Banks not guilty, but punished anyway

Since the correction, and its subsequent bounce most analysts have drawn on the old adage that the defensive characteristic of banks make them safe havens in a time of crisis. That may be all well and good but the problem this time is that the crisis is actually in the financial sector.

Only JP Morgan has to date been prepared to suggest that the credit crunch will have a meaningful effect on bank earnings ahead.

In the week to August 30, the prices of bank shares have fallen: Westpac by 0.52%, Commonwealth Bank by 2.09%, National Australia Bank by 2.69%, ANZ by 2.72% and St George by 3.91%. The ASX 200 fell by 0.41%

As the bounce from the correction has unfolded, many commentators have suggested some wonderful valuation opportunities have opened up in quality large-caps due to the one-in-all-in nature of the 15% fall. The same is true of the United States. However, in the US the view is that it's a good idea to steer clear of financials for the time being – until the bad news is all out in the open. The same should thus follow for Australian institutions. It is only in the "asset originators" such as Macquarie (MBL) and Babcock & Brown (BNB) that all analysts agree the level of guilt by association was overdone.

It's not that Australian banks are about to reveal massive sub-prime losses. It’s just that they are going to find the going tougher in the new credit regime.

The market, however, had obviously decided this week that there were better sectors to plunder than the banking sector, as the ASX 200 lost 0.4% over the week to Thursday (after a big rally the previous Thursday) while the big five lost an average of 2.4%. St George (SGB) was the worst offender with a 3.9% fall while Westpac (WBC) held up well with only a 0.5% fall.

Current FNArena ranking, Buy/Hold/Sell ratios and average target price (between second brackets suggested share price upside):
1. Westpac 6/4/0 ($28.58) ( 7.32%)
2. ANZ 5/5/0 ($31.76) ( 11.09%)
3. CommBank 4/4/2 ($56.11) ( 4.18%)
4. National 4/5/1($42.83) ( 9.68%)
5. St George 0/9/1 ($35.76) ( 7.87%)

The only notable sector update from the brokers this week came from JP Morgan. The analysts pointed out that Australian banks have a combined $25 billion exposure to SIVs (structured investment vehicles) and conduits, broken down as ANZ (ANZ) $6 billion, Commonwealth (CBA) $2 billion, National (NAB) $10 billion, Westpac $5.5 billion and St George $1.3 billion. And that's just the majors.

These types of investment vehicles were lent money by the banks at 30-day rates to invest in three to four-year CDOs. Unable to sell the collateral, banks will now have to bring these toxic instruments on to their balance sheets. For a full explanation see Show us your SIVs and conduits published on August 30 at www.fnarena.com.

However, given that the size of the global SIV/conduit market is in excess of $US1 trillion, Australian exposure is minimal. JP Morgan calculates the overall balance sheet impact on the majors to represent on $A1.2 billion of capital, so they should be able to easily cope with that. Nevertheless, it just goes to show what the rest of the global financial world is facing.

The market is not listening to analysts when it comes to Macquarie Bank. The shares had bounced from $62 to $76, but week-on-week Macquarie Bank is down 7.8%, the bulk including a 3.8% fall on Wednesday. It is clear any bad news in US financials is going to be reflected in the Macquarie share price no matter what. On Tuesday night the bad news was that Merrill Lynch had downgraded Lehman Bros, Bear Stearns and Citigroup from Buy to Neutral ahead of profit reports that are expected to be less than positive. There is very little correlation between Macquarie Bank and any of those institutions, but the market doesn't care.

Babcock & Brown suffered a similar fate, falling 8.2% over the week despite its profit report in which earnings guidance for 2007-08 was increased from 30% growth to 40% growth. This prompted both ABN-Amro and Credit Suisse to upgrade the stock from Hold to Buy, and thus B&B now boasts a 6/0/0 Buy/Hold/Sell rating in the FNArena database. But the market doesn't care.

ABN-Amro also upgraded Suncorp-Metway (SUN) from Hold to Buy following its profit report this week, but was the only broker to do so. Suncorp's Buy/Hold/Sell ratio now stands at 3/6/1. ABN's justification for the upgrade came from the insurance side, given the reserve releases Suncorp made to cover this year's storm losses. With more reserves available it suggests Suncorp is somewhat insulated against further catastrophes.

All the brokers liked the reserve releases, but those on Hold are not going to shift until the integration of Promina is under way and integration risks begin to reduce. Once again it is JP Morgan (Underweight) taking a largely contrarian view to its colleagues, suggesting that insurance margins achieved on commercial lines were way over market and would surely fall. This will cause Suncorp to fall into an "earnings hole", according to JPM.

Postscript: Merrill Lynch upgraded St George Bank to Buy from Neutral on Friday morning because the broker believes the shares deserve a higher premium against the peers than currently priced in by investors.

Produced by FNArena.com for banking sector e-zine The Sheet and subsequently updated for Eureka Report.