- Bank results largely meet with expectations.
- Not a lot of earnings upside post results.
- High funding costs mean banks are actually better off not writing new business.

By Greg Peel

Over the past twelve months, bank analysts have in general been wrong on two counts. The first was the expectation that the level of bad and doubtful debts (BDD) on bank loan books would not drop rapidly post-GFC but would instead provide a “long tail” of decline. The second, in some ways counter to the first, was that the lack of recession in Australia and rapid return to low unemployment would mean consumer spending would bounce back quickly and that business credit demand, which was still in steady decline, would very soon bounce sharply.

Six months ago analysts were caught out when the big banks made big cuts to the BDD provisions rapidly set aside in 2009. The cuts were made possible mostly because there was not the level of follow through into small and medium enterprise (SME) bad debts as had initially been feared at the height of the GFC, given the lack of actual recession. The banks had thus over-provisioned and were now able to bring some of those provisions back into earnings. Hence bank earnings appeared to make huge jumps out of their GFC depths, and hence the media, the public and politicians erroneously assumed banks were making too much money.

They weren't. Indeed, they were really just making accounting adjustments. But it didn't get any better at the last quarterly round of earnings updates, three months ago, when the banks again posted strong results which were again assisted by more provision reductions. They also made big increases to their mortgage rates, given rising funding costs. We know just how the public responded to that news.

Bank analysts had long expected the banks to raise rates irrespective of RBA policy and the increases in reality were long overdue. At the same time banks became very competitive on deposit rates too, on the other side of the coin, but those with savings aren't the target of political spin doctors.

Having conceded that banks were able to reduce provisions faster than first thought, analysts had to also admit the long expected business credit bounce was still missing in action. And consumer spending was not bouncing back. If anything, it was going backwards, and credit card balances were dropping. The retail sector – as Gerry keeps telling us, a major employer – was in trouble. Outside of the resource sector, everyone's business was subdued.

Now another three months on, retailers claim they are in the worst recession they've ever seen. Worse than 1992. Data show that Australia's manufacturing sector is contracting and doing so a quickening pace. The same is true for the services and construction sectors. If not for the resources sector, with which banks conduct little business given its inherent risks, Australia would be looking a lot more like the US and Europe and a lot less like China.

Bank analysts are still waiting for credit demand to return, and for consumers to start spending again. What growth there has been has been fought over by the big four like hyenas on a carcass. The analysts still think both will occur, eventually. In the meantime, Australia's housing market seems to have stalled, leading to lower auction clearance numbers which should imply lower mortgage demand.

All the while bank funding costs continue to rise given the roll-off of term funding struck on pre-GFC rates to be replaced by GFC-period term funding on substantially higher rates. Not until next year will bank bonds begin to roll back down in interest cost. But as UBS points out, in light of the recent round of bank results, a lack of credit demand and lending growth has actually been a good thing.

It's not the way you'd want to run a business continuously, but it has bought some time. Banks need more funding when they write more loans. If they're not writing loans they don't need more funding. At the moment, funding costs are expensive, both on the basis of offshore interest costs required and on domestic competition for deposits. The fewer loans the banks write, the less funding they need at high cost and the less they need to fight each other with attractive deposit rates. Pressure is thus taken off margins for new business, allowing current margins to remain for the business already on the books.

In other words, it might actually be better for the banks if the long awaited bounce in credit demand held off for another year and instead coincided with the peak in funding costs.

It's a Catch-22, as UBS declares, although it does make strange sense. But what it also thus means is there is not a lot of upside to get excited about for the banks over the next twelve months. If credit demand grows, margins will tighten again, acting as a dampener on earnings. If credit demand does not grow, margins remain steady which helps offset lack of earnings. Only when credit demand rises and funding costs come down will the banks be back in the box seat they once enjoyed.

In the meantime, if BDDs have peaked then the banks can continue to top up earnings with provision reductions. However, since the first reductions in provisions occurred a while back, analysts are now taking account and the market has factored in such reductions.

The latest round of bank results once again had politicians screaming and there were even calls again for a super tax on bank profits. Yet percentage increase comparisons were being made with the same period last year, not the last period, and thus again provision returns made the results look good alongside what little pick-up in loan demand there was. As far as analysts were concerned, on a net basis all bank results came in pretty well on expectation. The results were solid, but there were no real surprises.

Overall, analyst target prices for the Big Four ticked up a bit on consensus. There is nevertheless some “roll over” effect here. If your forward earnings forecasts improve with time (and for banks they should given anticipated credit demand growth and funding cost reduction) then your twelve-month target price will respond to a shift out along the forecast curve when reset.

