Treasure Chest: Big Four Banks At Risk Of Further Capital Raising

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

By Greg Peel

FNArena’s recent bank sector update, Beyond Reporting Season, outlined the various issues weighing on Australia’s Big Four as three begin FY16 and Commonwealth Bank ((CBA)) heads into its second quarter. The two primary issues to consider are ongoing, and as yet uncertain, regulatory tightening and, or on top of, earnings trajectories at risk of being very subdued.

Welcome to the post-GFC world, which for Australia’s banks is all rather new and all very strange.

We recall that in 2008-09, in response to the fall of Lehman Bros and a global credit crash, Australia’s Big Four banks were all forced to raise new capital – twice. The collapse of bank share prices in the lead-up to the raisings came as surprise to many a local bank analyst, who up to that point had ensured investors that banks are defensive stocks in times of crisis.

This attitude surprised FNArena, given the crisis at hand was a financial crisis at its heart, rather than a general market blow-off from over-exuberance such as the Crash of ’87. Surely banks were at risk, FNArena argued, and indeed they were.

So perplexed was I with bank analyst calls I asked to meet with the only analyst, as far as I could ascertain, who in defiance of his peers had strongly warned that the banks were in big trouble. Why, I asked Brian Johnson, a former colleague in a previous life as an investment banker, did the rest of them get it so wrong? Because they’re not old enough to remember, he said, how in the early nineties recession Westpac ((WBC)) nearly went broke. Their charts only go back five years, and they have never seen anything like this before.

The risk at the time was that banks would suffer a huge blow-out in bad debts. As a result, all the banks took major provisions onto their balance sheets for such an outcome, killing off all earnings growth potential in the near term. They then went to the market for more capital, and then they went one more time.

History shows that Australia made it through the GFC relatively unscathed. The avalanche of bad debts expected to hit banks never occurred. Thus as each successive year passed, the banks were able to gradually bring increasingly unnecessary provisions back into their P&Ls to show solid earnings growth, from which they were able to pay handsome dividends and thus attract yield-thirsty shareholders here and abroad. At the same time, the banks tightened their lending conditions such the likelihood of any new debts turning bad was minimal.

It’s now seven years since the fall of Lehman. It’s taken that long for two post-GFC assumptions to come to pass, coincidentally. 2015 will go down as the year global regulators finally began the process of implementing “too big to fail” capital requirements and the year Australia’s Big Four ran out of surplus bad debt provisions. Indeed, given the strictness of bank lending in the interim, Australian bad debt levels have reached historical lows.

The only way from here, therefore, is up.

On top of global regulations, we’ve seen local tightening from APRA both on investment mortgage lending specifically and on additional capital buffer requirements for Australia’s own TBTF banks, albeit the latter is yet to be fully resolved. With regard the former, the banks have been able to offset lost earnings potential with mortgage repricing, but just how far can the banks push the cost of lending before orchestrating a destructive house price collapse?

The bottom line is that if bad debts begin to rise again, as analysts assume they soon will, and regulators decide more capital is needed to protect against another GFC event, the first thing to give way will likely be bank dividends, as previously discussed by FNArena in ANZ Dividend Cut Inevitable?

The next thing to “give way” would be capital ratios, leading to the necessity of another round of capital raisings.

Brian Johnson, now of CLSA, believes the combination of higher capital requirements and weak earnings growth will lead to potential big bank dividend payout ratio cuts of 10%, translating to actual dividend cuts of 15-25%.

Johnson notes that bank share prices have de-rated substantially since their (yield-driven) peaks in April this year. Capital raisings, uninspiring FY15 earnings results, a deteriorating macro environment (China), the threat of a US rate rise (Australian yield less attractive), and the threat of a bursting of the housing bubble have all conspired. The earnings the banks have managed to post have been enhanced by aforementioned historically low loan losses and by low quality tax items, to the extent Johnson suggests the banks have “over-earned” by 10%.

At some point the banks will suffer from not having any more provisions to draw upon. And at some point APRA will reach a conclusion on just what level of capital Australian banks must hold. Not just capital, but liquidity, loan duration and possible “bail in” bond* issuance as well.

*See aforementioned Beyond Reporting Season article for an explanation.

This time, however, Johnson is not a lone voice. Most Australian bank analysts are approaching the sector with caution. Morgan Stanley is one house that stands out as having correctly insisted the banks would need to raise capital at least once, as they have done, and is now most insistent dividend cuts are coming.

Yet individually, bank analysts have substantially more Buy ratings on the banks than they do Hold or Sell. The reason is that bank share prices have fallen so far as to have dropped well below analyst target prices. This would suggest that at current levels, bank shares are now “value”.

Johnson believes the banks will ultimately have to target tier one capital ratios of 10.5%. On that basis he believes share prices have further downside to suffer. However, once that downside plays out, when the banks all undertake a second round of capital raisings, then there will be value to be found.

“History tells us that when it comes to banking, you make the serious money on the last recapitalisation raising,” said Johnson in a recent note. “During the recapitalisations of 2008/2009 most of the banks came back to raise capital on two separate occasions. From a sectoral perspective, we would recommend staying Underweight but would look to participate in what we believe would be the last round of recapitalisations”.

Underweight is CLSA’s sector call. Within the sector, Macquarie Group ((MQG)), National Bank ((NAB)) and Westpac ((WBC)) are preferred over ANZ Bank ((ANZ)), Commonwealth Bank and the regionals, Bendigo & Adelaide Bank ((BEN)) and Bank of Queensland ((BOQ)).

Note that FNArena’s broker database, in which CLSA is not included, rates the big banks in the consensus order of preference of Westpac, ANZ, CBA, NAB.
 

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