On 18 May 2011 Australians awoke to the surprising news that Moody’s Investors Service downgraded the long-term debt ratings of Australia’s pride and joy – the Big Four Banks – Australia and New Zealand Banking Group (ANZ), Commonwealth Bank of Australia (CBA), National Australia Bank (NAB), and Westpac Banking (WBC).
Why did they do this? About 40% of the deposit mix of the big four was from wholesale funding – meaning offshore debt as opposed to Australian commercial and consumer deposits. As if that wasn’t enough, Moody’s also downgraded the overall BFSR (Bank Financial Strength Rating) from B to B-.
Some Australians sport a sense of pride in our surviving the GFC relatively unscathed with what appears to some less fortunate Western countries as a prideful swagger. It didn’t happen here, we were told, because the lending practices of the Aussie Big Four were markedly different than those of those profligate and foolhardy Americans. One of the most often cited reasons was the fact residential mortgage loans here remain on the books of the issuing institution rather than being sold and sliced and diced into exotic investment instruments as happened in the US.
Following the Moody’s bombshell we began to read of the improvement in our banks funding mix, as deposits increased. Although the housing market began to quake a bit and unemployment rose a bit, all was well as long as China, India, and the miners remained intact.
Then on 02 December 2011 the Big Four went down a credit notch again – this time from Standard & Poor’s. Many Australians shrugged off the downgrade since it was due in large part to changes in S&P’s rating criteria and Australia’s Big Four still remain among the few banks in the world with a Double AA rating. The downgrade was from AA to AA-. However, the rationale stated by S&P is the same as Moody’s concern – wholesale funding costs. S&P maintains that the banks still rely heavily on offshore wholesale debt to fund much of their loan books. Credit spreads have already widened because of the sovereign debt crisis in Europe and if they explode as happened in the GFC, our banks are at risk.
Following this downgrade we were again treated to an impressive array of reassurances about our comprehensive and conservative regulatory system. Not to worry.
On 31 January, 2012 Fitch Ratings got into the act, putting on negative ratings watch citing the same reasons. Then they went on to compare us to the Canadian banking system, and sung the praises of Canada’s six major banks. Should we be worried?
Fitch noted Canadian banks have better funding profiles and a lower proportion of total assets held as loans. Although Australian banks are still highly profitable, the combination of increased borrowing costs in overseas markets and a continued slowdown in Australian property markets is cause for concern, they claim. The funding profile in Canadian Banks has a lower loan to deposit ratio, although both countries have housing markets still over-priced in the eyes of many experts.
To put this all into some kind of perspective, let’s see what a recent UBS Securities Report on the Australian Banking System has to say. The report cites a “dangerous situation” confronting the Big Four due to higher wholesale funding costs and the competition to write home loans. In short, the banks are losing money making home loans given current interest rates and funding costs. And remember, according to the Ratings Agencies the asset base of our banks is overweight in residential loans.
The author of the report, analyst Jonathan Mott, said banks will be left with a stark choice if the Reserve Bank does cut rates today. They can re-price the interest rate on new mortgages above the official cash rate, they can hope for wholesale funding markets to improve, or they can stop writing mortgages.
The RBA unexpectedly let rates stay the same. At best, this is a temporary reprieve, as the UBS report claims the banks were already losing money at the rate in place. Nevetheless, ANZ and Westpac this week defied the RBA move by upping rates anyway. ANZ hiked variable rate mortgages and small business loans by six basis points. Westpac is upping its standard variable mortgage rate by 0.10 percentage points to 7.36%. Westpac group executive Jason Yetton said the rate hike reflected the increased cost to the bank of raising money.
The following chart tells the tale:
As you can plainly see, the Banks have not lost money on new mortgage loans since the early days of the GFC in 2008. The cause of the dramatic drop off at the end of 2011 has to be attributable to a combination of lower rates and most importantly, funding costs.
Once again, the troubles facing Australia’s Big Four banks appear to originate from the same source – reliance on overseas debt to fund their loans.
The following graph shows the cost of recent bond issuances from each of the major banks. You have heard again and again the cost of wholesale debt has exploded, with bond issues costing the issue approximately twice the 2009 cost of unsecured debt. Here you see it in bold relief. The prices account for conversion costs into Australian dollars (ll-In Cost).
In order to illustrate the extent of the rising funding costs, the below chart estimates the all-in prices (including costs associated with swapping the bonds into Australian dollars) of the banks’ recent covered bond issues.
As you can see, it is costing the banks 6.2% on average to borrow money which they are then in turn lending out at cripplingly low rates. The profit margins when you include the average variable mortgage rate and term deposit rates earned by the bank are now at a weighted average of .39%, according to Macquarie Research.
Although the calculations of these averages is complex, anyone can understand the basic principle profit margins that low can lead to serious trouble. What would the banks have done had the RBA lowered the cash rate as expected? What will the big banks do if wholesale funding costs continue to rise as investors grow increasingly wary over the never-ending saga of the European sovereign debt crisis?
Apparently share market participants are as yet not that concerned. The following price movement chart shows two of the Big Four Australian Banks – Commonwealth Bank of Australia (CBA) and Australia and New Zealand Bank (ANZ):
The following table, courtesy of Thompson/Reuters First Call, summarises analyst ratings for the last month for CBA and ANZ as well as the two remaining big banks, National Australia Bank (NAB) and Westpac Banking (WBC).
Finally, here is a one year price movement chart for the remaining two of the Big Four Banks:
All four started 2012 in an upward trend and with the exception of NAB have yet to see a price drop commensurate with a worried crowd of investors. In short, they are not yet worried, or so it would seem. If you dig into the analyst recommendations you will find one word repeated again and again – margins. The fact our Big Four carry residential loans on their books may have saved us from GFC 1, but that saving grace may be our downfall in the event of a GFC 2.
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