Stop Press: RBS Upgrades A Bank

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By Greg Peel

Ever since veteran bank analyst Brian “Grizzly” Johnson jumped ship from JP Morgan to join an expanding CLSA, the mantle of most bearish broker in the FNArena broker universe in regard to banks has been taken over by Royal Bank of Scotland (RBS, which acquired ABN-Amro). Johnson has been the Meredith Whitney of the Australian banking sector since mid-2007, and correctly so, but remains considerably more bearish than his peers. RBS later subscribed to Johnson’s views, however, in believing Australian bad debt levels would rise much further in the GFC than market consensus was suggesting.

While other major brokers in the FNArena universe have one by one begun to turn more positive on Australian banks, RBS has stuck stoically to its view. With Macquarie leading the charge, and GSJB Were being the most recent to fall into line, most analysts have now adopted a “look through” approach to bank earnings post economic recovery – out to FY11. On that basis, the Big Four banks began to be looked upon more favourably by analysts in a longer term valuation sense, although recent share price moves have now taken the banks above most shorter term broker price targets.

Aside from “looking through”, many an analyst has also more recently begun to believe the latest economic data do indeed suggest the impact of the GFC on Australia will not be quite as dramatic as first thought. This has led more particularly to an easing of trepidation surrounding the smaller and riskier ANZ Bank ((ANZ)) and National ((NAB)). The two have subsequently enjoyed some re-rating from analysts, while on the other side of the coin the much bigger Commonwealth ((CBA)) has been declared overvalued by the analysts. Westpac ((WBC)) is the Goldilocks at present.

It’s never been quite such a rosy picture for the regionals however, with leaders Bank of Queensland ((BOQ)) and Bendigo and Adelaide ((BEN)) most under the microscope. Whereas the Big Four have always been able to boast solid deposit bases in their tier one capital ratios, and AA credit spreads on the offshore funding used to prop up balance sheets and drive leverage, the regionals have suffered from lower deposit bases (mostly loyal locals) and lower credit ratings. That was okay in the boom however, because the difference was made up from asset securitisation markets.

Indeed, so liquid did the global securitisation market become (think mortgage-backed securities and CDOs) that Australian regional banks and non-bank lenders, along with foreign bank branches, were able to significantly undercut the traditional market share of the Big Four, and force the Big Four to also join in the spurious cheap mortgage bonanza. We all know what happened next.

When the subprime crisis hit in mid-2007, securitisation markets immediately shut down and general credit markets froze. The securitisation market remains as good as shut to this day. General credit spreads were still tight into 2008 (remember when the RBA was raising rates and the banks raising mortgage rates again independently?) and then blew out again when Lehman went down. Only recently has there been some easing on that front.

Obviously the Big Four banks found themselves in all sorts of trouble, particularly when big-ticket landmines like ABC Learning started exploding. But at the same time borrowers and depositors rediscovered the safety of history and size, and rushed their business back into the sanctuary of the Big Four. Non-bank lenders bit the dust, foreign banks pulled stumps, and suddenly the regionals could no longer be competitive. The Big Four rapidly gained market share in a diminishing market, and gleefully turned the screws on the competition. The big banks might have been looking at a dire situation, but the regionals were potentially facing catastrophe.

The result was improving big bank margins at the expense of diminishing regional bank margins. This provided a buffer for the big banks against rising bad debts, but the opposite was the case for the regionals. Bendigo and BOQ both saw their share prices fall 60% at the depth. Before this morning Bendigo could still only boast one Buy rating in the FNArena database to three Sells, and BOQ one Buy to five Sells.

But today RBS took its rating on BOQ to Buy from Neutral. RBS does not have a Buy at present on any other bank, if we don’t include banker/insurer Suncorp ((SUN)). It is indeed a momentous occasion.

In short, RBS believes the margin compression suffered by the regionals to date has now reached its nadir. They should remain flat or even start to rise from here over the next 12-18 months, the analysts suggest. Their reasoning comes down to what they call “a tale of two cycles”.

Regional bank margins have fallen by a whopping 35 basis points over the course of GFC, the analysts note, compared to only 7bps for the majors. With securitisation markets closed, and lack of access to offshore funding, the regionals have been forced to compete by offering expensive retail term deposits. While the majors have still been independently creeping up fixed and variable mortgage rates, they have nevertheless crushed the competition by passing on most of the RBA cuts into mortgages while cleaning up on not reducing business loan rates by nearly as much. But that is about to end.

Banks fund their loan books mostly against the peak of that book’s duration, while at the same time riding the yield curve by borrowing in the shorter term and lending, particularly in the case of mortgages, in the longer term. A positive yield curve thus means positive margins. This means banks tend to fund mostly around the two to four year mark. So while the big banks have been forced to scramble for expensive funding since the GFC began, they had not yet used up their original rolling maturities. In other words, they still had cheap pre-GFC funding in the tin and only needed to find the balance. But we are now approaching the second anniversary of the initial subprime crash and credit crunch (depending on exactly where you mark it). Hence the big banks’ cheaper funds are beginning to roll off.

The end of big bank margin dominance is now over, RBS thus declares. No longer will they be able to keep a foot on the neck of smaller competition. Margins should now begin to decline for the majors, and the flipside is a chance of improvement for the regionals.

The other side of the coin, of course, is bad debts. RBS has long pointed out that bad debt cycles run in three phases – big names, little names, consumers. The big names went under in FY08, and FY09 has brought the rise of SME bad debts. Consumer debt difficulties tend to follow unemployment, and unemployment tends to lag a recession. Thus in theory, we have yet to really enter Phase III. (Phase III is now well underway in the US, however.)

Regional banks don’t lend to big names. They lend to local businesses and consumers. Thus for the regionals, RBS suggests, the bad debt cycle is only really beginning. However – and listen closely – the analysts have this morning claimed:

“We believe peak cycle BDDs [bad and doubtful debts] may not be as high as we initially predicted given the likelihood of a milder recession than we expected.” (My emphasis, and I’ll come to why in a moment.)

So despite BOQ being specifically exposed to a state which has seen its resource boom come to a screaming halt, RBS now thinks the numbers suggest BOQ is showing value.

Unfortunately for Bendigo, a big exposure to the failed Great Southern trees-for-tax debacle means any upgrade for the Victorian/South Australian regional will have to wait.

The reason I underlined the words above is that they are not specific to the plight of regional banks, just banks in general. Could RBS be about to ease its view on the majors as well? Or will this rolling funding threat mean RBS’ longstanding Underweight rating on the sector will remain? So far, that is the case.

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