Feature Stories | Mar 19 2021
This story features COMMONWEALTH BANK OF AUSTRALIA, and other companies. For more info SHARE ANALYSIS: CBA
Rising bond yields, rising margins, ongoing growth-to-value rotation and the prospect of higher dividends have brokers remaining bullish on the banks. But a resurgent housing market may yet prove an impediment.
-First sector earnings upgrades in six years for Australian banks
-Looser lending standards driving loan demand
-Will APRA be forced to step in once more?
-Have we seen this movie before?
By Greg Peel
“The Credit Squeeze experienced over the last six months is now expanding, with owner-occupier lending now falling alongside investor lending. UBS believes further credit tightening is “almost inevitable” post the Royal Commission final report due next year. The upcoming federal election is likely to reduce credit demand as borrowers contemplate changes to negative gearing and capital gains tax relief.”
(Australian Banks: Uncertain Times, December 19, 2018)
We recall that once the dust had settled following the 2008 GFC, Australia’s economy began to grow once more. Not only did Australia manage to avoid a technical recession, the wave of loan defaults anticipated by Australia’s banks never materialised.
But a funny thing happened. A stock market’s movement typically correlates with the strength or otherwise of the underlying economy. But as the economy rose out of the GFC, the stock market lagged. It took Wall Street three years to regain its pre-GFC high. It took the Australian market twelve years.
One major drag was the Aussie dollar, which moved above parity with the US dollar. Australia had avoided a recession from what we call the Global Financial Crisis. Americans refer to their experience as the Great Recession.
The stock market has always been the first go-to source of investment for retirement. But not post-GFC. With stock market returns muted, and interest rates still low in the wake of the GFC, retirement investors turned to property instead. The banks welcomed these investors with open arms, making borrowing as accessible as possible.
The result was a housing bubble. As the RBA became increasingly concerned a housing bubble would ultimately result in a housing bust, it turned to APRA to tighten lending standards for investor loans. The risk was as rates rose, which was what the RBA was signalling at the time, investors on interest-only loans and owner-occupiers on high loan-to-value (LVR) ratios and high debt-to-income (DTI) ratios would be unable to service those loans, leading to a cascading effect when house prices began to fall.
And after two incursions from APRA to tighten lending standards, fall they did.
Then along came the Banking Royal Commission, and a bloke called Bill Shorten. Aside from the many crimes and misdemeanours the RC exposed, one element was very lax borrower scrutiny from lenders. In short, the banks were happy to simply take borrowers on their word in relation to any other debt obligations they may be carrying.
And everyone lies.
Before the final RC report was handed down it was already feared even stricter lending standards would follow, and that would only further fuel what was now becoming a “housing crisis”. And it didn’t help that the Labor Party was considered a shoe-in at the 2019 election, running on a platform of abolishing negative gearing.
Ironically, the RBA was forced to start cutting rates again.
History shows the May election was not Bill’s finest hour. A gloating Coalition then turned its attention to a budget surplus. It appeared the housing crisis would now come to an end, although banks would still be required to lend only to those applicants deemed safely able to service their mortgage, following close scrutiny of their household balance sheets.
That, in essence, meant not lending to anyone much.
The Coalition then stopped gloating when covid hit. The risk of a renewed housing crisis, and a surge in loan defaults on everything from mortgages to business loans to credit cards, was starkly real. It was grim-faced Josh Freudenberg who had to deliver the news that the government’s surplus assumptions had just gone out the window. Instead, Australia would need to go heavily into debt.
The RBA did what it could by cutting its cash rate to as good as zero, but urged the government to do even more on the fiscal side. JobKeeper, first homebuyer grants and HomeBuilder subsidies were just not going to cut it. Fearing he would go down as the Treasurer that lumbered Australia forever with record government debt, Josh had an idea.
Reverse the tightening of lending standards. Put the onus back on the borrower to be honest about other debt obligations. And it worked. Between historically low mortgage rates, government subsidies and relaxed lending rules, the housing market turned around.
