Why Spain's pain is Australia's gain

PORTFOLIO POINT: Australian banks will benefit from the moves to stabilise European financial markets, but the banks’ offshore funding legacy will live on for some time.

The recent meetings between world and European leaders have resolved to increase and focus financial assistance towards the weaker parts of the European Union.

At the G20 meeting in Mexico some $456 billion was pledged in bilateral loans to the IMF, which will parlay them to euro members via rescue funding lines. This weekend in Europe we may well see more substantial resolutions to aim towards a form of European fiscal union.

Specifically following the G20 meeting it is likely that two European rescue funds – the 500 billion euro European Stability Mechanism (ESM) and the 250 billion euro European Financial Stability Facility (EFSF) – will be authorised to buy the bonds issued by beleaguered European countries. Under this new plan, the money in these funds will not be given directly to governments but will instead be used to buy up government debt on the financial markets. These purchases of bonds on the open market draw upon the success of the open market operations adopted by the US Treasury and Federal Reserve (Fed) in 2008-09.

From a European bank perspective, these market interventions should ensure that European bonds stabilise at interest rate levels below where the market may have priced them. It may also curtail excessive speculation (shorting or hedging activities) by market participants. The stabilisation of bond markets will help hold down the cost of debt to governments and limit write-downs by banks that hold bonds.

These developments are positive news for Australian banks. Any direct intervention that stabilises European debt markets will help the wholesale funding activities of Australian banks. Similarly, the proposed bail-out of Spanish banks is also a positive for our banks, although it may not be good for Spanish bank shareholders. To understand this we need to understand how a government bail-out works.

What is a bank bail-out?
To answer this question we do not have to reflect too far into the past. In 2008 the US government (through Treasury) undertook a TARP (Troubled Asset Relief Scheme) scheme that ostensibly ensured that major US banks and financial institutions were well capitalised. The aim was simple – to ensure that no one could doubt the solvency of the US financial system following the collapse of Lehmann Brothers. Included in the TARP scheme (total size US$700 billion) was a direct investment of about US$120 billion, via preference shares, into a dozen or so major institutions. Many recipients protested that it wasn’t needed, but the Fed insisted because a recession can transform into a depression if people doubt the solvency of the banking system. That is what causes bank runs and indeed we are witnessing a type of bank run in weaker European countries right now. This is shown by the flow of deposits from the weak European states to the stronger, which is settled through the Target2 system.

Target2 is the euro’s cross-border payments system and, as such, reflects the stresses that the financial and sovereign-debt crises have wreaked on the single currency area. Capital from crisis-stricken countries like Greece and Italy has sought safety in northern havens such as Germany and the Netherlands. As banks from southern states have borrowed cash from the ECB, imbalances have built up. While Germany, the Netherlands, Luxembourg and Finland have a net claim on the system’s hub (the ECB), countries including Greece, Italy, Portugal and Spain have net liabilities.

Source: Financial Times

To reverse this flow, the European Union needs to work on schemes that give depositors confidence in their local regional banks.

Thus, the 100 billion euro loan from the EFSF will allow the Spanish government to invest “capital” into Spanish banks. It would surely be counter-productive for the Spanish government to lend to the banks; instead, it should move to recapitalise or indeed nationalise weak banks. This is particularly so if the banks are significant participants in the economy. Whether the 100 billion euros will be enough is unclear, and it depends upon what further support is committed by the European Union and the IMF. In the meantime, there is no doubt that Spanish banks are in deep distress as massive amounts of property loans move into the non-performing loan category.

Source: Bloomberg

Claims that the Spanish government is merely borrowing to provide loan funds for Spanish banks are wide of the mark. From a government balance sheet perspective, there is no increase in net indebtedness because the loans are matched by investment assets which will include preference capital (and possibly some illiquid mortgage assets). Presumably the Spanish government will ensure that the yield on these preference shares exceeds the cost of the loans; if that is the case, the Spanish people will benefit from net revenue generated.

The beauty of the preference capital scheme is that, if structured correctly, the banks will repay them when the economy and markets recover. Further, the illiquid assets will return to fair value and the government will make a reasonable return. That is exactly what happened in the US and the Treasury has actually made a significant positive return.

However, there are a few negatives for bankers and their shareholders. First, whilst the capital is in place the banks are forced to agree to remuneration rules that limit salaries and bonuses. Secondly, speculative trading activities are curtailed and the financing of bank trading related entities is stopped. And, from a shareholder perspective, there is the potential dilution impact of the preference share capital if they are not redeemed, and this effectively crimps down the ownership of common shareholders.

Conclusion
The Spanish bail-out will be good news for European wholesale debt markets, and therefore for the large Australian banks. The stabilisation of bond markets and the bolstering of the capital base of European banks are further important positives for our banking system. While local retail deposit bases are lifting in the funding profile of Australian banks, the legacy of about $600 billion of offshore funding will be a continuing issue for many years.

From a valuation perspective, both CBA and WBC are trading at a healthy discount to my forecast valuations for 2012. Both companies’ dividend yields are enhanced by franking credits and based on market consensus forecasts and company guidance the current dividend yields are attractive.

Growth Model Portfolio

-Clime Model Growth Portfolio (prices as at June 28, 2012)
Company	Code	Purchase Price	Market Price	June 2012 Value	Safety Margin	GU Yield	Total Return
BHP Billiton	BHP	35.5	30.73	47.16	53.47%	4.79%	-13.44%
Commonwealth Bank	CBA	50.78	52.62	58.92	11.97%	8.58%	3.62%
Westpac	WBC	22.02	20.82	26.49	27.23%	10.22%	-1.73%
Blackmores	BKL	27.55	25.95	28.33	9.17%	0.61%	-5.81%
Woolworths	WOW	25.85	26.84	31.53	17.47%	6.44%	3.83%
Iress	IRE	6.75	6.42	7.40	15.26%	8.08%	-4.89%
The Reject Shop	TRS	12.04	9.11	12.56	37.87%	4.86%	-24.34%
Brickworks	BKW	10.45	10.00	12.33	23.30%	5.86%	-4.31%
McMillan Shakespeare	MMS	11.01	11.70	11.43	-2.31%	4.52%	6.27%
Mineral Resources	MIN	11.77	8.82	13.83	56.80%	6.64%	-25.06%
Rio Tinto	RIO	66.6	55.16	84.98	54.06%	3.08%	-17.18%
OrotonGroup	ORL	8.64	7.22	9.38	29.92%	9.89%	-16.44%
* Market prices as at close June 14, 2012

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