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Banking on healthy housing

Every year since 2005, Warren Buffett has increased his stake in US bank Wells Fargo. And you can understand why. Wells is a hugely diversified financial institution with the country's largest branch network. Throughout the global financial crisis, it remained profitable and earnings per share have now exceeded their pre-GFC peak.
By · 10 Nov 2012
By ·
10 Nov 2012
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Every year since 2005, Warren Buffett has increased his stake in US bank Wells Fargo. And you can understand why. Wells is a hugely diversified financial institution with the country's largest branch network. Throughout the global financial crisis, it remained profitable and earnings per share have now exceeded their pre-GFC peak.

Over the past year, its share price has increased 33 per cent and yet it still trades on a modest-looking price-earnings (P/E) ratio of 11.5.

Commonwealth Bank's recent history is not so different. It currently trades on a P/E ratio of 12.8 and increased its market share during the GFC.

And while Wells Fargo sports an overall valuation about twice that of CBA, it also reported roughly twice the profit in its latest full financial year. That's as it should be. Commonwealth is half as profitable as Wells and half the price.

There's one more major factor that Buffett's brain would be sparking over. Unlike their US counterparts, Australian banks are well regulated and well capitalised.

Severe losses in mortgage lending, the largest slice of Commonwealth's loan book, are less likely because mortgage lending is "full recourse" to the borrower, unlike parts of the US.

Loans are also back-stopped by mortgage insurance. Compared with the US, the effects of a property crash in Australia are therefore likely to be minimised.

Dollar-for-dollar of revenue, in its latest full-year result, CBA was almost twice as profitable as Wells.

Impairments (the polite banking term for bad debts) are the big difference. More than 25 per cent of Wells's pre-tax profit was swallowed up in impairments, compared with 9.9 per cent for CBA.

So Wells is working through the detritus of the US housing collapse. But the recent trend in impairments is clear: since peaking at $US22.7 billion in 2009, the subsequent annual figures have been $US15.8 billion and $US7.9 billion (a little more than 1 per cent of its total loan portfolio).

Australian banks are at the start rather than the end of the cycle.

ANZ and NAB have recently indicated that bad debts are likely to rise over the coming year. We expect a similar trend at CBA. With impairments as a percentage of its loan portfolio at 0.21 per cent, there is still the possibility of substantial increases in this figure.

Bad debts act like a cost spring. For Wells, having suffered through the GFC, a previously extended spring has been contracting. For CBA, the spring is coiled and likely to expand over coming years. The question is by how much. Without a housing disaster, an increase in bad debts is quite manageable. With one, Australian mortgage defaults are likely to rise sharply.

Mortgage insurers would be all but useless in this scenario: their balance sheets would vaporise and the banks would be left footing the bulk of the bill.

But a housing crash is unlikely. The risk has receded in recent years as local banks have changed their capital structures and reduced low-doc lending.

On asset-based measures such as price/book value and price/net tangible assets, Commonwealth is almost twice as expensive as Wells Fargo, reflecting its higher margins.

Both institutions have managed to grow their earnings per share over the past five years, but Wells has reduced its dividend, conserving capital to deal with those bad debts.

For Australian investors who have forgotten what a recession looks like, this is a good reminder of the pressure tough times can place on bank balance sheets. And that, in the end, is the point of this comparison. Australian banks - a cosy, immensely profitable cartel - do very well right up until the point they don't.

Wells survived the GFC intact but is still paying the price. CBA, which on some metrics looks similar to it, hasn't yet faced a crisis and may not have to. If it did, shareholders might see their fate in that of their Wells Fargo brethren.

This isn't to predict a crisis, merely to accept the possibility of one.

Commonwealth will probably continue to deliver fat, fully franked dividends - amounting to a current yield of 5.8 per cent - even in the face of moderately rising bad debts.

But if you're one of the many Australian investors whose portfolio is weighted more heavily than Intelligent Investor's recommended 10 per cent maximum to bank stocks, then at least you are now facing the risks with your eyes open.

This article contains general investment advice only (under AFSL 282288).

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Frequently Asked Questions about this Article…

According to the article, Buffett has steadily increased his Wells Fargo holding because the bank is a hugely diversified financial institution with the country’s largest branch network, it remained profitable through the global financial crisis and its earnings per share have now exceeded their pre-GFC peak. The article also notes Wells’ share price rose about 33% over the past year and it trades on a modest P/E of about 11.5.

The article highlights that Wells Fargo reported roughly twice the profit of Commonwealth Bank in its latest full financial year, which helps explain why Wells’ overall valuation can look higher. On simple earnings multiples, Wells trades around a P/E of 11.5 and CBA around 12.8. On asset-based measures such as price/book and price/net tangible assets the article says CBA looks almost twice as expensive as Wells, reflecting CBA’s higher margins.

The article states Australian banks are generally well regulated and well capitalised compared with their US counterparts. It points out mortgage lending in Australia is 'full recourse' to the borrower (reducing severe losses) and loans are often back‑stopped by mortgage insurance, so the effects of a property crash in Australia are likely to be more limited than in parts of the US.

Impairments are the banking term for bad debts. The article notes more than 25% of Wells Fargo’s pre‑tax profit was swallowed by impairments at one point, compared with 9.9% for CBA. Wells’ impairments peaked at US$22.7 billion in 2009 and have since fallen to US$15.8 billion and then US$7.9 billion. CBA’s current impairments are low as a percentage of its loan book (about 0.21%) but could rise.

The article suggests Australian banks are at the start, not the end, of the credit cycle. ANZ and NAB have indicated bad debts are likely to rise over the coming year and the article expects a similar trend at CBA. While CBA’s impairment rate is currently low (0.21% of its loan portfolio), there is scope for substantial increases — manageable in a mild downturn but painful if a housing disaster occurred.

The article warns that in a severe housing crash mortgage insurers would be largely ineffective: their balance sheets could be wiped out and banks would likely be left footing the bulk of the bill. That’s why the scale of a housing crash would matter a great deal to bank balance sheets.

The article says a housing crash is unlikely. It argues the risk has receded in recent years because local banks have strengthened capital structures and reduced low‑doc lending. However, the piece cautions investors to accept the possibility of a crisis even if it is not being predicted.

The article’s message is a reminder that recessions and rising bad debts can quickly pressure bank balance sheets. It notes CBA will probably continue to pay generous fully franked dividends (a current yield of about 5.8%) even with moderately rising bad debts, while Wells has reduced dividends in the past to conserve capital. The article also refers to an Intelligent Investor guideline of a 10% maximum allocation to bank stocks, advising investors who are more heavily weighted to banks to recognise and accept the risks.