Banks At The End Of Their Tether?

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This story features ANZ GROUP HOLDINGS LIMITED, and other companies.
For more info SHARE ANALYSIS: ANZ
The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

The Australian stock market cannot fall 15% in a couple of months without its two main sectors – resources and banks – leading the charge. However, since the initial announcement of the proposed, and now much altered, RSPT at the beginning of May, banks have been hiding in a media shadow.

Granted, there has been a little bit of discussion about mortgage rates and whether or not the banks will raise them despite a now rigid RBA, but realistically the mining sector has sucked up all the media and analyst oxygen these past two months. Yet banks have performed just as poorly as resource stocks.

Clearly this performance is related to the simple notion of concern over global economic slowing and talk of double-dips, which implies lower credit demand, along with the European debt crisis and the potential for higher bank funding costs, implying lower margins. But these considerations were already being discussed by analysts back in May, along with ongoing weakness in business sector borrowing, the overhanging concern over potential regulatory changes, and competition for deposits. Nothing much has actually changed since, other than the market has fallen a lot lower, bank stocks included.

The following is FNArena's irregularly published Big Bank table:

The last time I published this table was in a story back on June 1. At that stage the ASX 200 had fallen 12% from its April high before attempting a rebound and then dropping further to be 15% down. What caught my attention most when I updated this table today (for yesterday's closing prices) is that two of four analyst average target prices have not changed since and the other two have changed very marginally. This has led to valuation gaps of 20-27% (price to target), and for banks you rarely see numbers any bigger.

So something has to give, in FNArena's experience. Either those targets must come down or the market must rebound. There are also now more Buy ratings for the banks, particularly for ANZ Bank ((ANZ)), than there were in June suggesting the analysts are not about to bottle. Note that National's ((NAB)) Buy/Hold/Sell rating is complicated by four of ten FNArena database brokers being retained as advisors on either side of the bid for AXA AP ((AXA)). We count those restricted ratings as Hold, whereas the restricted analysts may well be champing at the bit to establish Buy ratings – we don't know at this point.

A clue to why there's been little movement in the above table in over a month lies in some extensive research performed recently by the JP Morgan bank analysts. JPM has been looking closely at the issue of bank funding and the potential impact on bank margins. In short, it's not good news.

Clearly the European debt crisis has had, and can only have, one flow-on effect, being a rise in credit spreads meaning a higher cost of funding for banks. This is problematic for Australian banks as (a) they rely on offshore funding and (b) it is an election year. The latter comes at a time when global financial sector regulations are being tightened (the US is clearly leading the charge here and Australia has yet to respond), which already poses issues for banks such as potentially higher capital requirements, but no bank would be game to raise its mortgage rate without an RBA rate rise and risk a scathing counterattack from a government trying to win votes. This means the banks currently have to cop any funding cost increase on the other side of the ledger as reduced margins.

The RBA, on the other hand, is more upbeat than downbeat, suggesting a rate rise would be possible but for the problems in Europe and slowing elsewhere. So rates are going nowhere.

Banks borrow money offshore to add to deposits locally by issuing bonds. As it turns out, 2009 was a record year for bank bond issuance ($228bn compared to the previous peak of $117bn in 2008 and an average of $68bn in 2003-07, JPM points out). In 2008, the banks were madly raising equity capital to strengthen their balance sheets, but they were simultaneously issuing bonds in line with “normal” practice. Those bonds were nevertheless very expensive to issue in 2008 (high interest rate cost to the banks) given we were in the middle of a GFC, so the banks settled on shorter durations rather than the usual longer durations so as to not have to pay too much.

What this has meant, notes JPM, is 2009 saw a convergence of maturity – the longer-dated bonds issued in 2004-05 converged with the shorter dated bonds issued in 2007-08 and suddenly the banks had an awful lot of funding to refinance. The fact that banks were also once able to rely on mortgage securitisation to balance offshore funding, but that that market is yet to return, only added to the problem.

The analysts note that in FY08, the banks would have been projecting a funding rollover in FY10 of a collective $100bn. However, recent disclosures suggest that number is going to end up being more like $140bn. ANZ and NAB are still running at their “usual” requirements of about $25bn but levels for Commonwealth ((CBA)) and Westpac ((WBC)) have blown out to to the order of $45bn.

What this means, the analysts suggest, is that the positive funding differential once enjoyed by the bigger CBA and Westpac over the smaller ANZ and NAB is being eroded.

And the story doesn't get much better. With the convergence of maturities ongoing, JPM notes the banks are now heading into a period where an increasing amount of annual debt issuance will be absorbed by refinancing. In other words, they will have to pay higher funding costs on both new and old business because they don't now have longer maturities to carry them through, as would normally be the case. And they have to push new bond issuance to beyond a maturity of FY12 because that's when the government will need to refinance the sovereign bonds it issued back in 2008 to guarantee bank deposits. No government is likely to withdraw those guarantees any time soon. And the banks don't want to be competing with the government for funds in FY12.

This is the major problem JP Morgan sees for bank funding ahead – not any question as to whether Australian banks will have trouble finding willing lenders while the European debt crisis rages. What it all adds up to is that banks will be forced to pay more for their funding from here. Normally that would mean raising lending rates, including their politically sensitive Standard Variable mortgage Rates (SVR). But at least before the election, that ain't gonna happen. And that means lower margins, and that means lower earnings.

The result is that JP Morgan has this morning downgraded its bank sector earnings forecasts, between 1-4% for the Big Four in FY11 and 3-6% in FY12. The analysts now only expect “mid single digit” growth in loans and also see less contribution from the banks' wealth management businesses given a weaker equity market. As a result, lower return on equity (ROE) numbers are also expected.

It's a far cry from the heady days of early 2010, when Australian banks were being touted to post exceptional ROEs in the inevitable FY11 recovery from the FY09 depths.

And that's the bad news. But fear not, for there is also good news. The good news is summed up in this statement by the JPM analysts:

“However, in our view, the recent sell-down of the Australian banking sector is factoring stronger interest margin and growth headwinds than are warranted by our recent analysis of the funding task at hand.”

And that is the clue to why analysts have not much changed their bank share price targets since May. Those targets had already assumed a growing level of margin pressure, and all that has happened since is that growing concerns over global economic weakness has seen bank shares fall further and further below even those sharply adjusted valuations.

Investors may like to take note.

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