By Greg Peel
If you'd been listening to ABC Radio earlier in the week, you would have been hit with the news-leading headline of “Bank analyst warns of housing bubble”. In typical news headline form, this was the one comment jumped on following a more extensive interview with said bank analyst on the wider subject of the prospects for the Australian banking industry and its shareholders in general in the post-GFC world.
The interview, as aired on ABC's World Today program, was with Brian Johnson of CLSA, formerly of JP Morgan. In short, Johnson warned Australia's bank shareholders (which, if you include superannuants, is just about everyone in Australia with a job) that the hazy, crazy days of the noughties were over. From here on in, banks would no longer provide the sort of capital return profiles and stock market outperformance they did in that wild time of cheap money. Which basically means they have now reverted to being the staid finance intermediaries they once were – defensive, and arguably boring as yield-driven investments.
Johnson did, within the interview, respond to a question the answer for which included a suggestion the Australian housing market was overheated. But that is not the subject of this article. It would be more relevant here to note that Johnson was one lonely analyst among peers (when at JP Morgan) who called the disaster that was soon to befall the Australian banking sector as a result of what then was only the “credit crunch”. Other analysts failed to see the writing on the wall. Johnson put this down to age and experience. Among his peers, Johnson was the only bank analyst at a major broking house who had analysed the way through the '92 recession. The rest were still at uni.
Despite all bank analysts soon coming to realise the impact of what became a GFC, by hook or by crook, it is important to note that many analysts, brokers and fund managers in the market today know only of Australian banks being stock market leaders and outperformers. When money was cheap, when securitisation was a significant source of funding, and when fees from broking, advisory and wealth management were running rampant, it was a bit hard not to make outstanding profits. But now, the game has changed.
Not that this has been immediately apparent to all. Having overcome their ultimate GFC fears, bank analysts were heartened by Australia's failure to fall into meaningful recession and were soon predicting that while FY09 was a shocker, FY10 would see the trough and FY11 would see a big, sharp rebound back to “normal” levels. The faster the Australian economy rebounded, the quicker bank analysts assumed the rebound would occur. But then along came the European crisis.
Perhaps, in retrospect, the European crisis was necessary to snap the world out of its post-GFC euphoria and reinforce the inevitability that a post-GFC world was going to be a very different proposition from a pre-GFC world, or at the very least that the next decade of the twenty-first century would be a lot different to the last. The European crisis served to highlight two problems for Australian banks: (a) wholesale funding costs are never likely to revert back to pre-GFC levels, at least not for a generation, and sharp blow-outs due to renewed global panic attacks are always a possibility, and (b) perhaps it wasn't such a great idea for the banks to lend so much money on mortgages to new homeowners during the stimulus period as a means of rebuilding loan books.
Once this became apparent, the new game in town was to suggest that previous expectations of a return to “normal” conditions in FY11 was a bit ambitious, even if bad debt levels themselves were to fall back to normal in the period, because the sort of net interest margins being achieved in the noughties now looked like a bit of a one-off. If anything, margins from here would undergo a gradual decline.
Politicians love to cry foul and whip the electorate into a frenzy when banks suggest they need to raise their mortgage rates. The fact that bank funding costs have increased is dismissed. Deutsche Bank estimates that post-GFC, wholesale funding is now 130-150 basis points more expensive than it was pre-GFC, while collectively the banks have only been able to raise their standard variable mortgage rates by 106 basis points independently of RBA cash rate movements. In the tight game of banking, every single individual basis point of borrowing-lending spread makes a significant impact on the bottom line.
The banks can, of course, further independently increase their SVRs now that the election risk has passed, but that's not the only part of the whole banking picture. Once having shuffled all elements, consensus forecasts now have bank margins declining by 5-10 basis points over the next couple of years. For shareholders hoping this whole GFC fiasco is now passed and shareholders returns can now make their way back to “normal” (being early twenty-first century normal), this is not good news.
Yet despite these disturbing consensus margin forecasts, Australian bank stocks have had a very good September. The stock market in general has rallied 7% over the period, but the banks have rallied 9%. It was only back in August when banks were providing somewhat disappointing profit results and guidance outlooks. Clearly, there is enough belief out there that Australian banks are still a potential source of ongoing outperformance.
UBS suggests September is all to do with the Aussie dollar, which itself is being driven by global macroeconomic factors. The two big areas of capitalisation in the ASX 200 are the resources sector and the Big Four banks, such that the two are often played off against each other. Right now commodity exporters are under threat from a stronger Aussie, while the banks are not. This means local investors can hide in the banks to avoid currency effects but at the same time US investors can choose Australian banks rather than miners to ride the Aussie dollar wave.
