Australian Banks: In A Fix

This story features COMMONWEALTH BANK OF AUSTRALIA, and other companies. For more info SHARE ANALYSIS: CBA

The RBA believes Australians are well-placed to weather mortgage stress from higher rates, but risks will increase sharply when fixed interest loans start rolling off.

-Households well-placed to weather higher rates
-Loan demand now falling
-Fixed rate expiries will lead to mortgage stress
-More buybacks off the table for now

By Greg Peel

The Reserve Bank of Australia’s recently released Financial Stability Review noted “In aggregate, the household sector entered the interest rate tightening cycle in a strong position”.

JPMorgan notes that underlying this determination is that while high inflation and rising mortgage rates will inevitably push some households into mortgage stress, household debt levels are highly skewed to high-income households, which can more easily afford higher rates.

Previous research by the RBA has shown that 75% of household debt is held by the top 40% income earners, yet these households have typically reported much lower levels of income stress than low-income households, despite higher debt-to-income ratios. JPMorgan suggests this is because they can direct more funds towards debt repayment after covering living expenses than is the case for low-income earners.

At the low end of the scale, recent first home buyers remain the highest source of risk and are highly exposed to labour market shocks (ie job loss). Between high and low-income earners, JPMorgan believes a material shock to employment is necessary to drive significant and widespread stress in bank household exposures.

UBS’ latest mortgage survey indicates that front-book (new) borrowers, which are arguably more risky than the back-book (existing) cohort, have capacity, via savings, prepayments and emergency funds to absorb the more than $7bn higher interest cost burden coming.

The first line of defence, income, is in good shape, UBS notes, with 33% of respondent household spending still well below income, and 42% easily or somewhat easily managing their finances.

The RBA persistently points to the build-up of large mortgage equity balances and liquidity buffers through the pandemic, which should provide financial support as rates rise. Such buffers include savings made during the pandemic from not spending, and from government support, and interest payments made on variable mortgages that were held consistent by borrowers at initial higher rates when rates were falling.

But while households have been able to absorb higher mortgage rates/inflation so far, should the cash rate push past 4%, JPMorgan would expect the level of mortgage stress to rise materially.

In the minutes of the September RBA meeting, the board noted “The full effects of higher interest rates were yet to be felt in mortgage payments, and the broader effects on activity and inflation would take some time to be apparent. The board was resolute in the need to ensure inflation returned to target, but mindful that the path to achieve this needed to account for the risks to growth and employment.”

The RBA grabbed the attention of the world after hiking only by another 25 basis points, to 2.60%, when 50 points was expected. The governor also conceded recently that there will inevitably be households forced into foreclosure.

Credit Quality

Morgan Stanley estimates that Australia’s major banks incurred a net loan impairment benefit in the June quarter, due to Commonwealth Bank ((CBA)) releasing some of its impairment provision. But while industry feedback to date suggests credit quality has remained resilient, Morgan Stanley forecasts charges of -$9bn in the September quarter, which equates to around -12 basis points of loans.

On balance, Morgan Stanley believes it's likely that loan losses are better than forecast in the upcoming bank reporting season, particularly at Westpac ((WBC)) which did not specifically disclose its June quarter outcome. However, the broker wouldn’t rule out the potential for larger forward-looking “economic overlays”, given the sharp rise in rates and uncertain outlook for 2023.

While the trajectory of rising loan losses won't become much clearer until 2023, Morgan Stanley’s current forecasts assume average loss rates of some -19 basis points of loans in FY23 and -28bp in FY24, compared to consensus of -15bp and -20bp, respectively, and a pre-covid five-year average of -16bp.

Every -5bp change in loss rates affects bank earnings by around -4%, Morgan Stanley notes.

Demand Falling

Australian Financial Group ((AFG)) has released its mortgage index for the September quarter, which shows home loan lodgements with AFG brokers down -11% year on year. JPMorgan assumes this reflects a combination of very strong growth in FY21, higher mortgage rates, falling house prices, falling borrowing capacity and weak home buyer sentiment.

Higher interest rates are also now leading to a drop-off in loan sizes.

JPMorgan notes that during the quarter, the major banks recouped some of the housing share they lost to second tier lenders in recent years, given much stronger growth from ANZ Bank ((ANZ)).

Major banks share of housing lodgements with AFG brokers increased to 61% in the quarter, which while below the long-run average represents solid improvement on the June FY22 quarter, which saw major market share fall to its lowest level since FY13, JPMorgan notes, when interest rates were last at these levels.

Fixing a Problem

Stiff competition among the majors for loans in the lockdown years saw fixed rate mortgages fall to historically low levels, and below standard variable rates. Borrowers jumped on the opportunity.

Hence some 35% of outstanding household credit is at a fixed rate, JPMorgan notes, compared to the usual 10%.

That same competition has led to a compression of SVR rate spreads, but the banks have been very slow to raise the deposit rate, hence there is near term upside potential to bank net interest margins, and thus earnings, UBS suggests.

But 20% of existing fixed rate mortgages are due to expire by March next year, after which maturities are expected to step up materially, according to RBA data.

While a lot will depend on the trajectory of the cash rate, JPMorgan estimates that were the cash rate to rise by 350 basis points overall, from May this year, some 60% of households will see their mortgage repayments jump by over 40%. Fixed rate mortgage holders will see a sudden jump up to variable rates as those periods expire.

This will inevitably push some households into mortgage stress, JPMorgan notes, particularly low-income earners, but the pressure overall will be partially offset by aforementioned buffers, including household savings, the liquidity buffer provided by low fixed rates over the period, and reduced household spending.

Bank Buybacks

Despite building up material excess capital as balance sheets were shored up during covid, the past 12 months have seen banks’ overall tier one capital ratios reduce by some -120bps, Citi notes.

Key drags to balance sheets have been share buybacks and growth in capital to risk-weighted assets (CRWA), but also a material drag from interest rate risk in the banking book (IRRBB).

CRWA and IRRBB are two metrics impacted by Basel III regulations due be implemented next year.

Citi believes the implementation of Basel III is manageable given risk-weight reduction. CRWA growth will accelerate, but be funded by retained earnings. The broker sees a reversion from IRRBB as rates normalise, seeing a pro-forma tier one capital ratio of some 12% in 2024 post APRA changes.

Consequently, further capital management in this cycle (ie share buybacks) is likely to be pushed out to FY24, as banks consider asset quality and capital reforms, Citi suggests.

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