Indeed, there is a general consensus among bank analysts that the market is now fairly valuing the banks, leaving not a lot of room for upside in the shorter term. At least there wasn't last week at the height of bank prices post-results (when I first prepared for this bank sector update) but we have since had a couple of biggish down days.

Nevertheless, the following table shows the fresh set of consensus targets from the eight brokers in the FNArena database compared to the highest closing prices of each bank just before the Libyan unease. As you can see, bank prices were already within a couple of percent of targets or, in Commonwealth's ((CBA)) case, above target.

FNArena has noted over many years that whenever bank share prices reach or exceed consensus targets after those targets have been recently reassessed, inevitably the banks are overbought and a pullback will soon ensue. As sure as night follows day. Sometimes such a pullback might simply reflect funds (particularly offshore funds) switching out of now expensive banks and into cheaper resource stocks, but in the current case we have had an exogenous trigger in the form of Libya which is not really sector-specific. So thus we have another set of prices based on yesterday's close:

We thus now have 4-7% price gaps, with ANZ ((ANZ)) bearing the brunt. Yet ANZ remains the top pick on analyst consensus. ANZ has at least one benefit in being able to source funding from deposits in Asia. CBA is the bank that always trades at a “size” premium to the others (even though Westpac ((WBC)) is actually bigger now) and analysts have long been querying whether the extent of that premium is still deserved, hence its lowest ranking.

So on the assumption we have now seen as much of a correction as the market requires to account for the Arab world issue, there is some upside in current bank prices but only to a limit before valuations look about fair again. If the Arab world issue is set to cause more strife, well then it's not a time to be buying banks.

Technical limitations

If you are reading this story through a third party distribution channel and you cannot see tables included, we apologise, but technical limitations are to blame.

By Greg Peel

“The reforms do appear quite hostile to the big banking industry with the government regularly forming assertions on major banks without reference to external data,” said the BA-Merrill Lynch bank analysts this morning. Allow me licence to provide a colloquial translation, unendorsed by Merrills:

“Those idiots in Canberra are quite simply clueless and would do well to actually research the topic upon which they are making populist policy decisions”.

Over the past couple of weeks the market has been selling down the Big Four banks and buying up regionals and smaller institutions in expectation that the government was about to shake up competition in Australia's retail banking industry in a big way. Leading the policy drive (no doubt) has been a focus group in one of Australia's swinging, mortgage belt electorates. But not only are the policy proposals announced unlikely to impact in the government's desired fashion, they've largely gone the other way.

Not that there's anything much wrong with the proposals, it's just that the anticipated shift in competitive advantage away from the Big Four – which control 90% of all Australian mortgages thanks to the government's GFC reaction – and onto other lenders will not result. As for Treasurer Wayne Swan's big push for a “fifth pillar” of banking in the form of the “mutuals” – credit unions, building societies and the like – well that just seems to have been missed.

It was Paul Keating – who deregulated the banking industry and gave us the “four pillars” in the first place – who once famously said that a parliamentary attack from Opposition leader John Hewson was like being hit over the head with a wet newspaper. That's probably how the Big Four were feeling yesterday.

There were 13 reforms in the package. Those of most significance were: the banning of exit fees on new home loans; a review of account portability; more oversight on credit cards, ATM fees and price signalling; the FCS to be made permanent from October; an additional $4bn of AOFM support for RMBS; and the introduction of covered bonds. Let's first unravel the jargon on those last three.

The Financial Claims Scheme (FCS) refers to the policy move the government made on the fall of Lehman to guarantee bank deposits up to a limit. This was set to expire but under the new proposal it won't, albeit the limit of guarantee thereafter is yet to be determined.

The Australian Office of Financial Management (AOFM) is that which actually handles the government's debt financing, including issuing bonds and so forth. Another previous policy was for the AOFM to provide support to Australia's residential mortgage-backed securities market (RMBS) which had shut down in the GFC, to the tune of $16bn. That support has now been upped to $20bn.

Readers may shudder to recall that the GFC itself was brought about (not solely but finally) by the collapse of the mortgage security market in the US. But the problems here related to the proportion of “subprime” mortgages securitised, the financial derivatives which were designed around them (collaterlised debt obligations or CDOs), the AAA ratings clueless credit agencies were paid to rate those securities, and the subsequent credit default swaps (CDS) written on them. All of the above was a US-centric confluence which never made it meaningfully across the Pacific.

The reality is RMBS, when respected and not exploited, are a valuable source of lower cost bank funding and a solid investment for fund managers. Quite simply RMBS allows indirect investment in “bricks and mortar” as an asset class through pooling and on-selling mortgage exposures. They also increase competition in mortgages, as John Symond and co would attest. Before the GFC, smaller institutions (including St George, for example) relied on RMBS for funding because they didn't have the credit ratings of the Big Four, which were able to access offshore funding as a result.

