Banks on borrowed time

Summary: Shoddy lending practices across the banking system, where borrowers have used false information to garner multiple loans, present clear and present dangers. 

Key take-out: The banks have been working hard to clean up their approvals processes and clamp down on liar loans, but we should expect a bad loans blow-out.

The Royal Commission is savaging not only the share price of the AMP but the banking sector as it becomes apparent that many of the practices that boosted profits in previous years are not sustainable.

On the other hand the discounting of bank shares is very severe, and for all their sins they do possess a good long-term business.

As readers know, my greatest long-term fear in the banking arena is that during the housing boom they made a series of loans that will create considerable problems in the years ahead. We all know about the interest-only loans that were undertaken and the fact that large sums are going to mature in the next three years. And borrowers will be required to meet much more stringent standards and almost certainly will have to sell houses to meet the new requirements.

But the second part of the banking threat concerns the research of UBS. You will remember that UBS revealed that when you compare the population statistics and the bank customer details in relation to income, something is terribly wrong.

It looks like there is massive overstatements of income, because there are not enough people in the higher income bracket to make the banks' revelations accurate.

What I have discovered is that at least some of the banks regard each loan as a “customer”. And so, if I buy six dwellings with six different loans in the same bank I am six customers, and if I buy two or three other dwellings from other banks then I am an additional two or three customers at other banks. So if I have a high income and ‘go for the doctor' and claim that I earn $500,000 a year, I could be at least 10 customers. This explains why the banks have huge numbers of customers in the high income levels and why the UBS figures made no sense. We now know that some banks may have liar loans, but they probably do not dominate the higher income levels of the bank borrowers.

But, of course, these scenarios raise a whole new area of risk because let's again say that I have bought 10 dwellings and I am therefore geared to the eye balls. So, if something goes wrong with my finances and/or there is a worthwhile dip in the housing market, I might get into big trouble. On the banks' ledgers, instead of one client falling over there are multiple clients. To make matters worse, banks have not been swapping information and the only ways the banks can pick up what my theoretical customer has borrowed from another bank is if that customer is honest or (foolishly) does a direct debit on the base income source banking account.

The banks need to urgently start to understand that some of their clients have multiple accounts and are a much higher risk than they look on the bank's books.

The impact of liar loans

The second area of concern in the UBS figures is the living expense ratios that banks have been applying to their borrowers.

UBS believes that a large number of the banks have taken the bottom levels of their living expenses formula as their base criteria for large amounts of their lending. And so, for a considerable number of the borrowers, living expense figures of around $33,000 were used when in fact the real level of living expenditures was around twice that level and, of course, the higher the person's income the higher their living expenses tend to be.

We simply don't know what the banks did in this area, and the fact the UBS didn't actually get the income level story a 100 per cent correct makes you a little more nervous about the expense level claims. And here I think the banks are going to be very different. NAB told the Royal Commission that it changed its expense ratio and questioning in 2016. The ANZ did it late last year and Westpac followed around December. I believe the Commonwealth has taken action in this area, but I don't know when it did and whether they went as far as the other big banks. The banks need to tell shareholders what they have done .

Part of the problem is that for roughly half the loans in most of the banks the forms are being filled out by a broker who has a clear vested interest in consummating the deal, because they receive good commissions. The banks don't meet the clients face to face. They undertake all sorts of tests to these broker applications and often pick up irregularities that way. It is a system that has some risk.

In the old days the bank managers knew the clients they were lending to. There is no way a client would deceive the bank on income levels and expenses, because the banker knew them.

But those days are well and truly gone and bank staff levels are much lower and the banks are much more dependent on systems that detect problems. I hope the Royal Commission gets into these areas. I understand that APRA is now looking much more closely at bank balance sheets and indeed is undertaking a much closer view of all the banks in 2018. It will be an important investigation.

All this helps explain why bank shares have fallen. It's always hard to pick the bottom but the base business of banking is a very good one.

In the US we are now starting to see the trends go in the way we thought they would. That is, people are selling their bonds and the bond interest rates are rising, reflecting the increased economic activity in the US.

The US 10-year bond is now above 3 per cent. As the bond interest rates rise so does the American dollar increase and the Australian dollar falls.

I and many others predicted this over a year ago, but have been constantly proven wrong because global nervousness has sent people scurrying for US bonds, reducing US bond prices and pushing the Australian dollar up.  

Now that has all been reversed and the early forecasts look good. Of course there is certain to be many more twists to the tale.