Deflating the banks' bubble

PORTFOLIO POINT: Investors have been enjoying good yields from the big banks. But the majors could be exposed if their property lending portfolios get out of control.

It is certainly satisfying as a fund manager to reflect on the September quarter. As the growth portfolio performance table below shows, this last quarter was a good one for quality shares and, in particular, the growth portfolio.

The uplift over the last three months more than compensated for the very rocky start in the June quarter when the market was floundering under the weight of European debt concerns. What the September quarter does show is that investors should ease their capital into the market and certainly buy the dips when a reasonable discount on value appears.

The differing returns for individual stocks in the portfolio does show the short-term stresses on certain businesses and the tail winds behind others.

In particular, the September quarter saw a re-rating of bank shares. Despite a benign growth outlook, the market clearly is driven by a desire to buy sustainable yield. To my mind this is a belated recognition by the market that broad earnings growth is difficult to see, therefore sustainable earnings and yield become attractive. The banks fit the bill, despite a growing and resounding chorus of debt warnings from many commentators.

Therefore, in reviewing the current bank valuations, I am compelled to examine the Reserve Bank’s latest interest rate cut. Further, I want take to task this week's debt warnings from a prominent ex-banker and an ex-RBA board member. In doing so, I am not shooting the messengers because some of their reported comments are pertinent. However, in proper context the warnings of a potential “Greek-like” debt explosion (David Murray) or the potential for a speculative residential property bubble (Warwick McKibbin) are truly intriguing given the backgrounds of both men.

For instance, whilst I agree with David Murray that Australia has a debt problem, I do not agree that the substantive problem is government debt. Rather, it is clearly the level of household debt and, as the former CEO of the Commonwealth Bank, he is surely aware of this. Further, he should acknowledge that the rivers of debt provided to households prior to the GFC came from well-rewarded bankers who were incentivised to grow banks quickly rather than sustainably.

The following chart may be a year old but it clearly shows this point. Australia has the highest level of household debt-to-GDP in the world. We are nowhere near the most indebted on a gross level of national debt and our government debt is very low on a comparative basis.

Figure 1. The composition of debt varies widely across countries

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The chart also gives an insight into how the household debt was and is funded. Australian banks could not fund the growth in loans to the household sector from the deposit base of Australia – even with an enforced savings regime through the Australian superannuation system. The banks borrowed substantially from wholesale markets in Europe to part fund the trillion dollars of housing loans. Towards the end of the debt bubble in 2007 some banks were beginning to offer 100% housing loans with virtually no deposit.

Thank goodness the GFC intervened to stop Australia being sucked into a real substantial debt trap by our banks. Thus, I pose the question as to whether the Australian financial system was well regulated, or were we just lucky that the sub-prime debt tsunami left the USA and headed east to Ireland rather than west to Australia?

In any case, the Australian government (i.e. the public) were called upon to guarantee the bank wholesale funding at the height of the crisis. Australian banks were generally sound, apart from some strange trading assets on most of their balance sheets and the special case of St George Bank, whose offshore funding base led it straight into the clutches of Westpac.

Figure 2. Household Debt

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Which brings me to reflect on the pre-2007 roles and activities of the RBA and the Australian Prudential Regulation Authority (APRA) in this country. Just how proactive were they? Did they really see the problems before they rose in 2008 or did they merely respond to events? I generally agree with the views of Warwick McGibbon and benefit from his comments, which are usually incisive. However, he is reported in the media as suggesting that the interest rate cut could generate a runaway property bubble and have catastrophic effects on the economy. Well it may well do if the regulatory authorities in this country do not start regulating the lending activities of our banks.

Figure 3. Dwelling Price-to-Income Ratios

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Source: ABS; Federal Reserve, RP Data-Rismark, Thomson Reuters, US Census Bureau

In my view, the RBA and APRA, like virtually all other banking authorities in the western world, let the banks run wild into the pre-GFC era. The excessive profit motive and remuneration structures of these banks perverted their function to facilitate the safe transfer of savings to sensible borrowers.

So today, when an ex-RBA board member suggests that an interest rate cut may lead banks to indiscriminately lend to borrowers, I fear that nothing has been learnt from the GFC era. Quite simply, the authorities need to instruct our banks to adjust their loan books so that within five years (say) no residential loans will be provided in our economy without a 30% (say) deposit.

If that was done, then there would be a proper deflation in residential property, affordability would rise, debt repaid and a fundamental economic base to allow consumption to recover. Without regulation, I am afraid that Australia could be caught in a debt trap. So why don’t either Murray or McGibbon give us the regulatory solutions? The last seven years clearly show that financial markets without proper regulation will unfortunately fail.

I remain optimistic that common sense will prevail and thus believe that Australia will navigate its way through its household debt. So I am not shooting the messengers but please, can well-respected commentators suggest solutions to perceived problems? Warnings without common sense solutions will compound negative sentiment shifts across the broader public. Economic problems could well be created from grim warnings that may never materialise.

My bank holdings

Whilst both Westpac and CBA have both lifted in price over recent weeks, I can report that they are still in value based on forecast earnings. As I noted above, the market is focusing on sustainable and high yields. Thus, assuming that the banks continue to provide credit on appropriate terms and there is not a sharp decline in economic activity, value is still on offer. Indeed, Westpac is well in value even assuming fairly flat earnings in the coming year.

Figure 4. CBA Price/Value Chart

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Source: MyClime

Figure 5. WBC Future Value Chart

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Also of significance is the improving funding profile of Australian banks. In his commentary announcing this week’s interest cut, the RBA governor Glenn Stevens noted the improving wholesale funding conditions in Europe. Further, should European Quantitative Easing begin in earnest following a Spanish bailout then conditions could improve further. The chart bellows shows this point clearly.

Figure 6. Offshore Funding of Banks in Australia

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So, in summary I remain a confident holder of the banks but I do expect the other battered down stocks in my portfolio to also positively contribute over the next six or so months. Also, readers should not expect another 12% quarterly return from the portfolio, as these types of quarters are likely to be rare events as the world muddles forward.

John Abernethy is the Chief Investment Officer at Clime Investment Management. Register for a free trial to MyClime – online stock valuation service.