The new threats to banks and property

Summary: Opposition leader Bill Shorten has announced ALP plans to abolish cash refunds for excess dividend imputation credits for share investors, with many retirees likely to be among the most affected. Meanwhile, “liar loans” by the banks could cause a property upset.

Key take-out: While any immediate impact on bank shares from the ALP's proposal is unlikely, the longer-term consequences of cutting dividend franking credits would make the banks less attractive for investors.

It's been a disturbing week for those investing in bank shares to gain a high income in retirement.

Most of the publicity has been concentrated on Bill Shorten's attempt to deny franking credits to superannuation funds in pension phase. Basically, Shorten is saying if you get a franking credit you can offset it against taxable income, but you can't take it out in cash.

Now, of course, a superannuation fund in retirement phase is allowed to have $1.6 million in tax-free funds and that means that all pension mode fund members don't pay tax when they have assets in pension mode of less than $1.6 million. If the policy is applied correctly it can be tagged to not only self-managed funds but retirement funds operated by the big superannuation groups including industry and retail funds.

What scared me was that Bill Shorten used his words to attack self-managed funds, and when the legislation comes through (assuming the ALP wins the next election, which is not a certainty) then we will need to watch out very carefully to make sure this is not a stunt to kill off self-managed funds in favour of industry and retail funds. The Coalition government will be able say that Bill Shorten is effectively reducing the pensions of those who have put money aside to fund their retirement, and there is no doubt that is exactly what he is doing.

Of course, it is the pot calling the kettle black. Indeed, the savagery that the Coalition government used to attack retirees trying to fund their retirement was in fact much more severe than anything Bill Shorten is proposing via franking credits.

We are headed into a society where a lot more Baby Boomers are going to retire, albeit that many of those retirements have been delayed.

When they do retire the majority will not have enough superannuation to fully fund their retirement, although superannuation savings can be a very handy adjunct to a government pension.

Potential impact on bank shares

Bank shares have been a favourite vehicle to maximise income and enable people to fund their own retirement and/or reduce their reliance on the government purse.

Effectively those retirement pensions are being reduced because less money comes from the bank dividends if franking is eliminated for those with funds in pension mode. Bank shares will be less attractive.

The whole question of franking is going to be one that is intensely debated in the coming years. Treasury hates franking credits and is constantly thinking of ways to try and get rid of it. Bill Shorten has given them a window. There will be other moves, but there will be a long delay before any of these things affect the level of bank share prices.

Dodgy home loans

In the short- to medium-term bank share price outlook, I am actually more concerned about the research being undertaken by UBS. You will remember that there was extensive publicity last year when it was revealed that about a third of bank borrowers fudge their income and other information when borrowing for home loans.

Now UBS have been studying the information NAB, Commonwealth Bank and Westpac have been providing shareholders about the income levels of their home loan borrowers. (ANZ does not provided the same detail).

When UBS compares what the banks are claiming is the income of their clients with how many people earn the level of income the banks claim their mortgage borrowers are earning, it is clear that either Australians have a much greater income that the official statistics claim, or the bank mortgage borrower incomes are very wrong and there has been massive fraud.

NAB and CBA look the most vulnerable, because their claimed borrower incomes are the highest. Westpac clients have much lower and more realistic incomes, which indicates there has been less fraud.

It looks as though much of the fraud has taken place because people have been providing forged pay slips.

Now this matter has received great press publicity, but I want to bring it back to the realities of the housing market. My guess is that, that assuming UBS is right, (and it is always possible that it is wrong) then it is highly likely that the investor loans have been the subject of most of the fraud.

During the boom people took out five-year interest-only loans and saw it as a ticket to make money with the rising dwelling prices. Banks, but more particularly brokers, were under pressure to write as many loans as possible, so the environment was right for forged pay slips and in many cases, of course, there was upfront commissions to the sales people.

This is exactly what happened in the US and led to the global financial crisis, but I don't think we are looking at anything as serious.

Nevertheless, as 2018 proceeds and we move into 2019 and 2020 a large number of interest-only loans to investors will come up for renewal. Once the investor loan comes up for renewal the bank client will be required to provide much more information about their financial situation and, in particular, their income. Almost always Australian Tax Office records will need to be produced.

Pressure on investment properties

If the investor was honest in the original application, then that investor will still be required to make much bigger payments because the banks are limiting their interest-only loans and are looking for a bigger commitment that reduces the principal. On its own that will cause many investors to sell their investment houses.

But if UBS is right, and there is a significant proportion of investment loans where there was fraud, then when the bank discovers the true financial position of their client they will require an even greater amount of payment and almost certainly the house will need to be sold.

If you have an investment house and it is in an area where there are a lot of other dwellings that have been sold to interest-only investors I would be a bit wary, although assuming you purchased prior to July 1, 2017 you have an asset you can depreciate and negatively gear.

Nevertheless, there is a clear possibility that there will be a significant rise in the amount of dwellings that will come onto the market.

Investors who buy “used” property now will not be able to claim a depreciation deduction, so any increase in selling by investors as a result of the bank frauds and or stricter lending criteria will affect the market.

And, if the ALP wins the next election, negative gearing like depreciation will be limited to new dwellings.  

I am not necessarily suggesting that you panic but be aware of what it taking place.

And, if UBS is right and, as the election gets closer, we find a significant number of retirees find their bank shares are of less value and the banks are suffering a greater level of loss on houses, share prices will be affected.

I don't think we are heading into a deep crisis, but suddenly these two events coming as they have in the same week add an element of caution to the market.