Feature Stories | Jul 31 2019
This article was first published for subscribers on July 25 and is now open for general readership.
The skies have cleared a little for Australia’s housing market, and the cash rate is falling. Are bank dividends worth the risk?
-Housing market supported by stimulus from all sides
-Mortgage access not necessarily improved
-Ultra-low cash rates a dilemma for banks
-But oh, those yields
By Greg Peel
Has Australia’s housing market bottomed?
Macquarie recently surveyed real estate agents and found improvement in both the demand and supply sides of the market, in terms of attendance and bidding engagement at auctions and prospective leads on new properties coming to market.
Clearly sentiment has improved since the federal election, APRA regulation easing and two RBA rate cuts. Macquarie acknowledges a shift in sentiment might be self-fulfilling, but does believe housing trends should improve to support an otherwise fragile credit growth outlook for the banks.
But just how impactful are the abovementioned factors?
Obviously Labor’s planned changes to negative gearing would have meant a major withdrawal from the market of those seeking to buy investment property. That’s now done and dusted, although it’s interesting to note, as was highlighted in a recent Sydney Morning Herald article, that rents are on the rise, and quite alarmingly so.
As is well understood, few are able to enter the property market for the first time despite low interest rates given the inability to save up enough of a deposit. House prices in Sydney, for example, may have come off the boil but after years of parabolic growth, the average price reduction really hasn’t changed the landscape that much. More aspiring homeowners have no choice but to rent, and that demand is pushing up rental costs.
So much so that the SMH was able to pinpoint suburbs in Sydney in which if you were to compare housing values, rents and mortgage costs, the monthly cost of servicing a mortgage is cheaper than the monthly cost of rent. While the cost of an investor loan is higher than an owner-occupier loan, the point is if rents get any higher…OMG, positive gearing.
As for APRA’s change to the mortgage serviceability requirement, Macquarie questions whether it will really make that much difference to loan eligibility.
APRA had flagged, and recently confirmed, it would cut its mortgage serviceability threshold from “at least 7.25%” to “at least SVR mortgage rate plus 2%”. Previously, even if you could afford the prevailing SVR of, say, 4.25% you had to be able to show you were financially capable of servicing that mortgage if the SVR rose to 7.25%, or to put it another way, if the RBA hiked rates 12 times.
Yes, it did seem a bit silly, and it has been since APRA flagged the change the RBA has cut twice.
Macquarie estimates the change will increase bank lending capacity of principal & interest owner-occupier loans by 11-15%, with smaller increases for interest only and investor loan customers. But the problem is, mortgage serviceability is not the only thing prospective lenders have to take into account.
Among the many horror stories emerging from the Royal Commission was that of banks paying scant attention to whatever other monthly financial commitments a prospective borrower might have before adding in the cost of a mortgage. In simple terms, the banks were lending to those who simply could not afford a mortgage, despite having a wage/salary of $X, given other monthly expenses.
The RC stopped short of recommending a replacement for the Household Expenditure Measure the banks had supposed to apply when considering loan applications, but you can bet your bottom dollar loan assessors will now want to know exactly how much you spend on beer each month, before rejecting your application.
The point being, as many bank analysts have pointed out, that what is gained on the swings of mortgage serviceability will to some extent be lost on the roundabout of stricter HEM consideration.
RBA Rate Cuts
We’ve had two, to 1.0%, another one has all but been confirmed by the RBA, and most expect a fourth as well, possibly by the end of this year, to take us to 0.5%.
Former RBA governor Glenn Stevens once suggested 1.0% was as low as the cash rate could go before further cuts began having little impact. Current governor Philip Lowe has not indicated disagreement, but he has made it plainly clear to a cloth-eared government that cuts below 1.0% must be supported by fiscal stimulus if they are to have any impact.
To have any impact, the banks must pass on the benefits. Given a long history of hanging on to a handful of basis points to bolster their own bottom lines, it’s easy to be cynical and assume this time will be no different. Of the -50 point cut the RBA has delivered to date, the majors have passed on only -43 to -45 points. But when rates get this low, the question becomes one not of will they pass on all of the cuts, but can they?
At the end of the day, the banks are businesses that have to make money, whether you like it or not. The base driver of bank earnings is their net interest margin (NIM), which is the spread between the net rate a bank can borrow money at and what they charge to lend it out, just like a retailer’s margin on goods for sale.
The primary sources of bank borrowing are deposits and debt issuance, the latter primarily targeted to offshore lenders. The good news for the banks is that at the time of the RBA’s first rate cut in June, to 1.25%, the spread between the Australian bank bill swap rate (BBSW) and the international overnight index swap rate (OIS) had been falling, as central bankers around the globe became more dovish due to global slowdown fears.
That is why, following the first cut, three of the four majors passed through -25 points in full. ANZ Bank ((ANZ)) kept some for itself. But the BBSW-OIS spread had stabilised by the time the RBA cut again this month, so three of the majors passed on not all of the cut, with ANZ the only bank to go the full -25.
