Riding The Bank Rollercoaster

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The company is included in ASX20, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

I've been saying all year that 2010 is looking ominously a lot like 2008, in that one can simply replace the US investment banks of 2008 – Bear Stearns and Lehman Bros – with the sovereign nations of southern Europe – Greece and Spain. The private debt crisis has not gone away, it's just become a public debt crisis.

The analogy seems even more complete today as Europe instigates what one might call a sovereign equivalent of a TARP – a promise of hundreds of billions of dollars worth of newly printed banknotes on offer to halt the slide if needed. It took the US Fed and Treasury around twelve months of dithering before the TARP was established, but it has taken the EU only five, albeit with no less amount of dithering.

A feature of late 2007-early 2008 was that Australian stock analysts refused to believe Australian banks could be impacted by a subprime crisis in the US. But when the subprime crisis became the GFC, analyst views became a lot different. We have nevertheless rebounded, which might lend some weight to the analysts' original argument. But then if not for China, who knows?

In a similar vein, analysts and the market had largely been ignoring the developing situation in Greece, with immediate responses being the Greek economy was too small to be concerned about. By the time the situation was escalating, the market was driving up Australian bank stocks to new highs based on analysts' FY11 earnings forecasts and buoyant sentiment. There was a modicum of concern over potentially rising funding costs, but it wasn't until last week that bank stocks really tanked on a renewal of global credit market fears driven by a crumbling eurozone.

But in actual fact we already had cracks appearing in the Australian banking sector, by virtue of the annual round of interim earnings reports from ANZ Bank ((ANZ)), Westpac ((WBC)) and National Bank ((NAB)). In general, they were not particularly well received.

It's always a bit frustrating as a financial journalist every time the general public, and the popular press, fail to “get” why companies can post record profits and then see their share prices drop. Not that they should “get” it necessarily, but it is not so complex a notion that share prices constantly reflect expectations, and as such if expectations are not met, the market responds accordingly. A record profit could still fall short of expectations. Failing that, traders can also simply “sell the fact” having profited from rising expectations.

But there is also another element to consider, which is that while stock valuation is all about numbers, the “quality” of those numbers is just as important as the quantum.

So let's think back for a moment to the previous bank reporting period in February, when Commonwealth Bank ((CBA)) posted its interim and the other three of the Big Four provided quarterly updates. Most notable then was the rapid drop-off in bad and doubtful debt levels across the sector, which led analysts to adjust their forecasting to reflect a swifter reductions in BBDs than previously expected, as well as a lower peak.

Earlier forecasts had the banks bungling through FY10 but really hitting their recovery straps in FY11 as BDDs subsided. But the updates caused analysts to bring some of their earnings growth expectation forward into FY10 at the expense of FY11. It wasn't quite at the expense, because the otherwise strong results meant upgrades to both FY10 and FY11 earnings forecasts. But what it meant was the increased rate of earnings growth expectation from FY10 to FY11 was now reduced.

This should have been a warning sign. For as the market kept pushing up bank prices in April, it was beginning to overprice FY11 earnings growth. FY11 earnings expectations had long ago reflected a strong recovery. Bank prices had begun to effectively push to levels above what those numbers reflected.

As my colleague Rudi Filapek-Vandyck deftly explained in his May 6 article Westpac Is The Evidence, there was really no further to go. Not until there was further confirmation of better than expected earnings recovery, hence not until some actual results were in. When bank prices begin to exceed their average analyst target prices, either the target prices have to go up or the share prices have to go down. Sometimes the targets go up, but almost always the share prices go down. And analysts had already priced for near perfection.

And so the share prices duly went down. Before we look at why, consider another lesson learned from not only the last quarter's bank reports but more so the FY10 reports posted in November. The lesson is that in times of high-level market volatility, the investment bank arms of commercial banks make a lot of money – in no-risk fees from stock and interest rate broking and wealth management, and in risk profits from proprietary trading. If you couldn't make money as an investment bank in 2009 then you should not have been there.

And this was fully recognised by analysts back in November in particular. Be warned, they said, these excess trading profits the banks are currently posting will simply not last when the market quietens down again.

And so we move to the interim bank results of last week. Among all three there was a simple stand-out factor – the results were a little better than expected on face value but only because analysts underestimated both the ongoing rapid reduction in BDDs (a plus for earnings) and the big falls in trading profits (a minus). In the former case, the analysts had already been caught out by falling BDDs back in February and in the latter case, well…the analysts knew this would happen but seemed to ignore their own warnings. We may have had some volatility this last week and briefly back in February, but realistically the ASX 200 has gone nowhere much more than sideways since late 2009.

So having netted out those pluses and minuses, what was left was not a particularly inspiring picture. It was a picture low in quality. Net interest margins – those which reflect the difference between a bank's funding rate and lending rate, or the “real” part of banking if you like – are under pressure. And there are several reasons why.

Firstly, no matter what politicians may harp on about, banks' funding costs are on the rise. This may seem counterintuitive because we're coming out of a GFC not going into one, but the fact is the average maturity of bank exposure between everything from passbook account deposits to 25-year mortgages is about four years, volume weighted. So when the GFC hit, banks already had mid-curve exposure covered. The GFC saw the cost of credit explode and recede again, but settle back at higher levels than before given the world's new found appreciation for realistic risk-pricing. In other words, the banks are still rolling into higher funding costs.

Secondly, the big banks enjoyed one helluva honeymoon in 2009. With the safety of government deposit guarantees combined with an Australian customer base running scared, the big banks were showered with new deposits (a rush to savings) and all the new lending market share. In the latter case, lending books were quickly built up on the government-sponsored rush for mortgages from first home buyers. The government provided the stimulus and the banks collected the spoils. Once again, bank analysts knew the honeymoon would one day be over.

