housing affordability relentless“. So screams the Real Estate Institute of Australia in its latest Deposit Power Housing Affordability Report, and they’re not the only ones. Of course, what they’re really screaming about is the (in)ability of people to purchase their own home – private renters, constituting a mere 25% of households, or social housing tenants at a mere 5%, only very rarely rate a mention. Why? The answer, in part, lies in just how beneficial it is to be part of that home-owning majority. The Australian tax system provides many advantages to the home-owner. The holy trinity of exemptions, in order of their estimated value in 2005-06 Australian dollars, are shown in the table below.

Tax	Exemption	Value
Land tax	Owner occupiers are exempt from state-based land taxes	$3.5 billion
Tax on imputed rent*	Imputed rent is not taxed, nor is it captured by GST	$11.7 billion
Capital gains tax	Owner occupiers are exempt	$29.8 billion

Table 1: Tax concessions to homeowners

These benefits are designed to encourage home ownership, which is seen as a social good. This argument is typically justified either on cultural grounds (the importance of home ownership to our society, or the centrality of home ownership to the “Australian Dream”) or occasionally on economic grounds, in that home ownership is said to produce positive externalities (for example, children of homeowners may have a higher likelihood of finishing school, or a lower likelihood of criminal behaviour). However, others argue that any social good which is intended by these benefits is undermined by the fact that the concessions are distributed inequitably, with high income households receiving a much greater advantage than low income households. In particular, the capital gains tax exemptions are worth seven times as much to the top income quintile as they are to households in the lowest income quintile. But Australians concerned about efficiency and equity in the tax system might take some heart from the fact that the grand-daddy of all tax concession to homeowners is missing from Table 1: home mortgage interest deduction.

In the United States, mortgage interest repayments are fully tax deductible on up to two homes, capped to a debt level of $1 million. Historically, this deduction was available across all interest repayments. Rising levels of household debt in the United States throughout the 1970s, associated with the rising popularity of credit cards, led to a rethink of the wisdom of interest deductibility. However, the deductibility of housing mortgages remained, ostensibly to facilitate ever increasing rates of home ownership, but perhaps more honestly as a nod to the middle class who had come to think of this deductibility provision as a birthright, as the keystone to the “American Dream” (a dream which is eerily similar, it seems, to the aforementioned Australian Dream). While it is true that home ownership rates in the United States have increased over the past fifty years, it is not clear that this is as a result of this particular tax benefit. Indeed, home ownership rates in the United States are comparable to those in Australia, which has no such concession (although both countries offer similar capital gains exemptions).**

Country	1961	1990	2007-08
Australia	70%	69%	68%
United States	62%	64%	68%

Table 2: Home ownership rates

Many argue that home ownership rates have increased far more substantially as a result of financial innovation and the deregulation of the mortgage industry – although, of course, the net benefits of these innovations are still being debated. In fact, many economists argue that, far from enfranchising aspiring homeowners, tax deductibility of interest is a regressive policy measure which affords a much more substantial benefit to the wealthy than the poor. There are three main reasons for this.

Firstly, the size of the concession is obviously related to the size of the mortgage, and as such wealthier households accrue a greater benefit, in absolute terms. Secondly, the deduction is more valuable to taxpayers in the highest income tax band. Thirdly, the deduction can only be claimed if an itemised tax return is submitted. However, lower income households overwhelmingly fill out a so-called standard deduction, not an itemised one. In fact, while 98% of households with incomes above $125,000 itemise, the figure is only 24% for households with incomes below $40,000, and therefore the remaining 76% would not be eligible to receive the benefit. One model estimates that in 2009, 68% of the total tax change associated with mortgage interest deductions went to the top income quintile, while nearly 90% of the total tax change went to the top two income quintiles.

Even more economists argue most against the mortgage interest deductibility provision on the grounds of its being so expensive. The 2010 United States Federal Budget calculates the cost of the mortgage interest deduction at US$131.2 billion. By comparison, the next largest housing tax expenditure was attributed to capital gains exemptions, which came in at US$49.6 billion. Another potential side effect of this concession is to encourage leveraging at the household level. In its latest Economic Survey of the United States, the OECD argues that increased preponderance of interest-only mortgages was a symptom (if not a cause) of the housing crisis. Interest only mortgages are particularly attractive in terms of the mortgage deductibility, as it makes repayments deductible in their entirety.

