PORTFOLIO POINT: Despite our supposed resilience to global economic woes, Australian banks are in panic mode, judging by the recent string of covered bond issues. With a rate fall almost certain for March and the attractiveness of Australian debt likely to fall, sell signals abound.
Last week FIIG Securities’ Elizabeth Moran suggested that readers think about selling the Commonwealth Bank hybrid, Perls III (see Time to review CBA Perls). This week, ahead of announcements from CBA (half-year, dividend), Westpac and ANZ (quarterly), I suggest that readers think about selling Australian bank shares (for previous analysis see Property boom’s Chinese foundations and The four broken pillars).
Based on modelling by FIIG, the price of Perls III had further to fall. The culprit? Covered bonds, where banks issue debt secured against specific balance sheet assets, typically offer cash flows from the safest of loans.
This week’s sell suggestion comes courtesy of covered bonds, too, though for an entirely different reason. I don’t just see covered bonds crowding out the value of other investments, but signalling deep trouble ahead for the major lenders and belying the market's obsession with strong bank dividends, or indeed the political football of NAB's 7.7% jump in first-quarter profits last week. As such, I wouldn’t be surprised to see CBA slash its dividend payout ratio this week for the first time to below 70%, thereby bringing its indicative full-year yield back towards the 5% range it was at before the GFC.
Being theoretically the safest form of debt, covered bonds should be issued at the lowest yield. So what does it mean if they aren’t? Based on data recently compiled by independent economist Leith Van Onselen, the weighted average yield of Australian covered bond issues from Australian banks is 6.2%: almost 100 basis points higher than Spanish government 10-year notes were at the time of writing. In fact, covered bonds are being issued at a higher rate than some variable rate home loans. So if covered bonds are so low-risk, why the high rate?
Perhaps the answer is that they aren’t low-risk at all. Or, rather, the issuers, Australia’s banks, aren’t as low-risk as you’d otherwise think. And while I don’t forecast a collapse of a big-four lender – the government would be almost certain to prevent that under any circumstances – I have deep misgivings about holding Australian bank shares.
What the covered bond market is saying, according to research from UBS, is that banks are in a "dangerous situation", being squeezed between higher funding costs and lower lending margins. The unsecured bond market seems to be saying the same thing as well: NAB just issued $750 million in five-year variable rate debt at 1.85% above the benchmark and $750 million at a fixed rate of 6%, according to the Australian Financial Review.
Indeed, based on UBS’s estimates, bank profit margins on new mortgages are now in negative territory. Put simply: amid the public’s call to reduce rates and pass on profits, the banks are already losing money on every new mortgage they issue.
No wonder then that residential mortgage credit is drying up. Housing credit growth currently sits at little more than 5% per annum, according to Van Onselen, using RBA data. In the mid-2000s, at the height of the property boom, housing credit growth averaged 15%, with the figure for investment property credit growth exceeding 30% at one point.
And showing that the credit drought isn’t confined to mortgages, personal lending actually declined in December; the first time since the financial crisis.
Source: MacroBusiness, RBA
But this isn’t just a worry for property investors hoping to ride another wave as returns in shares look risky and returns in fixed interest look less attractive amid expectations of an interest rate cut (I didn’t expect one last week, but I do for March). Most of all, this should be a worry for investors in banks.
In the most basic of terms, for far too long Australia’s major banks have been earning lazy profits and lazier executive bonuses through a dangerous reliance on offshore funding, an over-allocation to residential mortgages and a cyclical terms-of-trade boom thanks to, mostly, Chinese commodity demand: a phenomenon that in my view is equally vulnerable (see China’s false dawn).
Now the chickens are home to roost. Australia’s banks are seeing their credit ratings put on negative watch and buyers of covered bonds are demanding more than their pound of risk. As for residential mortgages, with the RBA’s decision to keep rates on hold this month, the banks are in a bind as to whether issue an out-of-cycle rate rise and risk the opprobrium of consumers, a vote-hungry government and a reader-hungry media. ANZ’s tepid attempt on Friday afternoon of a six basis point rate increase, followed by Westpac at 10 basis points, shows just how much of a bind they are in. As does ANZ’s decision today to lay-off 1000 employees, a move that was not entirely unexpected but was nevertheless of a greater quantum than anticipated.
And as for Australia’s terms-of-trade boom, while my colleague Robert Gottliebsen had an optimistic reading of BHP’s results on Friday (click here), my personal tea leaves say otherwise. I can’t help but notice Friday's shock news that China's imports fell 15.3% year on year and 22.5% before seasonal adjustment, or analysis that points to a coming crash in iron ore prices.
Source: Also Sprach Analyst, China General Administration of Customs
Global economists have written extensively in recent months of an international search for safe-haven assets. Yet if Australia isn’t safe, then what is? Judging from the strength of the Australian dollar, we are a safe haven, but judging from the yield on Aussie covered bonds and their spread above both the cash rate and the bank bill swap, we’re not. What that says to me in turn is that (again) the Australian dollar is in a speculative bubble, which only reinforces a bearish outlook for the banks: if and when the Aussie falls (most likely on the back of a Chinese slowdown; according to HSBC the Aussie is 40% overvalued based on OECD purchasing power numbers) then that will most certainly result in a rapid flight of foreign money from Australian assets (for thoughts on how to hedge against this see Ten-gallon stock tips).
According to ratings agency Fitch, Australia's net external debt now dwarfs that of Italy and as for debt maturing on the balance sheets of Australia’s major banks, which issue 80% of mortgages, most of this is in foreign currency. With 80.4% of Australia’s sovereign debt held overseas, this is a risk for the Australian government too, as British institutional fund manager M&G points out, when justifying its net short position on Australian debt to its investors.
And with the Australian dollar to US dollar currency pair now coming as fourth most-traded in London's forex market – the world's largest – things begin to look particularly scary, as does an IMF working paper that urges higher capital requirements for the big four banks, something that would only further squeeze margins and depress dividends.
Australia’s government likes to boast that we have low debt to GDP, but when assessed in terms of total debt, not just public debt, that’s borrowed from overseas we’re up there with the worst. Our net external debt position comes in at 64.3% of GDP, according to latest figures from the IMF. Italy's, by contrast, is 24.3%, America and Britain's are 17% and 13.1% respectively. And while Ireland, Greece and Spain are undoubtedly in a worse position, that's already priced in, which begs the question as to what makes us any difference other than a lot of expensive dirt in the ground.
As for the lenders themselves, three Australian banks are in the top 15 with the biggest US money market fund (MMF) exposure – a clearer sign than any of hot money vulnerability without a booth at the Bernie Madoff investment symposium. According to Fitch, Westpac in particular relies on MMFs for 4.8% of its funding, with NAB and CBA relying on these footloose yield-chasers for 4.6% and 3.1% of funding, respectively.
A bubbly currency, squeezed margins, a failing manufacturing and tourism sector, a mining industry that’s reliant on China building things that defy economic logic, and a property market that’s priced to perfection: all are omens that it’s time to get out of bank shares if you haven’t already.
Sure, we have low unemployment, a low current account deficit and the ability to print money, plus the banks are all on forward earnings multiples of less than 12 times, but with downside risk for dividends, an unfriendly political environment and a wall of foreign capital that could easily disappear, are you willing to take the gamble? It’s time to duck and cover.