Bank Recovery Remains Some Time Off

This story features COMMONWEALTH BANK OF AUSTRALIA, and other companies. For more info SHARE ANALYSIS: CBA

By Greg Peel

If you want to generate the greatest amount of visceral anger and disdain from Australian public, just tell it a bank has made a record profit. The populist media likes nothing more, because it makes for sensationalist headlines to spark fury amongst the great unwashed – or in this case, anyone with a mortgage or anyone who's been knocked back on a business loan.

While anyone knocked back on a business loan has a legitimate axe to grind, they can still lay more blame on the populist media and today's purely populist and shallow politicians. For it is they who entrench the notion in the average Australian that all that matters in life is the standard variable mortgage rate, and that banks are the Evil Empire which control the SVR at the average Australian's expense. Aside from Australia's bizarre tradition of basing a 20-year loan rate off an overnight cash rate, the irony is that it is the SVR obsession which is currently impacting heavily on the earnings outlook for banks.

The Big Four banks appeared to sail through the GFC, but for that they only have a populist government and a panicked electorate to thank. Despite hatred of the Big Banks being Australia's favourite indoor sport, it only took a GFC to send those same Australians rushing to the safety and the sanctity of those same banks in 2008-09. And given it is apparently a right and not a privilege in Australia to own one's own home, the government hurled money at prospective home buyers in that period. And where did Australians run to for their mortgages? To the Big Banks they otherwise despise. And so the Big Banks loaded up with new mortgages, as well as old mortgages from bankrupted lenders or gobbled-up smaller banks.

That loan book growth ensured the Big Banks were sitting pretty in FY10 at a time when analysts had expected a year of little earnings growth given likely bad debt write-offs and low credit demand (beside first home mortgages). This was great news, because analysts also expected FY11 would be the golden year when credit demand would return and the recapitalised Big Banks would see exceptional earnings growth off a cycle-trough base.

But there have been a wealth of problems with all of the above.

Firstly, banks simply do not borrow money at the overnight rate to on-lend to mortgage applicants or anyone else. So while the RBA was slashing its cash rate, banks could only remain competitive and slash their SVRs as well (albeit not by as much). The victims in this debacle were the business borrowers who saw little relief at all and a “talk to the hand” attitude from their lenders. SVRs are sacrosanct, and the banks had to act accordingly, at least as best they could.

I say as best they could because the banks knew they were facing a serious funding challenge which was a lot more than credit spreads spiking in the GFC. Outside of deposits, banks tend to borrow to fund their businesses by issuing bonds (of various shapes and sizes) in the two-five year range, not overnight. That is where the concentration of the average bank's loan exposure lies. So when the GFC hit, banks still had at least a couple of years of pre-crisis funding at low rates to carry them through.

When it came time to add more funding, it was simply no longer viable to roll over existing loans out to the same sort of 2-5 year maturities. The blow-out in credit spreads had made rates at that distance ridiculously expensive. So the banks had to take another tack, and that involved three separate strategies: (1) they went to the equity market and raised more capital; (2) they raised their deposit rates at the expense of their interest margins; and (3) they rolled longer term loans into short term loans. Short term loans were relatively much cheaper given the impact of massive global stimulus from central banks (eg, Fed rate at near zero).

The banks knew that they had to somehow get through the period where their previous cheap funding would become a lot more expensive, while at the same time being forced to drop their SVRs. It would be a tense time given the banks also had to put away provisions for an expected flood of customer debt defaults. But the hope was that FY09 would be the disaster, FY10 would be a year of trying to bungle through, and by FY11 the recovery would be underway and things would start going back to normal.

Enter Greece. As we moved into the second half of FY10, funding rates which had been quietly subsiding began to shoot back up again. Fortunately the RBA had also begun to raise again, so at least some relief was offered on margins as SVRs could also be quickly raised. But now that we have entered FY11, the world is facing a possible “double dip”.

To top things off, financial market reform has been on the agenda since the GFC and it is an election year in Australia. Knowing the obsession Australians have with SVRs, and just how popular a politician would become if he/she introduced legislation to curb bank profits, the banks were loathe to raise their SVRs any further than the cash rate implied. At the same time, their funding costs were becoming greater, and greater, and greater. Those short-date loans the banks had taken in the hope things would have settled down by this time now have to be rolled as well. And competition for deposits is fierce.