Australia’s average house price rose 3.0% in the December quarter when economists had forecast 1.8%. House prices rose 2.1% in the month of February, marking the fastest pace since 2003. Westpac economists believe prices in Sydney and Melbourne could rise by as much as 20% over the next two years.
Who said history never repeats?
A Bumper Quarter
Rising house prices imply rising demand, rising demand for houses implies rising demand for mortgages, and thus greater potential for better bank earnings, assuming the banks could exploit such demand in a low interest rate environment.
The bank earnings result season just past, in which Commonwealth Bank ((CBA)) posted its half-year result while Westpac ((WBC)), National Bank ((NAB)) and ANZ Bank ((ANZ)) posted quarterly trading updates, led to the first bank earnings upgrades since 2015.
“The February bank results season was one of the strongest in recent times,” noted JP Morgan.
Not only were performances better than expected across all banks, they were better across all key bank metrics.
The biggest surprise was an improvement in net interest margins – in simple terms the spread between deposit rates and lending rates. Businesses are still reluctant to borrow while covid continues to reverberate (and JobKeeper is set to end), so all the action was in the housing market.
The banks managed to keep their variable mortgage rates unchanged in the period, instead offering teaser rates in fixed loans as well as cash-back offers in the competitive landscape. The surprise was they managed to lower their deposit rates, with term deposits now offering a handsome 0.1% (in line with the overnight cash rate and three-year bond rate).
At the end of 2020, Australia’s headline CPI was running at an annual rate of 0.9%. So a one-year term deposit rate of 0.1% equates to a real rate of -0.8%.
As well as being able to attract deposits at negative real rates, the banks were also able to attract offshore funding at commensurately low rates, to the extent they have not so far had to tap into, in any meaningful way, the term funding facility offered by the RBA. The spread on funding costs to lending income allowed the banks to improve their net interest margins.
Increased demand for loans also increases bank fee income.
On the other side of the coin, and reminiscent of the post-GFC years, the banks saw a general reduction in loans in arrears. CBA continued to top up its provision against bad debts but NAB didn’t, while ANZ and Westpac actually released some of their provisions. A fall in risk-weighted assets also meant solid improvements in bank capital positions.
And hence the dividend switch was turned back on.
All is Forgiven
What Royal Commission?
Those aforementioned crimes and misdemeanours unearthed over two years ago now seem but a distant memory since the world was turned upside down last year. The banks are nevertheless still paying remediations, but had previously provisioned sufficient funds so not to impact on earnings going forward.
One of the impacts of post-RC regulations was increased costs of scrutinising loan applications to APRA’s satisfaction, but costs fell in the December quarter, with some help from Josh.
With all that had been thrown at them, the banks had been in a downward share price cycle from early 2017 but by late 2019 had managed to enjoy a path to recovery. Then from January to March last year, bank share prices fell around -30%.
We are now approaching the anniversary of the covid market bottom – March 23 – and since that time the financials sector has rebounded some 33%. That doesn’t mean covid never happened, because to recover all of a -30% fall, a 43% rebound is required.
The initial rebound from last March initially reflected calls of “oversold”, and then ramped up when the national lockdown ended. There followed a period of reflection and ongoing uncertainty, particularly when Melbourne went back into lockdown.
Melbourne finally emerged blinking into the sunlight just as the first vaccines were announced, at a time the government had introduced the HomeBuilder subsidy and had extended both the first homebuyers grant and JobKeeper (albeit at lower levels). Suddenly there was a global rush out of covid beneficiaries and “growth” stocks and back into cyclicals and “value” stocks – the banks being flag-wavers for the latter.
Of the 33% the banks have currently rallied by from the bottom, 29% has been since November. Positive earnings results announced in February and the return of dividends have served to help.
But are we all now a bit too over-excited?
Don’t jump off just yet
All brokers acknowledge the re-rating of banks stocks to date has been significant, so the greatest gains have already been booked. But as Credit Suisse puts it, “While the cheap seats have been taken, we believe there is still upside remaining and we remain positive on the sector”.
Credit Suisse notes that despite the rebound, the sector is still trading at a -21% discount to the index and typically has traded without any discount on the exit of prior crises.