Thirdly, while this stimulus was supporting the consumer base, business lending was still trending down. And it is still trending down today, albeit that trend is now quietly easing and flattening out. There is disagreement among analysts as to how long it will take for business lending to actually recover. Given the banks all but abandoned businesses to their own fates in 2008, shutting up their lending books like clams and simply raising new capital to provide a buffer against the expected rolling wave of BDDs, any business credit recovery was always going to take a lot longer than the apparent consumer credit recovery. RBS, for one, suggested last month market consensus had business lending recovering a lot quicker than the history of recoveries from recession would indicate. And ask anyone in small business today and they'll tell you the banks still don't want to know them.

Fourthly, the GFC buried the mortgage securitisation market in Australia (and globally but for central bank support) which was the sole source of funding for many non-bank lenders and the most important source for smaller and regional banks. In general, the smaller institutions lost market share to the Big Four on a simple belief of “bigger is safer”. Now that we are coming out of the GFC, that trend is quietly reversing. It will continue to reverse (assuming no more GFCs) as the dust continues to settle, which means the Big Four will see market share gains begin to ebb away.

What the above also means is all banks will now find themselves in a more heated battle for deposits – the most coveted of funding sources.

Which brings us to fifthly. I am writing ahead of tonight's Federal Budget but irrespective of what that may bring for banks, the push is on globally for stricter financial market regulations. Among those regulations will undoubtedly be a requirement for banks to hold more capital and more liquid assets in their balance sheets than previously. This reduces the banks' capacity to leverage funds into profits. What's more, it's an election year and bank-bashing is the average Australian's favourite sport. Could the banks be hit with something along the lines of a super-profits tax?

Whatever that outcome, the bottom line is an impact on bank margins. Indeed, all of the above imply an impact on bank margins. We may be about to move into an FY11 of great expectations for ongoing economic recovery, but bank earnings will be constantly facing the headwinds of margin contraction.

And that's what bank analysts have suddenly realised this past fortnight. Although to be fair, they were already beginning to see the writing on the wall. What the actual results provided, however, was confirmation. And so it was last week we saw something which the FNArena database has never experienced before – six out of ten brokers simultaneously downgrading their ratings on Westpac, not so long ago the darling of the market (four to Hold, two to Sell).

The moral to all of the above story is that bank valuations had simply become stretched. In 2009 the market re-rated banks not on immediate earnings potential, but on eventual economic recovery potential – out to FY11 and even FY12. So as we approached the final quarter of FY10, it was all in there. Something rather extraordinary would have to happen to see analysts lift their earnings forecasts even further, and that something extraordinary would have to be revealed in the banks' actual results.

We didn't get anything extraordinary. We only got what analysts had pretty much already figured out for themselves.

So that's what the picture was, heading into last week. But by the end of the week, something extraordinary did happen.

The Europe situation finally reached a crisis point, just as the investment bank situation had done in 2008. Despite Australia's bank experience over that GFC, being initial sell-off on fear followed by a quick realisation fear was overblown, last week banks were sold off on fear again – heavily. Which means whatever negative valuation implications were provided by the actual bank reports of the last fortnight, the market has now rather rapidly priced those in by default.

So we have a new question: If we assume banks were expensive a fortnight ago, are they now cheap?

At least two major broking houses have expressed such an opinion since last week's big sell-off, albeit prior to the European “TARP” announcement.

Deutsche Bank notes that the big Australian banks have raised more than half of their calendar 2010 funding requirements already. Thus while the European situation could well lead to higher global funding costs once more, the Big Four should not be heavily impacted. What's more, they are all four among only a handful of global commercial banks still boasting an AA rating, which means they should not have any trouble attracting required wholesale funding from offshore.

Deutsche does add however that if ongoing funding does become expensive, Westpac and CBA have a greater need than ANZ and NAB and thus will be impacted more.

GSJB Were makes note that by the end of Thursday's big sell-off, the price/earnings multiples of the banks had returned to the depths experienced at the bottom of the GFC cycle, being around March to May 2009. Yet at that time, there was great concern over the need for capital raisings, commercial property risk, rising unemployment, corporate deleveraging and runaway bad debts.

We know now that the capital has been raised (indeed to levels exceeding current statutory requirements), the commercial property market has steadied, unemployment is falling, corporates have largely repaired their balance sheets and bad debts are falling more rapidly than previously expected. Therefore, suggests Weres, last week looks like a bit of an overreaction. There is much greater earnings certainty among analysts since successive results post-GFC have come in, exhibited by a much narrower range of forecasts than had been the case in previous times.

Weres also echoes Deutsche's comfort on the issue of funding.

The result of all of the above is there has been a bit of a shift around in analyst preferences among the Big Four. It wasn't that long ago that CBA was the pariah as far as analysts were concerned given supposed overvaluation by the market. Westpac was a bit of a darling, although not seen potentially as good a value bet as the smaller two and particularly NAB. If the market was overpricing CBA on “big bank safety” it was supposedly underpricing NAB on UK concerns and uncertainty surrounding its takeover bid for AXA-AP ((AXA)) which has now (probably) been nipped in the bud.

The latest table of bank ratings in the FNArena database (see below) shows a different picture than before. Although it must be noted several brokers are advising NAB, and as such have been omitted from the Buy/Hold/Sell count. This is possibly misleading on a ranking basis.

But we can see clearly from the difference between average targets and yesterday's closing prices that the smaller banks are still favoured to outperform, while the bigger banks have further upside potential as well now that they have re-rated downwards in rather a hurry.

What we likely won't see this time, in the wake of the European scare, is bank valuations running too far ahead of forecast valuations. At least, that's what one might presume.

Please note CBA will provide a quarterly update tomorrow.

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