Pete Wargent blogspot

Co-founder & CEO of AllenWargent property buyer's agents, offices in Brisbane (Riverside) & Sydney (Martin Place), and CEO of WargentAdvisory (providing subscription analysis, reports & services to institutional clients).

4 x finance/investment author - 'Get a Financial Grip: a simple plan for financial freedom’ (2012) rated Top 10 finance books by Money Magazine & Dymocks.

"Unfortunately so much commentary is self-serving or sensationalist. Pete Wargent shines through with his clear, sober & dispassionate analysis of the housing market, which is so valuable. Pete drills into the facts & unlocks the details that others gloss over in their rush to get a headline. On housing Pete is a must read, must follow - he is one of the better property analysts in Australia" - Stephen Koukoulas, MD of Market Economics, former Senior Economics Adviser to Prime Minister Gillard.

"Pete Wargent is one of Australia's brightest financial minds - a must-follow for articulate, accurate & in-depth analysis." - David Scutt, Business Insider, leading Australian market analyst.

"I've been investing for over 40 years & read nearly every investment book ever written yet I still learned new concepts in his books. Pete Wargent is one of Australia's finest young financial commentators." - Michael Yardney, Australia's leading property expert, Amazon #1 best-selling author.

"The most knowledgeable person on Aussie real estate markets - Pete's work is great, loads of good data and charts, the most comprehensive analyst I follow in Australia. If you follow Australia, follow Pete Wargent" - Jonathan Tepper, Variant Perception, Global Macroeconomic Research, and author of the New York Times bestsellers 'End Game' and 'Code Red'.

"Pete's daily analysis is unputdownable" - Dr. Chris Caton, Chief Economist, BT Financial.

Wednesday, 9 July 2014

Banks

Bankers

A massive subject with a huge range of angles that could potentially be looked at, certainly many more than be considered in a short blog post. But let's see what we can rip through in a few hundred words.

I've previously looked at bank share price valuations several times before, including here among other places (not all that great). 

Today, let's consider bank profitability and mortgage lending, and what that is all likely to mean for the property markets in the near future.

Profits soaring

Information flow from banks is often quite timely but also opaque.

However the first observation to make is that bank profitability - particularly in the Big 4 banks, but actually across the banking sector - is very high and is cruising even higher. 

Meanwhile, bad debt charges are falling implying that, generally, loan books are currently in pretty good nick.

Bank Profitability – Profits and Bad Debt Charges graph

Since 2006 in Australia we've been operating under an improved accounting regime in respect of bad and doubtful debt provisioning. 

The old Aussie 'A-GAAP' rules have been canned and we're now reporting under International Financial Reporting Standards (IFRS).

This should mean that rainy day or 'big bath' provisioning is no more. Doubtful debt charges should only be based upon specific allowances, and under IAS 39 general provisioning should be out. 

The data up to the last week of June 2014 suggests that while bad and doubtful debts recorded a bit of a spike through the financial crisis, they are now declining back towards relatively speaking very low levels. 

The surge in bad and doubtful debts experienced in the early 1990s demonstrated how the combination of higher unemployment and very high interest rates can cause financial distress to household budgets.

Bank Profitability – Key Indicators graph

Net interest margins for the banks have been declining. We'll come back to the impact of this in a little more detail below.

Major Banks' Net Interest Margin graph

In terms of banks' non-performing assets from global operations, these are reverting downwards again after the sub-prime fallout of half a decade ago saw a significant increase in the percentage of on-balance sheet assets impaired or written down.

Banks' Non-performing Assets – Consolidated Global Operations graph

And in terms of banks' domestic loan books, non-performing assets never really got that high in Australia as compared to other countries, and are now also declining again to very low levels.

The chart below is wonderful to see, of course, but in itself is not all that useful as a forward indicator. 

Today, we have rock bottom interest rates and relatively low unemployment in Australia, so in turn you'd expect the percentage of non-performing assets to be low.

The real question is: what happens if the unemployment rate rises significantly? 

I note that some have already called the peak of the unemployment rate for this cycle, but that isn't necessarily so. 

The resources sector looks likely to shed plenty of jobs over the next two to three years, so it's largely a question of how efficiently the great rebalancing away from the boom in mining construction progresses.

Banks' Non-performing Assets – Domestic Operations graph

Capital ratios

A subject which generates untold debate, a great deal of it emotive, some based on guesswork, some factual...bank capital ratios. 

The topic would be a dissertation unto itself, but a few general points of note here. 

Firstly, 'tier one' capital ratios - the core measure of bank stability, mostly comprising ordinary shares and disclosed retained reserves - have clearly increased since the financial crisis, and sit well above 10%, which is welcoming to see, if not as high as might be desirable. 

Capital Ratios graph

The regulations of Basel III recommended that banks hold a greater percentage of tier one capital. 

There isn't space here to consider the risks in detail, merely to note the obvious mismatch in timing between the sources of funding (short-term deposits) and the predominant composition of loan books (e.g. 25 year mortgages).

'Tier two' capital has been declining as a percentage of risk-weighted assets, as you can see above, but since tier two capital consists primarily of subordinated debt and other less relevant reserves (including preference shares in the Australian banking system) it's not of that much interest here.

Subordinated debt and indeed deposits are not genuinely at a great deal of risk in Australia's major banks due to guarantees in place, especially since the major banks will never be allowed to languish insolvent.

Australian banks will never "run out of cash", since the Reserve Bank of Australia (RBA) is putting in place from 2015 a monumental bailout facility, known in technical jargon as a "Committed Liquidity Facility" (CLF) aka. the $380 billion "mother of all bailout funds".

