Australian Banks: Beyond Consensus

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– Housing bubble feared
– Authorities warn on lending practices
– Unemployment rising
– Share prices exceed targets

By Greg Peel

The Australian banking scene in the past week or two has been dominated by two themes – talk from authorities that lending restrictions may be needed and talk from US hedge funds of an imminent collapse in Australian banks share prices.

We can dismiss the second theme straight off. Those fools have been short for five years and have suffered as a result, with the same broken record of house price bubbles and Chinese slowdowns being played again this time around. Every now and then they’ll try to talk their book and scare the market into providing an opportunity for them to recoup their substantial losses. Every time they are ignored. Hopefully they’ll all be broke soon.

That is not to say that “housing bubble” talk has not emanated from elsewhere. Many US commentators are concerned that the Fed’s relentless QE is not encouraging a housing recovery but fuelling the next housing bubble, not to mention the S&P 500 having surpassed its pre-GFC high. Last night’s decision by the Fed not to start tapering yet was met with derision in some circles. Meanwhile, the RBA made note at its last meeting of the influence historically low rates are having on Australian house prices. The assumption is the central bank has now pulled back to a neutral stance lest it, too, were to fuel an asset price bubble.

Connected with bubble concerns is fear from authorities of a return to lax lending standards among Australian banks. We all remember the NINJA loans (no income, no job or assets) and sub-prime mortgage securities that helped precipitate the GFC. The US is not quite back to that standard, although there is despair things are easing again. Australia never came close to that standard but we did see loan-to-value ratios (LVR) in excess of 100% pre-GFC, along with “lo-doc” and even “no-doc” loans.

It is worth noting that current strength in Australian house prices is being driven almost exclusively by investors, with actual homeowners hardly getting a look in. While investors can drive a bubble (they jump over each other to buy only existing properties) they should also, in theory, be of a much lower risk than a first home buyer with an overstretched mortgage. They pay a much higher interest rate for starters, and if rents fail to rise in step with house prices (ie yields fall), presumably the buying will stop.

But it is mortgages which have drawn attention recently, ever since the Reserve Bank of New Zealand announced last month that from next month, banks will be required to restrict lending at LVRs in excess of 80% to only 10% of new housing loans. While an obvious victim of this new restriction is ANZ Bank ((ANZ)), all of the Big Four have mortgage exposure across the ditch. The earnings impact on ANZ group earnings will be about 0.2-0.4%, suggests Deutsche Bank.

The impact in New Zealand is not really the focus. The market has become worried the Reserve Bank of Australia might be prompted into applying a similar restriction. The Australian Prudential Regulation Authority (APRA) has weighed into the argument as well, as has the International Monetary Fund (IMF), for what it’s worth (very little).

Deutsche Bank does not believe the RBA will act. House prices and credit growth have not risen as fast in Australia as they have in NZ, and the proportion of high LVR loans also appears to be higher in NZ. Indeed the Australian regulators have ruled out following the RBNZ for now, despite rising house prices. APRA has suggested it will just bring the banks in for a quiet word. Any restrictions that might eventuate would likely apply only to mortgages, suggests CIMB, rather than to investment loans.

Discussion of bank credit risks from a property bubble is premature, in Macquarie’s view, given prices are moving up on light volume and credit growth remains subdued. There is no actual definition of what a “bubble” is, but Macquarie notes that while property prices are up 0-8% in key states after several years of stagnation, transfer rates actually remain low given an abundance of stock. Hence credit growth remains slow.

As far as bank lending standards are concerned, Macquarie suggests Australian banks remain conservative. Customers are assessed using a “significant” buffer around affordability which has continued to be raised as rates have declined. While APRA has noted potential room for improvement, it has also highlighted the banks’ good practices, Macquarie points out.

In the longer term, Macquarie sees the only real risk being if another player outside the Big Four came in to shake up the mortgage market (just as was the case back in the nineties) and cut rates, forcing the pillars to follow suit and perhaps then look at easier standards.

So we can assume that if there is no housing bubble as yet, we have no need to be concerned bank share prices are about to collapse. But where do they really sit? The following table provides some clues.
 

Given this report is being written on a day when the local stock market is up 1%, I elected to mark “Previous Close” prices as at 1pm this afternoon, rather than yesterday, to account for yet another sector rally. The point that immediately jumps out is that at 1pm, all four of the Big Four were trading at prices in excess of FNArena database consensus target prices. The two smaller business banks by some (ANZ just a little) and the two big mortgage banks by a lot.

Regular readers of FNArena will be aware that whenever bank share prices exceed consensus target prices, one of two responses will follow. Occasionally bank analysts are forced to move their targets up further, but most often bank prices suffer a correction – perhaps 5% or so – then we start all over again. However the last twelve months has been an unusual period, in which bank analysts have been forced to concede that the attraction of solid, fully franked bank dividend yields in an increasingly lower bank deposit rate environment has meant adjusting up “fair value” price/earnings multiple expectations beyond what history might suggest.

These concessions became even more necessary after the May interim reporting season when it became clear the banks are now playing to the investment crowd. Increased payout ratios and special dividends were slavered over by the hungry mob. Indeed, Commonwealth Bank ((CBA)) left many investors sorely disappointed last month (note that CBA is the only one of the four to account on a June year-end) when it did not provide a special dividend.

