CBA’s Credibility Shot

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This story features COMMONWEALTH BANK OF AUSTRALIA.
For more info SHARE ANALYSIS: CBA
The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

The blame game is underway, and so is the investigation. Commonwealth Bank ((CBA)) asked Merrill Lynch to implement a $2bn institutional placement, providing the broker with confidential information that the bank had increased its bad loan impairment expectation from 40-50 basis points to 60bps. In layman’s terms this means bad loans are now expected to be up to 30% worse by the end of FY09 than management previously expected. Merrill Lynch made the placement at $27, but failed to inform institutions of the bad loan increase.

So the questions are: (1) why didn’t Merrills spill the beans; and (2) why did CBA not just announce the profit downgrade to the greater market under normal disclosure rules?

The result was a withdrawn placement, followed by a fresh placement at $26 by new broker UBS, which represents about a $100m loss for the bank. But it’s not really a loss, as the bank intended institutions to know about the profit downgrade, if not the whole market – yet.

The response has been a lot of wailing and gnashing of teeth, and handbags at ten paces between the CBA and Merrills CEOs. Analysts have mostly shaken their heads at what has been a black comedy of errors, bemused that one of Australia’s largest corporations could so majestically stuff things up, but not incredulously surprised. Analysts aren’t really much interested in the stuff-up per se, as it is not the source of the real credibility challenge. That CBA should have such a vague grasp on its bad loan potential is what analysts are more concerned about.

Indeed the $2bn placement that has been left in the settling dust is a plus for CBA as it shoots the bank to the top of the pops with an 8.5% capital ratio. Did CBA raise more capital because it felt it needed to, or because everyone else has? Was the 60bps loan loss forecast the catalyst? Does CBA have any sort of handle on the current operating environment?

These are the questions being asked by analysts this morning as they take a knife to their earnings forecasts. There was also some severe target price adjustments going on, with Deutsche Bank (Sell) announcing it had little confidence the 60bps will be the end of it “given CBA’s poor track record for forecasting its own loan losses” before cutting its target from $33 to $23 in one fell swoop.

That’s a 30% target price reduction on a major bank – not some junior miner.

Target adjustments across the board see the FNArena average fall from $33.07 to $30.20 but we have only had responses so far from five of nine brokers. High marker UBS (Neutral – $35.00) will be on restriction until the deal is complete. Deutsche is the low marker at $23.00, just below JP Morgan on $24.00.

Two days ago JP Morgan upgraded CBA from Neutral to Overweight on the strength of the original placement, oblivious to the profit warning to come. This morning JPM has downgraded straight to Underweight.

JPM contends that the significant loan loss increase means it’s all over for CBA’s longstanding premium to its peers. Deutsche Bank and Merrill Lynch (Underperform) concur. CBA now has five Sell ratings to its name along with two Holds and two Buys.

Macquarie (Outperform) acknowledges that the credibility loss will affect near term share price upside, but counters that the increased bad loan loss forecast and capital raising now remove the two major concerns hanging over the market. CBA’s dividend yield is now above 9% and the analysts believe CBA will maintain its payout.

The dividend is a bone of contention, with analysts wavering between believing it should hold, believing it will hold only if things don’t get any worse, and, in JP Morgan’s case, now expecting that the 266c dividend of FY08 will be cut to 220c in FY09. JPM is also alone in suggesting that from an historical perspective, the major banks should be looking to top up to 9.5% capital and not just 8.5%.

Whichever way you look at it there’s no pretty picture here, although this morning’s trade shows the market is happy to buy at the $26 placement level – 10% below the close before the trading halt. On a sector-relative basis, CBA now sits in fourth in most analyst tables. For the sector in general, it all comes down to just how bad things will get from here, whether any more “names” might implode, and just how high the unemployment figure might rise, impacting on mortgage defaults. We are only now at the beginning phase of a recession that may last some time.

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