Now we expect a further cut or cuts from the central bank. Alongside debt issuance are deposit rates, and as UBS points out, many deposit products have already hit or are approaching zero.
On the assumption there would not be too many Australians keen to pay the banks to hang on to their money, deposit rates cannot go lower. If mortgage rates go lower, so do NIMs, and hence bank earnings. To preserve NIMs, the banks would have to at least keep some of the RBA cut for themselves. But keeping too much would be to risk losing market share to the other guy who passed on more, unless they all fall into line.
It is one reason the RBA has warned that at such a low level, the impact of monetary policy stimulus becomes less and less effective. The RBA knows that if the banks do not pass on a rate cut in full, it’s not just because they’re greedy you no whats.
Earlier this month, APRA announced the banks will be required to increase their TLACs to 3% of RWAs to bring Australian D-SIBs into line with G-SIB requirements. The announcement came as a bit of a relief, given APRA had earlier flagged a 4-5% requirement.
Yes, I thought you’d be pleased to know.
To understand the above one must appreciate that over a decade ago we had this thing called the GFC, and if it weren’t for government intervention around the globe at the time the entire world’s banking system would have collapsed. Since then, regulators have been working on ways to ensure such a situation never reoccurs, and have been extremely slow about it.
It’s not APRA’s fault per se, given the Australian regulator has been waiting for the international panel of regulation-setters who meet in Basel to settle on new standards for globally systemically important banks (G-SIBs), which are best described as the “too big to fail” banks, before setting commensurate standards locally for domestic systemically important banks (D-SIBs), being the Big Four, as they are “too big to fail” in Australian terms.
Such consideration brought about a long-awaited decision previously on a necessary level of tier one capital to ensure the banks are “unquestionably strong”, and now APRA has moved onto the consideration of total loss-absorbing capacity (TLAC) as a percentage of the loans on the books, which each carry different levels of risk and are thus weighted accordingly in a calculation of total risk-weighted assets (RWAs).
To achieve this new requirement, the banks must carry a level of tier two capital – hybrid or subordinated debt – alongside tier one capital – equity and retained earnings. Previously APRA flagged a TLAC of 4-5% of RWAs, but after consulting market participants, settled on 3% — a target required to be reached by 2024, some 16 years after the event that prompted the requirement.
The bottom line is the market for Australian bank tier two capital is just not big enough to cope with a 4-5% requirement, notwithstanding subordinated debt has to offer higher rates than senior debt in order to account for the greater risk. At 3%, the banks will between them need to issue around $50-60bn of tier two debt, bank analysts calculate, over the next five years.
This is not considered onerous, and the expected impact on bank earnings is in the order of -1%.
But wait, there’s more.
Returning to APRA’s earlier decision on “unquestionably strong”, which requires the Big Four to hold 10.5% of tier one capital by next year, we note that right from the outset bank analysts forecast the banks would meet such a requirement comfortably, and indeed they remain well on track today.
Then along came the Royal Commission.
Even before the RC, Commonwealth bank ((CBA)) was under fire for a list of serious misdemeanours. The RC only exposed more. In May last year, APRA concluded a prudential inquiry into the operations of CBA and hit the bank with an additional $1bn capital requirement.
All this additional capital requirement may at least be not as bad as feared, but it still creates another headwind for the banks when earnings remain under pressure from possible NIM contraction ahead. And let us not forget the banks still face RC-related remediation charges that are yet to be determined, albeit provisions have been made.
It’s not just a matter of how the banks might respond to further RBA rate cuts, but who ultimately will suffer.
Despite all of the above, the majors still expect to be as profitable now as they were before the GFC, as reflected in targeted shareholder returns.
Before the GFC the banks were enjoying the benefits of deregulation, low levels of capital requirement, high interest rates and consumers happy to borrow up to their eyeballs. Today they face increased regulation, compliance and political scrutiny, high levels of capital and liquidity requirements and historically low interest rates. Yet still they are targeting a 13.5% return on equity (ROE).
UBS calculates that with a ten-year bond rate at 1.35%, and a cost of capital for the banks of around 8%, if the banks do reach their ROE targets their relative returns would be consistent with pre-GFC levels. As such UBS believes such targets are difficult to justify, potentially impacting their ability to meet community expectations and the efficient implementation of monetary policy should further RBA cuts not be passed on.
“Should rates continue to fall banks are left with a choice of either protecting NIM/ROE or protecting market share. Earnings and dividends would be under threat in either scenario. We do not believe this situation is sustainable”.
Morgan Stanley notes that since the election, APRA changes and RBA rate cuts, bank valuations have improved on average to 13.2x price/earnings from a prior 11.9x. While tail risks in relation to the economy, mortgage market and regulatory environment have reduced, Morgan Stanley acknowledges, the broker believes such a re-rating only increases the risk for investors and will not be sustained unless economic trends improve, material earnings upgrades emerge and a sustainable decline in payout ratios reduces the probability of dividend cuts in 2020.
