Feature Stories | May 25 2020
This story features COMMONWEALTH BANK OF AUSTRALIA, and other companies. For more info SHARE ANALYSIS: CBA
The focus of recent bank earnings reports was not that of earnings, but of capital positions and bad debt provisions in the face of a recession only just now manifesting.
-Australian banks' past half’s earnings not particularly insightful
-Capital management the key focus
-Bad debt forecasting a challenge
-Valuations build in risk
By Greg Peel
As the world ticked over into 2020, Australia was staring down a recession, exacerbated by a bursting of the housing bubble, which had already forced the RBA into cutting rates. All around, bushfires were raging, adding to recession fears. Even the government’s stubborn budget surplus intentions began to develop cracks.
Our biggest trading partner was now dealing with some new SARS-like illness.
Australia’s bank analysts were already predicting subdued growth, if any, in the face of the housing slide, and were convinced dividend payout ratios were unsustainable.
When Australia ultimately went into lockdown, and the stock market crashed through to late March, the question was no longer whether the banks would cut their dividends but by how much, and whether they may need to raise fresh capital. All of course, at that stage, was a Great Unknown.
“The bottom line is the longer the country remains in lockdown, the greater the number of unemployed workers, bad debts and bankruptcies. This is, or at least was, the swing factor in bank analysts determinations of the potential of, and the extent of, bank dividend cuts, bearing in mind the banks were likely to cut, analysts assumed, even before the virus emerged.”
This is an excerpt from Australian Banks: There Go The Dividends, published on April 8 (https://www.fnarena.com/index.php/2020/04/08/australian-banks-there-go-the-dividends/)
“Analysts had gone to a lot of effort to produce base case and bear case scenarios the two largely split on the possible longevity of the crisis using assumptions about peak unemployment levels and the impact on mortgage defaults, and peak business stress and the impact on loan defaults. These scenarios had informed dividend assumptions, and the consensus conclusion was that elevated dividend payout ratios would have to be reined in, amounting to dividend cuts.”
But just as debate was raging, and even as the stock market began to rebound, APRA stepped in to direct the banks to either defer or significantly cut their dividends. There would have been some sense of relief in bank boardrooms, for now the difficult decision was as good as taken out of their hands.
Such a directive from the regulator came as a surprise, given it was APRA who had insisted that given the GFC experience, prior to which Australia’s (and global) banks were clearly under-capitalised, Australian bank balance sheets had to be “unquestionably strong”, which was eventually defined as carrying 10.5% in tier one capital. And well before APRA’s deadline, the banks were all unquestionably stronger than unquestionably strong, which, along with low levels of bad debts, had allowed for elevated dividend payments up to that point.
Now the regulator was implying, by directing the banks to defer or slash their dividends, that capital positions were not unquestionably strong at all.
From late April, the banks began reporting their first half earnings results, at which they were due to announce their capital management plans. The exception was Commonwealth Bank ((CBA)), which accounts on a July-June basis as opposed to October-March for the other Big Three. CBA had already delivered its earnings result in February and made no dividend cut, and had subsequently already paid that dividend, when it provided a March quarter update once the other banks had reported.
ANZ Bank ((ANZ)), National Bank ((NAB)) and Westpac ((WBC)) all reported their first halves, which given they stretched from October, were never going to provide a realistic view of virus impact. That would have to wait to the second half (end-September).
Only One Focus
On that basis, actual earnings results were not particularly informative, and thus not that important. What was important is whether the banks chose to defer or cut and whether there would be any new capital required.
Blindsiding ANZ Bank, which traditionally reports first, and catching analysts on the hop, NAB jumped in early to deliver the bad news. It had cut its dividend and raised capital, sparking market speculation the others would be following suit.
As it transpired, neither ANZ nor Westpac announced capital raisings, but they did defer their dividends. In Westpac’s case the board suggested it was just following orders. A deferred dividend is not a lost dividend, just a postponed dividend, which could be either paid at a later date or made up for at the full year result release in October when final dividends are declared.
Or a decision could be ultimately made that it will be a lost dividend, or at least a slashed dividend. Such decisions remain entirely at the hand of the virus and the likely economic fallout.
Which leads bank analysts into making judgements (guesses, really) as to the extent of that fallout, and “the possible longevity of the crisis using assumptions about peak unemployment levels and the impact on mortgage defaults, and peak business stress and the impact on loan defaults”
Analysts were eager to hear what the banks themselves were predicting.
What the banks were effectively predicting was apparent in the extent of provisions taken against increased bad debts. Bearing in mind, the banks had already put away huge provisions for remediations stemming from the Royal Commission, and even now what those ultimate costs will be remains unresolved. The banks had also begun topping up their bad debt provisions before their result announcements.
