CBA Not In Trouble

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

By Greg Peel

FNArena reported yesterday (“CBA Tanks On Accounting Changes”) that the market had been spooked into speculating that Commonwealth Bank ((CBA)) had made changes to its profit reporting in order to cover up derivative losses. While changes have indeed been made, and the market indeed reacted on what little it first knew, it turns out there is nothing sinister going on (as we can tell from information available).

What really set the banks off yesterday, apart from any misguided reaction, was an announcement from Moody’s.

The CBA accounting changes relate to very specific (and complex) rules under the AIFRS system, and relate to “hedge ineffectiveness”. Without wishing to get bogged down, banks are able to account for offsets on hedging positions against profits and losses from those positions being hedged. Then there are further rules if hedges prove ineffective. A hedge may, however, prove ineffective but still actually make money, in which case the treatment of such “profit” is considered differently under AIFRS.

Australian banks have been quietly making the transition from the old accounting standards to AIFRS. The move yesterday by CBA is part of this transition, and JP Morgan’s Brian Johnson points out that the previous hedge treatment meant cash profits were being declared when they didn’t actually translate into distributable cash. CBA has now withdrawn any profit made form ineffective hedges from its bottom line, resulting in a 1.7% drop in EPS.

That’s all it was, and it actually provides for more realistic reporting.

Johnson had already factored in such variances to his banking sector numbers, and he notes the only bank left to fall into line is Westpac ((WBC)). But he also notes that yesterday’s bank slide, and subsequent index slide, was more to do with Moody’s ratings.

Every time Australia becomes more comfortable with the concept that global credit contagion is not really having too much of an impact downunder, something else happens, be it a Centro or an Allco or  Tricom. This time, Moody’s has announced a ratings downgrade to local insurer PMI Mortgage Insurance. What thus transpires (and there are echoes of Ambac here) is that 325 tranches, or $83 billion, of outstanding residential mortgage-backed securities (RMBS) are under review by Moody’s for possible downgrade.

Such downgrades can lead to forced divestment by institutional funds which are restricted to holding only highly-rated paper. A knock-down of prices of RMBS would lead to revaluation of such positions which could be held by all and sundry, including banks who have brought their SIV positions back onto their balance sheets. However, Johnson is not overly concerned about the big banks. He suggests, however, that St George ((SGB)), the regionals, and non-banks are the most likely to be affected, relying as they do on RMBS issuance to finance dividend payouts. Such issuance provides regulatory capital relief and provides for the maintenance of what have been historically high dividend payout ratios.

In other words, what’s been going on in the US to everyone up to Citigroup may well become more of a problem here. Australia is not immune.

Coming back to CBA, the hardest hit amongst the big banks recently due to general credit crunch problems, Johnson believes that in fact the opposite is true. He suggests the other banks will come off worse than CBA, and that CBA’s high dividend payout ratio is more secure than its peers.

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