Morgan Stanley thus suggests investors take the opportunity of re-rating to reduce their bank shareholdings. This suggestion was made back on July 4, the day before the ASX200 hit a new post-GFC peak – a peak which as I write on July 24, is being surpassed.
Morgans states the obvious in suggesting the banks should be more attractive to investors from a yield perspective as bond yields fall. It is pretty clear the reason bank share prices have been on the rise again is not just expectations of the end of the housing bust, but a preparedness to take the risk on all the headwinds facing the banks when the yields they offer provide such a significant buffer in a low rate world.
Assuming, of course, dividends aren’t cut.
The most likely contender is Westpac, given the bank stands out with a forecast payout ratio of over 90%.
Clearly, UBS and Morgan Stanley are among the camp who would not be surprised were Westpac to cut its dividend with its FY19 result. But not all brokers believe a cut is necessary.
Morgans expects Westpac to implement a discounted dividend reinvestment plan (DRP) with respect to its final dividend, which is by any other name a backdoor capital raising. The broker does not see any further discounted DRPs beyond FY19 from a tier one capital perspective, and no nominal cut to the dividend ahead.
Indeed, Morgans believes recently announced fiscal (tax), monetary (RBA) and macroprudential (APRA) stimulus initiatives are positive for bank system credit (loan) growth and asset quality (bad loans). The broker expects the banks to become more attractive to investors from a yield perspective.
Macquarie sees earnings headwinds for the sector and risk to consensus forecasts. The banks still carry a valuation discount relative to the market and Macquarie acknowledges this captures downside risk, but the broker suggests it will be difficult for the banks to outperform until the downgrade cycle stops.
Citi believes the banks will be able to keep their NIMs broadly flat for twelve months in the face of RBA rate cuts, through mortgage repricing (not passing through), deposit margin management and slimming down liquidity portfolios, and suggests investors not be too bearish. However, the broker sees NIMs being more challenged over two to three years from the elongated impact of lower interest rates.
Citi has a Neutral rating on the sector.
Credit Suisse expects the reality of historically low rates will hit bank bottom lines in the next six months. The result will be a fade in the sector re-rating post all-of-the-above, given that re-rating is purely sentiment driven (higher PE).
Credit Suisse also makes an interesting suggestion regarding the likelihood the banks will not pass through all of the next RBA rate cut(s) given near-zero deposit rates.
When the Bank of England cut its cash rate to 0.25% from 0.5% in the wake of the Brexit vote shock, the central bank acknowledged the NIM dilemma with respect zero deposit rates and introduced a term funding scheme that offered cheap funding to UK banks in exchange for passing through all of the cut.
Credit Suisse believes such a scheme could be an option for the RBA if rates continue lower. But the broker notes subsequent outperformance of UK bank share prices did not last long. Smaller banks used cheaper funding to discount mortgage rates in order to gain market share and “competed the benefit away”.
On that note, we recall that the average pass-through from the majors of the -50 point cut to date has been -43 to -45 points. Bank of Queensland ((BOQ)) passed through -40 points, Suncorp ((SUN)) -39 points and Bendigo & Adelaide Bank ((BEN)) -37 points.
So not exactly offering up mortgage competition there. Shaw & Partners nevertheless notes the regionals rely less on at-call deposits than the majors which may give them an advantage in a low interest rate environment.
“Advantages are rare for them,” notes Shaw.
|FNArena Major Bank Data||FY1 Forecasts||FY2 Forecasts|
|NAB||3/3/1||28.33||27.11||– 4.63||– 4.7||– 16.2||80.8||5.8||6.1||0.4||76.5||5.9|
|WBC||2/3/2||28.39||28.44||– 0.72||– 13.6||– 1.1||91.2||6.5||9.5||– 1.0||82.4||6.4|
|CBA||0/4/3||82.35||73.25||– 11.23||– 8.9||0.1||88.6||5.2||4.0||1.8||86.6||5.3|
FNArena last analysed the state of play for the banks on June 3 (Australian Banks: New Horizons), following the election, APRA announcement and hint, at least, that the first RBA rate cut was coming.
Comparing the same table as above at the time we find now, not much has changed.
The average order of broker preference among the Big Four is unchanged. A total Buy/Hold/Sell rating ratio of 7/16/9 back in June is now 6/14/8 – little different.
Brokers have lifted their price targets in the the interim, to a simple average $39.24 from $37.81 in June. The mix of share price rally and target price increase for each means there is no notable change in “upside to target”, except for NAB, which is now 5% above its target having been close enough to on it in June.
The one particular difference is average yield, which back in June was 6.15% but on share price re-rating has now dropped back to 5.85%, with no brokers actually forecasting any dividend cuts, just warning of their potential.
So there’s the rub. Term deposit rate? Negligible. Lend your money to Scott Morrison for ten years? You’ll get 1.3%. Buy property? Maybe, if you can get a loan. Take the risk on downside earnings potential for the banks when you can get 5.85% before full franking?
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