The Bush administration convened an expert panel to develop tax reforms, one of which was a proposal to change the home mortgage deduction to a 15 percent credit and making it available to all filers, regardless of itemization status. This was immediately rejected out of hand. The Obama administration more recently suggested that home mortgage interest deductions would be capped at 28%. However, commentary on this proposal suggests it has failed, although everyone appears more focused on the politics of such a measure, not the economics.

It seems that this is yet another example of “Murphy’s Law of Economics” – the overwhelming weight of expert opinion is no match for the American Dream. Must we, then, accept that this is an instance of the truism of tax concessions, which is all too apt when one is talking about the family home: that they are easy to introduce, and near impossible to repeal?

* A renter has to pay rent from income that is taxed, but the homeowner does not. It can be argued that the homeowner effectively earns an income from their property, in that they pay an “imputed rent” – to themselves. This effective income is not taxed, although some would argue that it should be.

** A limited home mortgage deductibility scheme was part of Gough Whitlam’s “It’s Time” package. It was designed as a response to rising interest rates, and was specifically targeted at the lower end of the income scale. As he said in his 1974 policy speech: “All taxpayers whose actual income is $4,000 or below will be entitled to deduct 100% of their interest rate payments. The percentage of total interest payments which is deductible will be reduced by 1% for every $100 of income in excess of $4,000.”

Data Sources: J. Yates, Tax expenditures and housing, AHURI, September 2009; U.S. Census data; Australian Census of Population and Housing

Photo credit: Copyright creative commons by woodleywonderworks

A Delicate Balance

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Ever since Julia Gillard managed to wangle the support of two of the three country independents and scrape through to a second term in government, speculation has focused on how long the arrangement can last…and not only in the media but also on the Mule Stable.

Challenging though the road ahead may be for the new government, with so many different interests to juggle, I am of the view that Labor will do whatever they can to hold on to power. Even if they are unable to pass “crucial” legislation, they would be very unlikely to go to the polls early lest they lose the election. After all, if they did not have the courage to trigger a double dissolution when they failed to pass emissions trading legislation to combat the “greatest moral challenge of our time”, it is hard to see what issue could be important enough to them to jeopardise their power.

As for the independents, another election would risk their own new-found power. Furthermore, in siding with Labor they have not really promised very much. All they are committing to is to pass supply and to support the government in the event that no confidence motions are brought against it. On each and every particular piece of legislation they are free to horse-trade once more and potentially vote against the government. Also, as Bob Brown recently pointed out, there is nothing to stop the independents and the Greens backing legislation initiatives brought forward by the Liberals. So there really is no good reason for the independents to withdraw their support from Labor.

Without the numbers, the Liberals and Nationals are powerless to bring on an early election. So, this unlikely new coalition government is likely to be here to stay. The only scenario I can see that could undo Labor is a by-election. If one of the MPs supporting Labor were to fall under a bus, retire, disgrace themselves and resign or in some other way leave the Parliament, the Liberals would have the chance to win the by-election and chance the numbers on the floor. Failing that, I would expect to see Labor ruling for a full term.

What do you think? While it may take some time to see the result, this seems like a good opportunity for another poll on the Mule, so have your say!

Infrastructure Bonds

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With Australia’s Federal election looming, the opposition has today proudly announced a new policy to fund infrastructure without actually increasing Government debt! What are we to make of this?

It’s hard to determine the details from a media announcement, but based on the text posted by Peter Martin on his blog, it would seem that the idea is to provide tax incentives for entities other than the Federal Government to borrow to fund infrastructure:

Private infrastructure operators and State and Local Governments will be eligible to apply for the concessional treatment.

The way the scheme would seem to work is that eligible projects could issue bonds and investors would receive a tax rebate amounting to 10% of the interest on the bond. So, if you received a $100 interest payment and your earning put you in the top marginal tax bracket, you would pay $45 in tax. Under this scheme, you would only pay $35 in tax.

So, the cost to the Federal Government would simply be forgone tax revenue (and this would be capped at $150 million per annum) and the Opposition believes that the program could support up to $20 billion in infrastructure financing. Presumably, investors currently buying plasma TVs would rush to buy these bonds instead.

Seems like a neat trick, but I have a number of reservations about the scheme.