As a result of the GFC, the RMBS market died across the globe, unsurprisingly, leaving smaller institutions high and dry and sending all mortgages the Big Four's way, aided by government hand-outs. That's why we're at this (ironic) point of at which the government is desperately trying to rekindle banking sector competition to appease the masses.

A “covered bond” is similar to an RMBS in that it represents the packaging up of assets such as mortgages or other loans for on-sale to the investment market. The difference, however, is that while RMBS and other equivalent instruments are packaged up by the banks and then sold off to new owners, the loans behind a covered bond remain on the bank's balance sheet. What you are thus buying by investing in a covered bond is not a slice of a bunch of mortgages, but a slice of the income stream from those mortgages. Again it is somewhat ironic that covered bonds have not previously been allowed in Australia, yet securitisation had been warmly embraced.

Now – what's the impact?

Well the exit fee thing was a definite fizzer. As we know, ANZ ((ANZ)) and National ((NAB)) had already done away with exit fees anyway. The expectation is that exit fees would be banned for all loans, but they've only been banned for new loans. The cost to the big banks will be immaterial, analysts suggest. The impact on the smaller institutions will actually be negative, as cheap loans at the front end are subsidised by such fees, allowing the littlies to compete with the funding-advantaged big banks.

So far anything to do with account portability and price signalling restrictions remains at the motherhood statement level, so what happens now is unclear. Credit Suisse notes that improving account portability may actually place a new IT cost burden on the smaller banks.

Were it not for some form of FCS insurance, depositors would prefer those banks with better credit ratings, notes JP Morgan. So that's a plus for the smaller banks, albeit it depends on limits, structure and fees to the banks which are, again, unclear at this point.

Bumping up RMBS support is fine, but covered bonds will actually provide a cheaper alternative funding source for the bigger banks – the ones with all the mortgages. So this really is a clear plus for the Big Four. It might help ease the cost of a mortgage, but it will not much assist competition.

Morgan Stanley estimates the Big Four could see 1-6 basis points of margin relief from covered bonds, affecting profit increases of 1-4% over time. JP Morgan suggests that the covered bond proposal may yet backfire to a degree because under the new Basel III regulations, Australian banks will be required to hold more liquid assets. Lack of government bonds is a problem, covered bonds would substitute, and so what may transpire is that the Big Four simply all buy each other's bonds. The only real relief would come from substituting for offshore corporate bond issues.

So that's a review of what has been proposed, and all bank analysts agree the Big Four can have a relaxing summer holiday while the littlies despair on what might have been. Perhaps what is more glaring in the policy package, however, is that which isn't there.

There was no talk of using Australia Post as a banking service. Probably a good thing since Australia once had a national government bank – the Commonwealth (CBA)) – but sold it. Postbank would have looked a bit silly.

There were no considerations given to risk weighting changes or the treatment of franking credits, as Deutsche Bank notes, but then that's probably a bit of a tough one for politicians. Most surprisingly, there was nothing in the package to support the “mutuals” – no wholesale guarantees or other means to improve distribution. So much for the “fifth pillar”. The impact for mortgage brokers is also unclear.

Citi notes, “Mutuals do not have the size, scope and expertise to compete effectively with the major banks in the foreseeable future”.

As the market's reaction to the package indicates (yesterday the big banks were bought and the small banks sold), Swan's proposals are not nearly as onerous as the market, or analysts, had feared.

Which, of course, has opened the door for the Opposition to attack the proposals as weak, for the Greens to insist on steeper measures such as ATM fee review, and for the independents to throw the rural hat into the ring. In other words, like every piece of proposed legislation that will hit parliament in 2011, there are no guarantees of passage and plenty of scope for heated debate and stalemates.

Such is Australia.

No changes of any note in analyst bank ratings or forecasts have emanated from these policy proposals (though Citi does have both regional lenders now on Sell and Morgan Stanley also downgraded Bendigo and Adelaide Bank ((BEN)) today).

By Greg Peel

Those looking in from the outside have always found Queensland a slightly strange place. Maybe it's because the state symbol is Bob Katter's hat. But realistically Queensland is presently caught a bit betwixt and between. The problem is it's Western Australia on the east coast.

Queensland has its coal mines and its burgeoning CSM LNG industry, as well as plenty of other mineral projects. WA also has lots of mineral projects including gold and dominant iron ore, and a massive offshore LNG industry. But while Queensland has the Gold Coast and – let's face it– little pockets of Gold Coasts all the way up to Port Douglas, WA only has a handful of resorts. WA's population is young and enthusiastic. Queensland is Australia's Florida.

