What is downside?
This week, I will consider a question I was asked recently. The question was, in essence, are you still not investing in banks? The implication was that with the share price falls over recent months, and the current dividend yield, they must now be an attractive investment.
You probably wouldn’t be surprised that our answer remains no – our assessment remains that the banks currently don’t meet our investment criteria. This week’s IM considers why.
Recent performance of this banks
Source: IRESS, First Samuel
Additionally, dividends in $ terms have been kept constant this year and are forecast to remain so (versus recent years). Thus, with falling share prices, they have increased in yield terms. The current forward dividend yields are: CBA 6% (9% with franking credits), NAB 7% (10%), ANZ 6% (8%) and WBC 7% (9%).
So an attractive investment?
With the banks on a more favourable valuation, and offering a very attractive yield, we should invest in them? Well, no. Not currently anyway. What the data in the previous section fails to consider is downside risk.
A recent article in the AFR surmised that the banks’ bad debt provisions were so low because the banks were actually very good at lending and making credit risk assessments on mortgages. My reaction to this didn’t involve a polite word.
It got me thinking:
Q1. how do we really know?
And more importantly,
Q2. what is the downside risk from bad debts (i.e. borrowers not repaying residential mortgages on time, or defaulting) if this theory was wrong (i.e. we saw a meaningful increase in bad debts)?
So to Q1: It certainly hasn’t been tested – it's been over 25 years since the last recession, and (you wouldn’t know it from the press hoo ha ha) housing prices have only had a very marginal decline recently. And this comes after two decades of booming prices. There has been some degree of mortgage stress, but excess equity is generally high (unless you purchased in the last 2 years), employment has remained strong, and Australian borrowers have a tendency to prioritise mortgage repayment over other financial commitments and spending.
Additionally, anecdotally, it seems where someone has been under significant pressure regarding repayments they have, either at their own initiative or with the encouragement of their bank, sold before the mortgage enters the formal bad debt statistics reported by the banks. They have been able to do this given recent market conditions. But this may not continue…
It is hard to answer Q1 as no one will really know until it is too late, but we do consider there is a real risk of an increase in missed payments and mortgage defaults. Therefore we consider question Q2.
A case study
Let’s select the CBA. Total provisions for impairment losses, as a percentage of gross loans and acceptances, was 0.5% at 30-Jun-18 (actually a slight decrease from 30-Jun-17, as individually assessed provisions, i.e. loans individually identified as problems as compared to a collective provision, declined). (Source: CBA Annual Report FY-18, Financial Report section 3.2).
For FY-10, the CBA’s provisions for impairment losses was double what it is currently, at 1.06% (Source: CBA Annual Report FY-10, Financial Report Note 14). FY-10 was the period immediately following the GFC – which wasn’t that bad in Australia: it didn’t encompass either a recession or a substantial property market decline. So, in reality, impairment losses could easily exceed 1%. In fact, it should be expected (including noting the transition from interest only to P&I).
Could they be even higher? Well, that again is a difficult question to predict. In the USA during the GFC, default rates exceed 10% (source: Delinquency Rate on Single-Family Residential Mortgages, Booked in Domestic Offices, All Commercial Banks, Board of Governors of the Federal Reserve System (US) fred.stlouisfed.org).
There were large swathes of the US that had significant default issues, but many other areas where the impact was minor (such as Texas). This sort of variation is feasible in Australia – hopefully, the average won’t be as extreme as in the USA - let’s assume loan impairments reach 4%.
Source: CBA FY-18 Annual Report, First Samuel
The increased amount required for the higher provision would be taken straight off profit in the financial year that the increased impairments were recognised. FY-18 cash profit was $9,233m. So it can be seen, even a 1% impairment rate would materially impact profit. A 4% scenario would be a very significant hit for shareholders.
But in reality it won’t be nearly as simple and easy as a once-off hit to profit. Yes, there will be the substantial flow through to profit, but it will also impact the capital adequacy of the bank, as well as confidence / sentiment surrounding the banks. The capital strength of the banks has been increased somewhat since the GFC (but arguably not enough). To retain an adequate capital base, to attract overseas wholesale funding, and not be a burden on taxpayers, one or more dilutionary (and likely highly so because investor sentiment will be impacted) capital raising/s will be required. Entitlement to future earnings shared across a greater number of shares, dividends cut and share prices will be impacted – the degree depending on the extent of the bad debt increases.
We are keenly aware that some investors think that because the banks are 'too big to fail', or have implicit government backing, bank shareholders are also safe. That is far from the case. Shareholder funds, and now potentially hybrid investors are part of the very fabric that is used to absorb occurrences such as increased impairments.
Other downside risks as well…
The above describes what we see as just one of the risks currently facing the banks. The other concern is that loan growth has slowed considerably. Tighter loan conditions (e.g. application of a rigorous 20% deposit requirement, limits on interest-only loans) and a peak in housing prices will mean that its largest source of a bank's revenue will not grow as much as in recent years. There are others, such as fines related to past regulatory breaches, cost blowouts for customer compensation, and structural sustainability of their models (banking / wealth / insurance unravelling).
Your Investment Team considers downside risk to be an important criterion when assessing an investment. Even with the recent share price falls, and attractive dividends, we don’t consider the big 4 banks to be attractive investments.