First, I have argued in the past that the near-hysterical concern about Government debt is overdone. For a start, Government debt in Australia is far lower than in other developed countries around the world. More importantly, the facile analogy that compares Government finance to that of a household budget does not stand up for one very important reason: unlike you or me, the Government is the monopoly issuer of Australian dollars. This changes the game and breaks the analogy utterly.

Second, the opposition’s policy would still involve raising significant amounts of debt, just not issued by the Federal Government. If that debt is all incurred instead by State Governments, should that really be a cause for celebration? After all, unlike the Commonwealth, State Governments do not control issuance of currency, so they really could go bankrupt and indeed, recent history has shown that many of the State Governments are loath to increase their debt levels too significantly for fear of having their credit rating downgraded. What if the borrowers are in the private sector? Well, that would be worse still! Back in March I updated my chart showing private and government sector debt. The debt level we should all be worried about in Australia is private sector debt, which is far higher than government sector debt.

Third, infrastructure bonds have form. Back in the 90s, the then Labor government introduced an infrastructure bond scheme which also featured tax incentives. Of course, it did not take long for clever investment bankers to work out how to surgically isolate the tax benefit so that wealthy individuals could take advantage of the concession without actually taking on any investment risk. In the end, the whole scheme was shut down, although some of the transactions that were done still survive today. I would expect exactly the same thing to happen with this policy. Any special tax treatment is always a red rag to the tax expert bull.

So, it may sound clever, but to me it does not seem to be sound policy.

Emissions League Tables

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Yesterday’s Sydney Morning Herald featured an opinion piece by Rodney Tiffen on Australia’s sluggish response to climate change. Deliberately provocative, the discussion was framed from the outset in the language of competition:

An international competition in self-righteousness would be closely fought. But Australia must be a strong contender.

Tiffen went on to draw on data from the International Energy Agency (IEA), but got his statistics slightly wrong in the process:

If we restrict the analysis to the most populous 130 countries, those with a population of 3.5 million or more, Australia is the world leader. Only a handful of small countries, especially oil producers such as Bahrain, Qatar and Kuwait, have higher per person emissions.

Australians may be disappointed to learn that we do not, in fact, take home the trophy in this competition. Both the United Arab Emirates and the United States have populations over 3.5 million and have higher per capita emissions than Australia at last count (2007). Nevertheless, coming in third place in this competition, Australia certainly punches above its weight, with per capita emissions running at 4.3 times the world average. Furthermore, as the chart below shows, we have been steadily catching up to the United States over the last 40 years. In fact, to give Tiffen the benefit of the doubt, the most recent IEA data is for 2007, so we may well be ahead of the USA by now.

CO2 emissions 1971-2007 (Source: IEA)

The reason Tiffen looks at per capita emissions is to ward off one common argument for inaction on climate change, namely that China and the United States are the only countries that can make a difference. There is no doubt that these two countries dominate the overall production of emissions. Throwing Canada and Mexico in with the United States brings North American emissions to almost one quarter of the world’s total. Add China and almost half the world’s emissions are accounted for.

Total CO2 emissions for 2007 (Source: IEA)

Nevertheless, if the aim is to attempt reductions in world emissions, Tiffen’s focus on per capita emissions is entirely appropriate. No-one would be convinced if the United States viewed its emissions along State lines, thereby arguing that their emissions were not so big by global standards after all (although, this defence would probably not be much use to California). While countries may be actors on the world stage through their political proxies at climate conferences, emissions are ultimately the product of people (both at home and at work) and not countries. Ranking countries by per capita emissions is thus useful as it gives some indication of where emission reductions may be more readily achieved. The chart below shows the top 25 (big and small) countries in terms of per capita emissions.

Top 25 per capita emitters for 2007 (Source: IEA)

Qatar ranks so high on this scale that it compresses the figures for all of the emitters below it, so here is the chart again with a somewhat truncated scale.

Top 25 per capita emitters for 2007 (Source: IEA)

There are certainly some small countries with high rates of carbon emissions per capita, but looking at a larger scale reveals that developed countries are the worst in per capita terms. It is worth noting, though, that Europe is doing better than the rest of the OECD and is also ahead of former members of the Soviet Union.

Per capita emissions by region for 2007 (Source: IEA)

Another useful approach is to consider emissions per dollar of economic output. This serves to highlight “inefficient” emitters, not to shame them but to identify where spending money on the problem is most likely to deliver significant results. It should come as no surprise that a league table of the highest emitters per dollar of gross domestic product (GDP) is a catalogue of troubled and/or small nations. Note that these figures are calculated based on conversion to US dollars using market exchange rates. Using purchasing power parity instead does reorder the list somewhat, but the names are largely the same.