This means bank margins have been squeezed, and squeezed, and squeezed. And what's more, the blessed relief expected in FY11 is no longer expected. Credit demand outside mortgages has never recovered – indeed it has only weakened – and with the cash rate now back at 4.5% demand for mortgages has collapsed. The global economy is noticeably slowing, and the absolute reality is Australia only ever escaped a “recession” because of iron ore and coal. Australia ex-mining has realistically been in recession ever since the GFC and will likely remain so for some time yet.

Yet the Commonwealth Bank ((CBA)) was yesterday able to announce a record profit, prompting apoplexy from the media, politicians and the great unwashed. And just wait until CBA lifts its SVR on August 23 which is odds-on. There will be lynch mobs in the streets.

It's a strange obsession we Australians have. As noted, banks do not fund mortgages from overnight cash yet they are trapped in this cycle of moving SVRs in lockstep with the RBA. Only about a third of Australians actually have a mortgage, and an ever-growing population of Australians (ie the aging) actually benefit when rates go up, given return on deposits and other investments rise.

And then, of course, virtually every Australian with a superannuation fund, meaning virtually every working Australian, will have an investment in CBA and the other banks. Solid bank share prices and dividends are actually good for a very large proportion of the Australian population which otherwise spits fire when a record profit is announced.

But while record profits should be good for shareholders, yesterday following the announcement CBA shares tanked. Why?

They tanked because it doesn't matter what profit result a company produces – record or otherwise – it matters only whether that profit met the market's expectations. And even if it met the market's expectations, it matters just how that profit was made. In the current environment, perhaps the most important factor is whether or not the company thinks it can do it again next year.

As it was, CBA's profit result was a tad above consensus. So tick that box and then move onto boxes Two and Three. How was the profit made and what guidance/outlook did management provide for the next year?

This is where CBA fell down, on both counts.

Within the record result was an accounting movement of previously retained earnings into realised earnings. This represented a “bringing back” to the bottom line of provisions made in 2008 for expected bad debts. Indeed, CBA cut its provisions back by a whacking 50% despite still having trouble with the bad debts inherited by buying BankWest. This was not “new” profit. This was just old profit that was held back in FY09 and has now been released.

There is a certain amount of encouragement in the fact CBA feels safe enough to halve its bad debt provisions now, provided its reasons for doing so are sound. It is true that all the Big Banks put aside hefty provisions in 2008 – not just against their specific loan books but against general ongoing crisis fears. And it is true that while the world is still struggling no one much is talking Great Depression II anymore. But it would not be comforting to think CBA has rushed provisions back to the bottom line simply in order to meet, or beat, consensus forecasts, and avoid a share price shellacking.

As it was, the shares did take a tumble despite the record profit which beat consensus. The reason is that CBA brought back a lot more in provisions than anyone expected – so much more than clearly there had to be an offset somewhere else. And there was. So desperate has the bank's funding cost issues become, at a time when CBA has no choice but to keep its SVRs on hold, that its profit margins were a lot lower than analysts had expected.

Thus if you assume provisions to simply be a timing issue – a net zero result across accounting periods – CBA has put in a disappointing result. Management also suggested it simply ain't going to get any better in a hurry. And the bad news for any bank investor is the bulk of the problem is sector-wide. Indeed, CBA is arguably the most robust of the Big Four.

Having said that, analysts were somewhat surprised to learn on Tuesday, ahead of the CBA FY10 result, that National Bank ((NAB)) had managed to maintain flat margins in its third quarter. All of NAB, Westpac ((ANZ)) and ANZ Bank ((ANZ)) run on October-September financial years, so the June quarter was NAB's third and its FY10 result is not due until November.

Readers thus have to be aware that CBA is into FY11 now but for the other three FY11 does not actually begin until October.

Bank analysts had anticipated margin erosion, being fully aware that funding costs have been rising, SVRs have been stuck for three months and the competition for deposits has meant some generous deposit rates. So both NAB and CBA surprised – NAB because margins were flat and CBA because margins were even lower than analysts had expected. Yet while CBA beat profit consensus, NAB missed.

The reasons NAB missed were largely twofold. Firstly, unlike CBA NAB did not bring back a big whack of provisions onto the bottom line. It did write-off less bad debts than analysts assumed it would have to, but management chose to keep the bulk of its “provisions against ongoing crisis” intact until it knows more about what regulation changes the government might soon dump upon it.

Secondly, of all the Big Four it was NAB that was caught out holding the most “toxic securities” when the subprime crisis became the GFC – far more so than the other three. Those securities are still sitting there, and will probably do so through to maturity. But NAB has had to take out offsetting derivatives against those securities to hedge its exposure, and those derivatives have to be marked to market in value each accounting period. Credit spreads blew out again in the June quarter as global fears heightened, so NAB was forced to show a loss which analysts had not anticipated.