Result season top-ups ranged from -$807m at NAB to -$1619m at Westpac, taking the total of virus-specific provisions across all four majors to -$5bn. UBS questioned whether this is sufficient to cover the majors’ total credit exposures of $4.1trn.
“Significant additional credit charges look inevitable,” said UBS, “as the economic slowdown takes hold”.
“Despite expecting economic scenarios not seen since the 1930’s, on average, expected loan losses were very mild compared to previous cycles,” JPMorgan suggested.
Which implies that despite dividend cuts and deferrals, and NAB’s capital raise, more provisioning will be required, further drawing on capital. This is why the jury is still out on whether the banks might have to defer their final dividends as well as their interim dividends. It is little doubt they will at least be cut. CBA has to make the decision in August, and the money’s currently on the bank having to defer. The others have until October.
That said, relative to capital and loan books, analysts agree ANZ and NAB’s provisions look light compared to Westpac and CBA, suggesting a greater risk of top-ups from the smaller two of the four.
Pro-Cyclicality and Risk Weighted Asset Inflation
Don’t be scared – the two are easily explained.
A bank’s “assets” are its loans, because interest paid on those loans provides a bank’s core income. Each of those loans carries a different level of risk of default, ranging at the safer end from mortgages and loans to large corporations to the riskier end from loans to small businesses, personal loans and credit cards.
Even so, in the current situation, “safe” mortgages are no longer so safe and many a large corporation is in difficulty due to the virus and subsequent lockdowns. Lockdowns may now be easing but the process will be slow, and as noted above, the real risk will be apparent when government support packages expire.
The banks have been attempting to ameliorate this risk with mortgage payment deferrals and other relief measures for clients, hoping they can ride out the worst of it and return to normal service, and normal payments, in the not too distant future. It is of no benefit to anyone – client or bank — to allow businesses or households to go under, particularly if it’s just a matter of having to hang on. This is not the GFC, or the 1990s, when trying to prop up borrowers would have meant throwing good money after bad.
A greater or lesser risk of a loan default informs that loan’s risk weighting, and APRA has placed a cap on the level of a bank’s total risk weighted assets (RWA) as a proportion of capital. It does nevertheless disturb some analysts that while the regulator sets the limits, it’s actually the banks themselves that assign the risk weightings.
That said, APRA is currently providing the banks with a period of grace with regard it’s RWA cap, and for that matter tier one capital ratios, recognising that the numbers will be skewed in the current situation of locked down businesses and temporarily unemployed workers, hopefully soon to normalise, and also the fact the banks themselves are providing a period of grace to their clients.
But even as the economy begins to reopen, RWA inflation remains a clear and present danger. Inflation implies the increase in risk of loan defaults at this time. In addition to increased risk, the values of homes and commercial property are falling, which is the collateral against which risk is measured. This suggests double-whammy impact. For example, an employee who loses his/her job can’t pay the mortgage, but the house is now worth less than they paid for it, placing the former employee in negative equity.
RWA inflation undermines bank capital. In effect, notes UBS, bank capital ratios will be hit on both the numerator (loan impairments) and denominator (RWA inflation) as arrears rise and property value fall. UBS forecasts a reduction in tier one capital ratios of -100-200 basis points, or one to two percentage points.
Closely linked to bank capital ratios is “pro-cyclicality”. For JPMorgan, the real surprise coming out of the bank result season was how pro-cyclical capital ratios will be.
Pro-cyclicality implies a tight connection with the overall economic cycle. It’s a bit like the “beta” of a stock. A pro-cyclical business is one that suffers along with the economy in general in the bad times, as opposed to a counter-cycle business, which thrives when others are in trouble.
Of course all businesses are not simply one or the other, and any measures taken to buffer the effects of a downturn would reduce pro-cyclicality – for example, diversification, or a solid cash balance set aside for rainy days.
NAB set the scene on the first day of results, JPMorgan notes, by disclosing an -80-180 basis point range of expected pro-cyclicality of capital ratios to deterioration in credit quality in this downturn. This was well above the broker’s expectation, and materially worse than the GFC experience (-30bps of tier one ratio impact in 2009).
This pro-cyclicality has negative implications for dividends over the next two years in JPMorgan’s view, with ANZ and NAB assumed to be the most negatively affected.
The Good, the Bad and the Ugly
Speculation abounds as to what shape a recovery for the Australian economy will take.
A V-shaped recovery implies things will quickly snap back to normal once the virus threat passes.
A U-shaped recovery implies that even if the virus-threat passes, things could get worse before they get better, and a return to normal will take longer.
An L-shaped recovery implies that at least in the foreseeable future, there will be no recovery. This is also known as a Depression.