WA's economy is booming. Queensland's economy has been in a slump since 2008. So much so that the government has been forced to sell off the family silverware, the latest being QR National. WA couldn't really care less about a rising Aussie dollar. Queensland's inbound tourism industry has been crippled. Even its interstate tourism industry is suffering given everyone's been to the Gold Coast and it doesn't cost much more now to go to Europe. And to top things off, in Queensland it is beautiful one day, bucketing down the next.

An immediate and ongoing victim of the GFC has been the Queensland commercial property market. Not just residential tower blocks and anything Gold Coast, but right down to shopping centres. Over the last two years, notes UBS, Suncorp-Metway ((SUN)), St George Bank ((WBC)) and BankWest ((CBA)) have all announced material losses from commercial property exposures in the Sunshine (?) State.

Bank of Queensland ((BOQ)), on the other hand, has seemed blissfully immune. Indeed, BOQ has managed to pick itself up out of the GFC ashes pretty quickly and expand its loan book and expand its net interest margin. Funding has always been an issue for the regional banks as they don't have the size of the Big Four (and the Big Four have their own funding issues), but with the Comrade Hockey-inspired bank sector regulatory review now going on, all analysts expect that regional banks can only be a beneficiary of any measures designed to support increased competition.

All of the above has meant that BOQ shares have run pretty hard of late, indeed outperforming the sector by 16% since CBA announced its big rate hike, JP Morgan notes.

But with the AGM coming up today, BOQ management had decided recently, over a pot of Four-ex, it might probably be prudent just to check up on its commercial property loan book. The review was prompted by two particular shopping centres on the books which were suffering from the retail downturn. This proved to be rather a wake-up call.

Those two loans were in trouble, and as such BOQ undertook a review of its top 250 commercial property loans, representing about one third of its overall CP loan book. The end result is an additional bad and doubtful debt impairment charge of $97m, of which the two big shopping centres represent 70%. BOQ has now increased its BDD guidance for the first half FY11 to $85-90m from a previous $53m.

The market has every right to be concerned that, to date, only a third of the loan book has been “forensically” reviewed. While the guidance update represented an extrapolation of that third, there is a growing feeling of unease that BOQ management has been fiddling as Logan burns.

Stock analysts have responded with forecast earnings downgrades of some 10-15%. Three out of eight FNArena database brokers have downgraded their ratings – two from Buy to Hold and one from Hold to Sell. Morgan Stanley has also downgrade from Hold to Sell. BOQ has gone from a B/H/S ratio of 2/5/1 to 0/6/2.

The news at the update was not all bad. Management announced that net interest margins had returned to levels of a year ago at a time when the Big Four are struggling to achieve any increases (out-of-cycle hikes notwithstanding). Costs are under control. Macquarie notes that the new impairment expense should have represented a profit guidance downgrade of 10%, but as the downgrade was only 5-8% it suggests BOQ's underlying operations are performing above expectations.

Indeed while having only reviewed a third of CP loans, management is confident that its BDD exposures will see “significant improvement” in the second half. It was at pains to point out the bank has limited exposure to the risky areas of high-rise residential blocks and anything on the Gold Coast. Macquarie notes BOQ's commercial loan book leans towards secured retail and business assets which tend to have lower losses.

Macquarie does not think the real issue for regional banks is bad debts. BOQ's current BDD impairments represent only 37 basis points which is well below the cycle peak of the Big Four at 80-90bps. Macquarie has been beating BOQ's drum of late, and is a little lonely in its dismissal of BDDs. Other brokers are less sanguine. Yet even Macquarie has decided that Outperform is no longer an appropriate rating.

Citi suggests that while BOQ's underlying numbers might look to be improving, the BDD shock is indicative of a rushed effort to lift the bank's return on equity from its current level around 8-9% to a target 15%. Citi notes BOQ has been expanding into higher risk segments such as leasing and equipment finance. Can management successfully handle greater risk?

Citi also believes the market has become a bit too carried away with BOQ's prospects from a mandated increase in bank competition. Credit Suisse suggests that if the government succeeds in supporting regional bank competitiveness, Bendigo & Adelaide Bank ((BEN)) is better placed anyway given its Adelaide Bank mortgage originator.

RBS is worried about further BDD stress, Deutsche Bank can't see any catalysts for outperformance, JP Morgan believes the risk/reward trade-off has now become more balanced and Goldman Sachs can't see any reason to buy while the shares trade at a premium to the majors.

Those white shoes are looking a little faded.