The good news is that the loss will eventually reverse, maybe even in the September quarter. More good news is that by not bringing back the same level of provisions as CBA, NAB still has those provisions to bring back at a later date. The bad news is one reason why NAB did not see the same margin erosion as CBA is because it has not been as aggressive in attracting fresh deposits.

What this means is that while NAB's margins and revenues are looking healthy at present, its capital position is not quite as comfortable as those of the other banks. This is rather important given it is NAB, not any of the other three, trying to take over AXA Asia Pacific ((AXA)). If NAB succeeds in its takeover, but most AXA shareholders take cash instead of scrip, a capital raising is a strong probability.

Nevertheless, bank analysts feel a little better about NAB's prospects than CBA's in the nearer term if for no other reason than NAB is currently undervalued with AXA hanging over its head, while CBA is still carrying its traditional 20% premium. In light of the CBA result, analysts were again forced to ask whether or not CBA still deserved that premium. Consensus suggests no, or at least not all of it, and indeed while the Big Two of CBA and Westpac deserve some sort of recognition for sheer size over NAB and ANZ, it also means they are carrying the biggest number of new loans, along with inherited and lower quality loans from BankWest and St George respectively. Hence the Big Two are feeling the margin squeeze the most and are unlikely to be able to grow their loan books ahead as aggressively as the Little Two.

For analysts still believe that while mortgage demand will slow up now, business credit demand is going to come back eventually. But it's not going to come back as fast as analysts were assuming back in 2009, or even as we entered 2010. CBA's FY11 revival now looks like being more of an FY12 story, with a period of low growth in between, while NAB will probably see low growth in the last quarter of its FY10, before a rebound sometime in its FY11.

NAB has indicated it will not move first in raising its SVR, independently of the RBA, immediately after the election. However, analysts assume that while NAB may not lead it will likely follow. CBA would not rule out an increase, which we can probably assume means an SVR hike on August 23, unless the banks go into one of their staring competitions. By lifting their SVRs the banks will be able to remove some of that margin pressure, but the fact remains funding costs are still an issue and the competition for deposits – although probably not quite as tight as a few months ago – only adds to the pressure.

What the Big Banks also have to deal with is that now that the worst of the GFC is (hopefully) behind us, the smaller banks are once again picking up business and renewing competition.

Bendigo & Adelaide Bank ((BEN)) released its FY10 result on Monday, ahead of both NAB and CBA, and boasted a doubling of profit from FY09. But Bendigo's result looked a lot like CBA's in many respects. Bad debts were lower than analysts had assumed, offsetting lower margins. It was a credible result, but a handful of analysts still worry that Bendigo is undercapitalised and will struggle to grow earnings meaningfully unless it can pick up an acquisition. Here, capital comes into question once more.

So what is the overall outcome of this week's bank results? Well, every bank analysts has downgraded earnings forecasts for FY11 for each of the three. Bendigo remains with half-hearted analyst support, showing a Buy/Hold/Ratio of 4/5/1 in the FNArena database.

NAB has come out with its ratio intact, remaining on 5/5/0. However, of the five Hold ratings, four of those brokers are actually restricted given their involvement in one or other side of the NAB-AXA takeover attempt. FNArena ascribes Hold when a broker is restricted given we cannot guess otherwise. Judging by analyst rhetoric however, NAB's ratio may well be closer to that of ANZ which currently leads the four on 8/2/0.

ANZ's ratio, and the better ratio we can assume for NAB, indicates the preference analysts have for the smaller banks on a valuation basis. Ostensibly, when the recovery comes the smaller banks will be looking at more upside potential.

The same cannot be said for the robust yet lumbering giants, who seem to have dug themselves into a bit of a hole as the world slips back into recession fears. Both CBA and Westpac are showing ratios of 2/8/0. Ahead of its result, CBA was on 5/5/0, but three brokers downgraded to Hold in the wake. CBA's average target price slumped from $56.53 to $54.15.

On the matter of targets, it would seem either the market responded a bit too negatively this week or bank analysts are still kidding themselves. CBA might look reasonable, but Westpac is showing a full 16% upside to target and can still only draw two Buy ratings.

We are yet to have a quarterly update from Westpac, or ANZ. Perhaps we shall then see some changes. But if the banks have been too heavily sold this past week then it does not detract from the fact they had become clearly overvalued. FY11 is simply not going to be the golden year analysts had once expected. If anything, the story moves out to FY12 following a period of sluggish growth, perhaps more sluggish than FY10.

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