Credit Suisse is far from alone.
Bank analysts, in chorus, cite four factors underpinning further potential upside for bank valuations.
- More room for net interest margin expansion. While analysts have been surprised by the extent banks have been able to squeeze the deposit side, and access cheaper wholesale funding, they still believe the banks can squeeze out a little bit more.
- Ongoing growth-to-value rotation. Morgan Stanley notes the bank downgrade cycle effectively began in 2014 with a pre-RC Financial System Inquiry and that cycle ended in March last year. Since 1992, there have been five sustained periods of bank outperformance, lasting between nine months and five years. At four months (since November), this one “may have only just begun”.
- Rising bond yields. Spikes in longer-dated bond yields both here and in the US, due to building inflation fears, have only been notable since the February result season. With the RBA holding all rates near zero up to three years, the yield curve now looks like the north face of K2. Borrow short and cheap (deposits, three-year wholesale funding) and lend long and comparatively expensive (mortgages). That’s how banks can really make money.
- Capital Management. Let’s go back to “history never repeats”. When the GFC hit, the banks were forced to raise fresh capital and put vast sums away in anticipation of a wave of loan defaults, as well as provisioning simply for possible ongoing disasters ahead. Neither of which happened, resulting in super-normal dividend payouts and additional special dividends when those funds were no longer needed. This time around the banks have again put away vast sums in anticipation of a wave of covid-related loan defaults, which so far hasn’t happened. Banks are awash with capital. Here we go again.
Hence, on the expectation of further net interest margin improvement, ongoing rotation into value stocks, rising bond yields and a dividend and share buyback spree, bank analysts are all pretty confident the bank re-rating cycle is not done with yet.
FY22? Well, let’s not get too far ahead of ourselves.
There might nevertheless be one little hitch.
“We expect macro-prudential controls will be introduced in Australia later this year,” said ANZ Bank’s economists earlier this month. “A soft touch from the regulator [APRA] is likely in the first instance, followed by harder limits, most likely targeted at high debt-to-income loans”.
When the Australian housing market was bubbling a few years back, APRA first applied a “soft touch” which was then followed up by harder limits. The RBA was concerned the housing bubble would turn to bust, and it did. The Royal Commission didn’t help, leading to even tighter restrictions, and only Shorten’s spectacular election defeat avoided a more pronounced crisis.
The RBA has been ready to raise rates at the time but did not want to be the trigger of a housing collapse. Pretty soon it was cutting rates again. And that all happened before covid.
When the banks found they didn’t need all the provisions they’d put away for the GFC, after raising new capital, they gave it all away to shareholders. When the RC threatened to hit bank balance sheets hard, there was nothing left in the cupboard. One bank raised new capital, while others began winding back excessive dividend payout ratios. Earnings were again put away in provisions.
When covid hit, more money was put away. One bank was forced to raise capital, others did so “backdoor” fashion with underwritten DRPs, and all were ready to slash or even cancel dividends when APRA stepped in and told them to do so anyway. With covid seemingly tamed in Australia, already some of those provisions are being released, dividends have been restored, and talk is of increased payouts and buybacks.
Do they ever learn?
UBS believes macro-prudential policy tightening is “just a matter of timing”, and will be implemented instead of rate hikes. The Council of Financial Regulators, which includes the RBA and APRA, has stated they will “continue to monitor developments” in the housing market and “consider possible responses should lending standards deteriorate and financial risk increase”.
They are specifically “watching carefully” for changes in lending standards. On the basis of December quarter data, they should be somewhat anxious.
UBS reports the share of new home loans with a “high” debt-to-income ratio of 4x or above rose to a record high 59.3% in the December quarter, up from 57.7% in September. New loans with a “very high” DTI of 6x or more rose to to a record high 16.9% from 16.0%. “High” loan-to-value loans of 80% or more rose to a record 42% from 39.9%
Fuelling higher risk-taking was a tick down in the average mortgage rate to under 3%, with the “assessment rate” dropping to 5.5%.