There is also another option, called the “swoosh”, being a reference to the Nike logo. A swoosh is basically a V but with the leg out of the V being more elongated compared to the sharp leg down. While a swoosh is arguably a lot more likely than a V, most economists are in the U camp. As is the RBA.
There’s also a W-shape of course, but this is more relevant for the forward-looking stock market rather than the economy. If the stock market has overestimated the speed of the recovery, it could well fall back again before finding a new bottom, which would describe a W.
The economy could, nevertheless, experience a W were there to be a dreaded second wave appearing at a later date, rather than immediately as a result of re-openings.
The great shape guessing game may seem a little juvenile, but it is the simplest way to sum up what remains the Great Unknown. Citi, for example, still sees average loan losses of around -100 basis points over three years, significantly higher than bank provisioning suggests, but admits the range of loss outcomes remains wide under the different scenarios.
On the other hand, Citi believes APRA’s intervention into dividend policy has set the majors’ balance sheets at a level to withstand even a worst case, elongated L-shape, without requiring new capital.
If, thus, the economy can appear to V or even U-bounce between now and October, when the bank’s next capital management decisions are made, it is possible APRA will be satisfied enough to allow dividends to be restored, Citi suggests. August may nonetheless be a bit too early for CBA.
And only if there were a “severely unexpected” loan loss spike in the first half of FY21 would FY21 dividends also be derailed, in Citi’s view, given provisions taken and unquestionably strong capital. The virus will impact on earnings and credit quality, but the analysts suggest dilutive capital raisings are now very unlikely.
Goldman Sachs suggest asset quality and capital will be the key focus into the second half of this year, and rather than earnings per se, investors will be heavily focused on the extent to which the banks have adequately provided for adverse virus impact via provision increases, and how the pro-cyclical nature of tier one capital will play out in the face of a deteriorating backdrop, which as a base case will be worse than the GFC experience.
All of the above now has to be considered within the context of where the market is currently valuing the banks.
With capital positions now bolstered, Credit Suisse remains constructive on a twelve-month view but acknowledges near term earnings volatility. The current event is thus an earnings issue for the sector and not a balance sheet one. Given the banks are trading below book value (the value the banks ascribe to assets minus liabilities on their balance sheets), and in some cases below net tangible asset value (excluding intangibles such as goodwill on the balance sheet), Credit Suisse sees this as an opportunity.
Bottom-up analysis from Goldman Sachs suggests the banks can sustainably earn a 10% return on equity in the current low rate environment, and based on the relationship between return on equity and price-to-book ratio, the sector should be trading about 24% from current levels (18 May).
UBS believes the banks which deliver the best asset quality (lowest bad debts) through the downturn will outperform. However, unlike recent cycles, quality is unlikely to be driven by exposure to large corporate failures but rather be more broad-based across smaller loans.
If that is the case, NAB is likely to see significant challenges to to its earnings and risk weighted assets, UBS suggests, being most exposed to small business lending. Westpac has the largest exposure to investment property, while CBA is largest in mass market retail and credit cards. ANZ has de-risked, but UBS ponders whether it can avoid a repeat of the mishaps of the past.
Again, this all has to be taken in the context of where the market is currently pricing each bank. To that end, we note from the table below that despite its exposures, NAB remains the top pick with six out of seven FNArena database brokers on a Buy or equivalent rating, irrespective of a lower upside to consensus target than ANZ or Westpac.
|FNArena Major Bank Data||FY1 Forecasts||FY2 Forecasts|
|NAB||6/1/0||15.34||18.28||19.16||– 34.9||– 58.9||58.7||4.5||25.8||47.3||68.7||6.6|
|ANZ||4/2/1||15.23||19.38||27.24||– 40.4||– 71.3||36.8||3.0||25.9||100.0%||65.3||6.8|
|WBC||3/3/1||15.01||18.59||23.87||– 53.4||– 71.8||45.5||3.3||44.8||100.0%||67.0||7.0|
|CBA||1/4/2||58.70||61.45||4.68||– 13.4||– 31.4||70.3||5.0||– 3.1||8.1||78.4||5.4|
With CBA indicating the lowest upside to target it is, as always, least preferred. This is not a reflection of how brokers perceive the bank, which is typically a case of “best in class”, but rather one of simple valuation.
What leaps out from the table is current year dividend yields – not a familiar picture. Mind you, in the context of lower for longer interest rates, yields of 3-4% (fully franked) are nothing to be sniffed at, and so far only NAB has actually cut its dividend, and raised capital, while ANZ and Westpac have deferred their dividends and not raised capital. CBA’s 4.9% yield includes an interim dividend already paid.
Following year yields look far more familiar, but as brokers are quick to point out, must be taken with appreciation of the Great Unknown ahead.
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