On that basis one might suggest recent bank outperformance has very little to do with margins, or lack thereof. But UBS warns that if an investment in Australian banks is a proxy for investment in the strong Australian economy then this is misguided, and in swapping out of currency-impacted resource stocks investors are actually swapping out of that which is driving the Australian economy in the first place. Banks, as a proportion, have not lent a lot of money to miners, and lending on risky mining prospects is not really a banker's game. They have, however, lent a lot of money on mortgages and to small businesses and institutions.
In other words, suggests UBS, bank investors are running up against Australia's “two-speed” economy. Strong commodity exports are going to lead to RBA rate increases and that's not going to bother the miners, but it will very much bother mortgage holders and business borrowers.
“Given the weak outlook for growth in bank pre-provision profits,” suggests UBS, “we believe most banks are now fully priced. Better opportunities may lie elsewhere.”
[Note: “pre-provision profits” exclude the return to the earnings line of earlier steep provisions made for bad debts which now will not be needed.]
Indeed, it is readily apparent from lending data that while the resources sector has led Australia out of the GFC, business credit demand has remained very weak. It declined as a result of the GFC, continued to decline on the way out of the GFC, and is only now starting to think about finding a trough. There was no such decline in mortgage demand, but then that was all about specific government stimulus. With the RBA cutting its cash rate to emergency levels, and the government providing mortgage deposits via hand-outs, banks were able to rebuild their loan books on “safer” mortgages while leaving the business community out to dry.
Not only did the banks not pass on cash rate decreases to business loan rates, they tightened lending standards, even on existing loans. If there is one thing the banks have no right to bemoan it is the failure of business credit demand to rebound.
Bank analysts also failed to appreciate the problems businesses were having despite Australia not falling into “recession”, and thus were a bit too optimistic in their expectations of a business loan rebound. RBS Australia, nevertheless, stood out as one broker who was more restrained. RBS thought it would take a lot longer than many assumed for businesses to get back on their feet and as such reflected such a belief in their forecasts. But now, it's time. And now RBS suggests business credit demand has indeed bottomed.
While recent bank updates from managements were relatively subdued, one area that stood out was the business credit “pipeline”. It is a pipeline because businesses arrange credit first and then draw down on that credit at a later stage when needed. So while business loan books remain constrained, and draw-down dates have been pushed out further than expected, the “pipeline” shows that a rebound is on its way.
RBS expects business credit demand to have now bottomed, that it will continue to improve in 2011, and that by 2012 double-digit growth will be reached. The analysts see 8.2% growth in FY11 (being September-ending bank years) and 10% in FY12 before credit growth settles back to more “normal” levels in FY13 at 7.2%.
RBS does acknowledge, however, that not all business loans will end up on Australian bank balance sheets. Right now there is a thirst overseas, and in the US in particular, for corporate bonds. Investors are willing to accept ridiculously low rates for corporate risk for the simple reason those rates are still much better than Treasury rates. RBS also points out that there are not many Australian companies which realistically have access to such offshore demand.
Despite RBS's forecast of a solid bounce in business credit, the broker is of the school that believes a combination of higher wholesale funding costs and pressure in retail banking will lead to a reduction in margins of 5 basis points in FY11. As we recall, consensus has margins falling 5-10%. RBS does, nevertheless believe, that margins will flatten out in FY12-13.
RBS suggests the Australian banking sector should trade at a 10% discount to its pre-GFC level. This harks back to Brain Johnson's warning not to expect the banks of today to offer the same returns as the banks of yesterday.
But even forecasts of 5-10% margin reduction are making one very important assumption. Without it bank margin decline could be a lot worse. That assumption is that the banks will be able to “re-price” their assets.
Asset re-pricing is bank-speak for the simple notion of raising interest rates on loans. But to be an actual re-pricing those rate hikes have to be above and beyond – independent of – any RBA rate hikes.
It had been anticipated the Big Banks would lift their SVRs immediately after the election once they were clear of potential bank-bashing from candidates. They haven't yet, perhaps because the new government is very wobbly but probably because they are now waiting to move under the cover of an RBA rate increase. If the RBA hikes 25 basis points the banks might hike 30-40 basis points. They'll still get a shellacking in the press, and in Canberra, but probably not as much so than if they hiked when the RBA was sitting tight. And if the RBA continues to raise rates in 2011, the banks can continue to sneak back a few of the basis points they have lost due to increased funding costs.
A combination of re-priced mortgages and a rebound in business credit demand does bode well for the banks. ANZ ((ANZ)) and National ((NAB)) will do better on expanded business credit because Westpac ((WBC)) and Commonwealth ((CBA)) are much bigger in mortgage financing, but then for the same reason Westpac and CBA will do better out of re-pricing.