Not that you’d know really. CBA has since pushed on to a new all-time high.

Thus for the last twelve months, bank analysts have been quietly raising their target prices to adjust for higher multiples, and we haven’t had a correction of any great note. If we were to see a correction, we can be fairly safe that a “collapse”, as the US hedge funds might be wishing for, is very unlikely given the yield safety net. Even at yields between 5-6% the banks are still a reasonable bet compared to deposit rates, and yields of 6-7% (on correction) will no doubt be jumped on.

But now that bank analysts have sorted out this yield premium thing in their own heads, further rallies have yet again pushed all four bank share prices above consensus target prices. Now is it time to say “correction due”? The reality is that while confidence might be looking just a wee bit rosier, credit growth in Australia remains sluggish, at best, and is unlikely to spike anytime soon. Meanwhile unemployment is rising, and expected to rise further, and increased unemployment is inexorably linked to rising mortgage defaults.

Rising unemployment suggests Australian economic growth is slowing, and indeed it is. The question is as to whether this implies businesses are now failing or just that the mining contribution is backing off (banks don’t lend a lot to mining companies, although they will have to mine workers). The banks have been seeing very little earnings growth of late (if any) from the actual lending business, but have managed to post healthy earnings increases through a reduction in bad debt provisions. Four years on, those GFC provisions continue to roll off, and anyone who was going to go bust from the GFC likely already has.

A slowing economy should imply rising bad debts. The risk is thus that the banks start to suffer not only subdued credit growth but a rise in bad debts to boot. Yet Deutsche Bank believes the market is actually already pricing in an increase in bad and doubtful debts (BDD) in the December quarter, and doing so erroneously.

“We estimate consensus is currently implying negative growth in cash earning in Q4, driven largely by analysts expecting increases in BDDs in Q4 despite the strong asset quality trends,” says Deutsche. “This negative implied growth looks too bearish to us given underlying earnings growth should be positive due to asset growth and some signs of easing in deposit spreads, and asset quality trends continue to be supportive of low bad debt charges. As such, we see some upside risk to consensus heading into the FY13 results.”

In other words, Deutsche Bank is suggesting that it is likely consensus targets will need to rise by or following the FY13 result season (in November), which means no “correction” call from FNArena’s bank target rule.

BA-Merrill Lynch does not see the overall sector outlook as “compelling”. Investors should not underestimate the banks’ ability to manage margins in a low interest rate climate, Merrills suggests, and benign BDD trends should continue into FY14, but rising unemployment poses clear risks, the analysts warn, especially given household debt remains elevated at 112% of GDP. “Political and A$ responses could be critical over the next three years,” says Merrills.

The analysts nevertheless believe all the banks can continue to generate surplus capital under new international rules, which means the chance of more special dividends. But individually, Merrills sees different trends emerging.

ANZ was once the great hope because of its unique exposure to the Asian market. But competition is fierce, Asian economies have slowed, and ANZ’s return on equity (ROE) is being dragged down by its capital investment into the area. National Bank ((NAB)), on the other hand, was once the pariah. The bank’s UK exposure, from which it has not been able to extract itself, has dragged down NAB’s ROE for five years. NAB was the wallflower at the interim result party in May, not being able to hand out the dividend goodies like its peers given the constraint of UK bad debts.

Yet even then, bank analysts became keen on NAB. Firstly, the yield hungry market had cast it aside. Secondly, the trend in UK BDDs was beginning to turn. And turn it has, faster than anyone ever expected. The UK economy is suddenly going gangbusters, making a mockery of Europe, the US and even China. Not only has BDD risk suddenly tumbled, the UK government has decided to offload the British banks it was forced to partially nationalise in the wake of the GFC.

In other words, NAB might now be able to find a buyer for its own UK business. A UK exit would provide for a solid re-rating.

Except that’s already basically happened. Over the past month NAB has well outperformed its peers, rising around 12% to Westpac’s ((WBC)) 3.8%, ANZ’s 3.6% and CBA’s minus 0.5%. The ASX 200 has risen around 2.7%. This hasn’t bothered Merrills nonetheless, with the broker yesterday upgrading NAB to Buy from Underperform and downgrading ANZ to Underperform from Buy. The broker’s target price for ANZ has been trimmed to $27.58 from $30.30 but NAB’s target has skyrocketed to $40.27 from $28.40.

Given recent underperformance from CBA, Merrills has upgraded to Neutral from Underperform. Did someone mention targets rising on increased multiple assumptions? Merrills target for CBA moves to $76.24 from $62.00.

And still consensus targets remain below share prices. Targets may be below prices, but FNArena database brokers are still applying a 15:8 net Buy:Sell ratio across the Big Four. All four banks provided quarterly earnings updates last month (CBA a full-year result) and bank analysts have had a chance to lift targets on what was essentially a net earnings “beat” on greater than expected BDD provision write-backs. And to catch up somewhat with market multiples.

Will bank analysts be forced to raise targets again? Merrills just did, substantially (except for ANZ).

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