In comparison to the net assets and market caps of the Big 4 banks, this effective 'line of credit' represents a truly colossal sum and ensures that whatever happens the music will not stop for the Big 4 while the CLF remains accessible. 

Deposits

There was a lot of debate in 2012 and 2013 about whether any housing market recovery would inevitably be stifled, since deposit growth could not be strong enough to allow it to be sustained. 

Funding Composition of Banks in Australia graph

This is another debate to be held in more detail another time, but in short, it's been widely countered that lending itself creates lenders and deposits, and therefore the housing market recovery was never going to be stifled for the reasons suggested.

In the simplest terms, if person A deposits $1,000 in the bank, and the bank in turn  lends capital to person B to buy an asset from person C, then person C has funds which may be deposited in another bank. Voilà, a fresh bank deposit, and, ergo, lending creates lenders.

You can, if you wish, choose to argue about the chicken and egg effect here.

The Bank of England wrote a paper on the subject tending towards the lending creates deposit view, rather than deposits being sourced from household savings.

My view was that banks ability to fund a housing market recovery, as recorded on this blog, was never going to be an issue. 

In any case, credit aggregates have continued to show that lending for housing has increased strongly over the past year (+6.2% y/y, and higher than that again for investment housing lending), so the stifled housing market recovery theory lost any traction it may have had right there. 

And that's even before the respective roles of foreign capital and self-managed super funds are taken into account.

Bubble?

I've always believed that while over the short-term events are unpredictable, over the long term well-located residential real estate will be a good investment.

Why? 

One reason is that well-located real estate in capital cities with growing populations is a near guaranteed inflation hedge over the long haul.

New housing stock will always by necessity be constructed using labour and materials at today's prices, and therefore the replacement cost of property is likely to remain roughly in line with inflation over a reasonable period of time.


If property prices fall below the replacement cost, construction projects become unviable and new building will dry up until upwards pressure returns on prices. The RBA itself talked a little about this itself in this speech here

But what happens if prices are in a so-termed "bubble" (however that may be defined) and dwelling prices decline sending the most recent homeowner demographic into negative equity, as is debated endlessly in Aussie media?

There are only really a few things that can play out:

-a huge percentage of borrowers default, leading in turn to potential bank defaults, leading to an almighty mess (cf. the CLF above);

-borrowers work extra hard to pay down debt. This sounds ideal in theory, but would likely lead to a significant fall in household consumption for other goods and therefore a likely recession and zero interest rates; or

-a combination of the above (the most likely outcome).

We saw a sharp property correction in the UK during the financial crisis, at least, outside of London. 

What happened, in the event, was that the base rate was dropped to 0.50% in 2009 where it has remained ever since, the Bank of England engaged in quantitative easing via a bond-buying program, and the 2% inflation target was effectively "looked through" as the currency depreciated.

In fact, until quite recently UK inflation has been tearing along at levels as high as 5% per annum, and much of the pre-existing household debt has effectively been inflated away over the past seven years or so, while mortgage repayments have remained outrageously cheap (we have one UK mortgage which attracts a rate of just 1.50%).


Stoked on by low interest rates average UK house prices have now returned to new all-time record highs in nominal terms, while London prices have just kept on rising.


In other words, for owners of well-located real estate in or around London, it's been a very comfortable outcome as real estate continues to act as an effective inflation hedge and interest rates at rock bottom.

Small business lending alive and kicking?

On a similar subject, there has been much debate in recent months about whether lending for housing has been crowding out lending for more productive purposes.

Such debates are often limited in their scope because the participants start with their conclusions and work backwards from there. 

Trying a different tack, I spoke to Jessica Gomas of Commbank's SME banking & commercial funding for her views on the subject yesterday.

She advised that, in CBA's case at least, the bank has funds ready to lend to small business and they are being encouraged to lend to small business wherever appropriate security can be found, with several significant deals getting across the line in recent weeks.

However, the data on the subject of loan aggregates is now quite opaque. 

The number of small businesses has not really declined over the last half decade, which is one useful indicator.

What is also certainly the case is that more frequently than before, borrowers are taking lines of credit against existing assets (i.e. their home) in order to fund small business expansion. 

Banks will always be keener to lend at lower rates against a house and land (which are immovable and cannot go anywhere) than they are to lend unsecured against a business which has yet to prove its profitability or viability.

The view of Gomas, and that of other attendees in the SME sector to yesterday's finance event in North Sydney, was that small business lending is very much alive and kicking in Australia, whatever the doom and gloom media chooses to report.

I consider the role of bank lending and whether it really is "killing productivity" in a little more detail here

Race to the bottom?

In the absence of policy intervention from APRA, this housing market rebound appears likely to have quite a way to run yet.

As discussed above, there appear to be few issues relating to deposit funding for the major banks.

And while the cash rate has been on hold at just 2.50% since early August 2013 - the longest period of rate stability in nearly a decade - the next move in the cash rate could easily be down to 2.25% later in the year given the fragile state of GDP growth (click chart):


In fact, the actions of banks of late suggest that mortgage borrowing is already getting even cheaper than it already is, regardless of what may or may not be happening in the board rooms at Martin Place.

For example, Westpac has now made a variable rate product available at an extremely tempting 4.84%

Meanwhile, Suncorp has slashed its lowest available variable rate to an unfathomably low 4.65%.

The relative cost of owning property as compared to renting is becoming so incredibly cheap that buyers appear likely to continue entering the market, while yield-starved investors are also lured into the risk asset classes.

These are a few of the reasons why I believe dwelling prices are likely to keep grinding higher until interest rates are normalised.