Yet despite these positive prospects, and the return of bad debt provisions to bottom lines, still margin decline is expected. Quite simply, wholesale funding costs will not return to pre-GFC levels for a long time. And in a rising interest rate environment, more frugal retail customers are simply not going to go berserk on mortgages and credit cards the way they used to. Business credit demand might rebound from very subdued levels, but the days of massive balance sheet gearing are gone. It is a new world. Or you could say, it is now an old world again.
One broker, however, is prepared to argue that expectations of margin decline are actually overstated. In fact, says Deutsche Bank, margins could even improve in the next couple of years. Deutsche is flying against consensus by holding such a view, but then its bank analysts have just released a lengthy report outlining their argument. At the very least, they suggest, margins could be flat to only slightly down in FY11 rather than 5-10 basis points down.
For starters, Deutsche's view is very much predicated on asset re-pricing. The analysts are factoring in 15-20 basis point ex-RBA increases to SVRs over the next six months. But then this is not inconsistent with consensus views.
Where Deutsche believes consensus is missing one big factor is on the deposit side of the equation.
Deposits are the cheapest form of funding for banks, outside equity. Pre-GFC, deposits were not all that important because there was little call for bank deposits as an investment from customers, the mortgage securitisation market was a great big pool of relatively cheap funding, and offshore institutions were so keen to lend money wholesale funding spreads were very low. But wholesale funding spreads are not low anymore, the mortgage securitisation market died in 2008, and while there's been a rush of customer “investment” back into bank deposits, the competition among banks for this funding source has been fierce, undermining its benefit.
The result is that while SVRs have had to be kept low despite greater wholesale funding costs, term deposit rates have also had to be lowered (relative to the cash rate) to attract funds. So margins have been squeezed all over. And this competition has persisted long after the banks raised fresh equity and temporarily cut dividends as their first GFC response.
Another post-GFC response has been to borrow wholesale for shorter durations rather than typical longer term durations for which the cost just became too prohibitive. This caused problems in FY10 because the banks would have been hoping to reverse the situation sooner rather than later, but along came the European crisis and funding costs blew out again.
Deutsche suggests that for the most part, the banks have done the “heavy lifting” and funding curves are quietly being brought back to more normal levels. Moreover, the banks have gone one step further and “pre-funded”. That is, they have loaded up on more shorter term funding than needed, albeit at a greater cost, just in case everything went pear-shaped again and the world was plunged into another crisis. As fears ease, this pre-funding has become a bit of a drag. But then it alleviates some of the need for more funding over the next twelve months.
Similarly, the Australian banks loaded themselves up with so much new capital through equity raisings that this also has been a drag on earnings potential, but that capital is now being put to better use (take ANZ's Asian forays as an example). The release of the new Basel III international bank regulations proved a big relief given the Australian banks found themselves to be well inside the new requirements.
So wholesale funding pressures have subsided somewhat, capital pressures have also subsided, and Deutsche also notes the first signs are emerging that term deposit rate pressures have also begun to subside. The spread between the cash rate and term deposit rates is easing. Alongside asset re-pricing, Deutsche sees a reduction in the “TD spread” as being of most significance in its forecast of flat margins.
And just as an addition, Deutsche notes the mortgage securitisation market is now making its first, tentative reappearance.
All this “good news” is not necessarily good news right away, and among the Big Four there are different potential impacts for each of the banks.
Wholesale funding costs may begin to subside on new borrowings but not on existing borrowings. Given banks typically borrow 5-year money, and we're only two years out from the fall of Lehman, banks still need to replace borrowings that were set at pre-GFC prices. Recall that when the GFC hit, they were only borrowing short term in the interim. So even if the cost of new wholesale funding falls from where it is now, it will not fall to anywhere as low as it was, so every old loan that has to be replaced with a new loan will mean a higher cost. Ergo, bank funding cost will continue to rise for a while yet. Westpac, for example, is suggesting a cost peak in FY12.
That's why asset re-pricing is so important. It's also why incremental positives such as cheaper deposits, capital that can be put to use, the return of at least some sort of securitisation market and (perhaps most importantly) the easing of global fears are also important. They are all why Deutsche believes consensus margin decline fears are overdone. But then this view relies on all the above elements falling into place.
So where does this leave the humble bank shareholder or prospective investor?
At worst, CLSA's Brian Johnson is warning shareholders not to expect any return to “normal”. Banks will revert to being the more subdued, defensive yield plays they were before the world went silly with “funny money”. They will once again begin to look more like utilities.
At the consensus level, the outlook for banks is becoming more positive but this will be in the face of still two more years, potentially, of rising funding costs. The funding cost will win, so to speak, and this will translate into lower margins which in turn translate into lower earnings.
At best, as far as Deutsche's analysis suggests, margins will be flat in the next couple of years.
Either way, banks won't stop being a significant investment opportunity as a combination of capital return and yield. But will they be able to be held up as an alternative to resource sector potential returns in any commodity boom ahead? Unlikely.