The assessment rate is the rate banks use to determine whether a borrower is a safe credit risk or not. To be approved for a variable rate loan at 3%, a borrower must show the capacity to continue to service the mortgage were the variable rate to rise to 5.5%. In the March quarter to date, that assessment rate is now trending down towards 5%.
The result, UBS notes, is a sharp increase in borrowing capacity and thus a large rise in average loan size. The analysts suggest it would be a prudent move by the regulators to lift the assessment rate to 6%, reducing borrowing capacity by some -10-15% and “taking a lot of heat out of the market”.
Interest-only home loans, which were a specific target of APRA tightening the last time around, increased to a 19.3% share in December from 18.7% in September, but remain well below the peak in the prior bubble in excess of 40%.
The minutes of the RBA’s March meeting suggested “lending standards remain sound and it was important that they remain so in an environment of rising house prices and low interest rates. The Board concluded there were greater benefits from a stronger economy, while acknowledging the importance of closely monitoring risks in asset markets”.
UBS suggests a further increase in higher risk home loans would challenge this view. But the analysts believe the timing of macro-prudential tightening is probably still only later in the year. Critical will be the impact of the end of JobKeeper and HomeBuilder stimulus this month.
All in the timing
Morgan Stanley agrees in principal but is a little more relaxed in terms of timing, suggesting new macro-prudential measures are possible towards the end of 2021 but more likely to be required in 2022.
For such measures to be implemented, Morgan Stanley suggests the regulators would need to see a sustained period of strong house price growth, a strong pick-up in investor loan growth to around 10%, and a material increase in interest-only loans and high LVR and/or high DTI loans.
APRA’s primary tools have typically been caps or limits on investor and interest only loans, Morgan Stanley notes, along with other restraints on risk-taking. Measures taken by APRA in December 2014 were relatively modest and had little impact on loan growth. Measures taken in March 2017 were far more comprehensive and restrictive, weighing on loan growth.
And on bank valuations.
ANZ Bank economists point out macro-prudential controls are already being put in place in New Zealand, specifically targeting high LVRs. While the Kiwi housing market is currently running even hotter than Australia’s, it’s still food for thought.
This was the grim state of affairs back in May last year, when covid fallout was still a matter of sheer uncertainty and APRA had on that basis told the banks to either defer or significantly cut their dividends.
Standing out are huge reductions in forecast earnings growth and dividend growth in year one, as well as much reduced dividend payout ratios and, subsequently, yields. But in year two, all bar CBA see swift forecast reversals.
Because CBA operates on a different accounting cycle to the other three, it had already paid its first half dividend before APRA pulled down the shutters.
Also standing out, nonetheless, are a net 14 Buy ratings from brokers (ten Hold, three Sell), based on very sizeable gaps (other than CBA) between a highly nervous market (share price) and far less pessimistic brokers (target price).
Well notch one up for the brokers, because if we fast-forward to today’s table, those target price gaps have all but shut, with two banks now exceeding, even as average targets have been materially re-rated in the meantime.
|FNArena Major Bank Data||FY1 Forecasts||FY2 Forecasts|
Earnings and dividend growth forecasts for year one largely match corresponding forecast for year two in the prior table, suggesting no change of heart. Forecast dividend yields are now looking a lot more familiar.
When share prices catch up to targets, typically that would prompt brokers to at least pull their ratings back to Hold. But no, Buy ratings have actually increased to a net 16 (nine Hold, three Sell). This aligns with the bullish views still held by brokers as explained above, and suggests the next move by brokers will not be to pull back ratings but to raise target prices.
Of course, CBA is back to having no Buy ratings, and sits in its permanent position as the lowest preference. This is because CBA trades at a premium to the other three, beyond broker valuations. It has done so for at least the last 20 years.
Will they ever learn?
Above CBA is a reshuffle of preferences from back in May, with ANZ Bank enjoying seven from seven Buy ratings. I think that’s a first in FNArena’s history, for any bank (at least as far as my memory stretches).
And ANZ Bank has already exceeded the average target.
So all seems rosy in Bank Land, for now, as long as the housing loan market and house prices don’t get too out of hand, just yet.
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