Top 25 emitters by emissions/GDP for 2007 (Source: IEA)

This perspective suggests that when developed countries consider programs to assist developing countries to reduce their emissions, they could reasonably focus on significant but inefficient emitters. The chart below provides a possible target list, showing the 10 worst-performing countries in terms of emissions per dollar of economic output after restricting to countries with emissions of at least 150 million tons of C02 per annum.

Top 10 large emitters by emissions/GDP for 2007 (Source: IEA)

When will Julia go to the polls?

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After taking Kevin Rudd’s scalp and now having done a deal with the miners, Australia’s new prime minister, Julia Gillard, is widely expected to call an early poll. The question is, when will the election be held?

As usual, my first inclination is to dig into the historical data. Looking at all of the Federal elections since Federation, December is far and away the most popular month for a poll. Although the election does not even have to be held this year, December is sufficiently far into the future that it fails to qualify as an early election. Unless the bounce Gillard has experienced in opinion polls proves to be extraordinarily short-lived, we should be looking at a somewhat earlier date. Interestingly, both July and August have only seen one election. On the admittedly spurious grounds of historical precedent, September would be a better bet.

Australian Federal Elections by month

But what of other sources of information? At the time of writing, the shortest odds from SportingBet were on August 7. In my own rather modest poll, August is also proving the most tipped month (it’s not too late to vote in the poll…just make your selection in the form below). No-one has voted for a date in July and I am inclined to agree that that is really a bit soon. Nevertheless SportingBet is still showing odds (admittedly long ones) for 31st July.

In a bid for contrarian status, I will diverge from both the bookies and voters in my poll and will tip a September election. But which date? History is not much help there. Of the four September elections in the past, there has been one on the 1st, 3rd, 4th and 5th Saturday of the month (1914, 1934, 1940 and 1946 respectively). So, I will veer as close as possible to the people’s choice of August, while still tipping September and predict that the election will be on Saturday 4th September. In choosing that date, I have not been swayed by the fact that the fourth Saturday of the month has been the most popular historically, other than to nominate 28th August as my fall-back selection.

Since I will most likely be wrong and you probably disagree with me, make sure to vote!

RSPT RIP – Long Live the MRRT

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In the third in a series of guest posts on the subject of Australian mining tax, Zebra (James Glover) considers the changes to the proposed tax the new prime minister, Julia Gillard, has negotiated with miners.

The Govt has announced a replacement for the RSPT discussed in earlier posts to a Mineral Resources Rent Tax (MRRT). The principle differences are the tax rate – 30% and a change in the deduction. For established mines it is now based on market value depreciated over 25 years and the uplift rate is 12% not 5%. In addition there is a 25% deduction from earnings upfront which makes the base rate of tax 22.5% rather than 40%.

This post replaces an earlier one I put up about the MRRT in which I erroneously assumed that the opt-in about using the market value of assets applied in the way I proposed in my second post. The key statement here is:

“Miners may elect to use the book or market value as the starting base for project assets, with depreciation accelerated over 5 years when book value, excluding mining rights, is used; or effective life (up to 25 years) when market value at 1 May 2010, including mining rights, is used. All post 1 May 2010 capital expenditure will be added to the starting base.”

In the case where the mining company opts to use a market value approach I take it to mean the depreciation takes place before the MRRT is calculated. This means the formula is:

MRRT = 30% x (75% x Earnings – Price(2010)/25)

Currently the mining industry average for P/E (price to earnings ratio) is 14, though in the case of BHP-Billiton it is 19. For an average miner then Price(2010)/25 = Earnings x 14/25 = 56% Earnings so the actual MRRT is based on 19% of Earnings. However the Price is fixed at the May 1 2010 value so this will not increase over time even though earnings will. Should earnings continue to rise at the dramatic rate we have seen in the past decade then the MRRT will eventually look more like the 22.5% base rate.

It appears that the Govt and the mining industry’s compromise is to push the revenue from the tax windfall out from today to later years. In a sense the mining industry has also removed the contentious “retrospectivity” of the tax by using the current high price and choice of 25 years depreciation to ensure the current value of the MRRT is minimised but will rise at 22.5% of increased earnings going forward.

Thanks to an observant reader who pointed out my error. Mea culpa.