Bank Stock Correction

As a mortgage broker, I can assure everyone from speaking to most of my panel lenders that lending activity has come to a screetching crawl, if not a full stop.

When you have got CBA offering to refinance within ten days without even obtaining the title from the current lender (this is a new initiative with criteria involved) & Suncorp offering up soft commission to first home buyers when they settle, you can safely say.. "Houston, we may have a problem".

What does this mean to ASF members?

Firstly, one can assume that bank stocks have topped out and that maybe a short position in such stocks may in future prove rewarding.

Secondly, if this leads to future profit forecast adjustments then this will definitely lead IMHO to a permanent downward correction in the local market, which is probably not a bad thing.

Thirdly, it will almost inevitably lead to a rationalisation of the entire sector which now appears overbanked. This will potentially include takeovers of some of the smaller players and may finally result in the collapse of the four pillar policy as bank strive to maintain shareholder satisfaction.

The only possible mitigant to these bear trends may come with the long awaited floating of the broking arms of CBA, WBC & NAB all of which are a certainity and may if announced assist in sustaining current shareholders values.

I for one have recently cashed out some of my portfolio based upon the realisation that IMHO a more permanent market correction is now on the horizon.

I am interested in any opinions for and against.

FWIW, I've shorted CBA today @ 60.25. I have a valuer friend who can confirm the trends? as you have outlined. Panic behind the scenes yet?

You may find this article interesting.

Cheers


BT



The Banks As Canaries?
FN Arena News - October 17 2007
By Rudi Filapek-Vandyck

The Australian banking sector is being hit with recommendation downgrades these days. Today CommBank (CBA) was downgraded by Credit Suisse, to Underperform, and Westpac ((WBC)) was cut to Hold by Merrill Lynch.
For both CommBank and Westpac it was the second downgrade in two days as Citi took a similar step yesterday regarding Westpac while UBS downgraded CommBank yesterday to Hold.

A week ago, ANZ Bank ((ANZ)) received the first recommendation downgrade with Credit Suisse changing its view to Neutral from Outperform.
Citi also cut St George Bank ((SGB)) to Hold yesterday.
All this means that since FNArena highlighted at the beginning of last week that banking shares were trading at or above their average twelve month price targets the major five have now received six recommendation downgrades by four different brokers.

Only National Australia Bank ((NAB)) hasn’t received one single recommendation downgrade so far and that is likely linked to the fact that National shares are not at their average price target just yet.
Have any of these recommendation changes had any impact on the share prices? This is not such a strange question as it may seem because every single recommendation change has at least been matched by a positive review by someone else in the past week. Those securities analysts who are positive about the banks, like Shaw Stockbroking for instance, or even Merrill Lynch and ABN Amro, would acknowledge banking valuations are looking “full”, but that doesn’t mean, in their view, that shares are due for a pull back.
The upcoming reporting season for banks should prove to be strong and this should keep the momentum intact, seems to be the overall view of experts with a positive bias.

So have any of the registered recommendation changes had any impact on share prices?

Well, we couldn’t help but noticing that shares of Westpac have been trending down since Monday. But then again, Westpac had been the outperformer among peers and the stock received not one but two recommendation downgrades this week.

For CommBank, the other bank that received two recommendation changes, the trading patterns has been much more erratic and volatile since last Thursday, but the trend nevertheless seems for three days of price decline. (The stock market is not closed yet on Wednesday when we write this story).
And shares of ANZ display a similar trend as Westpac's despite only receiving one downgrade. St George Bank shares also received one downgrade and its pattern looks similar to that for CommBank. The underlying trend, however, is for three declines in a row this week.
And National? Three days down in a row.

Are there any lessons we can draw from this? Well, close followers of the sector know banking stocks tend to move in unison, unless there’s a specific reason that distinguishes one from the others. This seems to be again the case this week, regardless of how many recommendation downgrades are being issued in the market.

The second conclusion is one we’ve drawn a few years ago already and which we pointed out last week as well. Banking stocks are not like resource stocks for which target prices and valuations can jump and fall with a single adjustment of the price estimate of a commodity. Whenever banking stocks reach their average price targets there’s often but one way to go, and that is back.

While a positive reporting season can potentially add some more upside potential through increases in analyst estimates, we’re usually talking about one or two percent only, not about resource stock-like increases.
Thirdly, and this is something we have noticed on many occasions as well: If banking stocks run past their average target prices, indicating their valuations are looking “full”, this is often reflects on the broader market as well. Hence, a pull back for the banks goes often hand in hand with a pull back for the market in general.

This is something we pointed out last week as well. Of course, the next few days will show us whether this relationship has remained intact this time around.

For the record, on Tuesday’s closing share prices, ANZ shares were some 2.5% below the average price target, CommBank was still 1.6% above, National still had 6.7% left, while St George was trading 2.7% above and Westpac had fallen 2.9% below.

After opening higher, the Australian share market finally retreated on Wednesday afternoon.

Following is a MUST READ report issued by Plan Australia a wholly owned subsidiary of Challenger Group, prepared and presented by its MD Alex Moulieris...

Each month we aim to update you on new projects, important information and any current industry issues, which we feel will be of interest and relevance to you.

This month's article focuses on the current financial market melt down - how and why it has happened and what it means for the future.

Turmoil in the Mortgage Markets. What Happened?It has certainly been an exciting time in broker land lately with the financial markets melt down and its knock-on effect of waking up the politicians to broker regulation. Of course, the meltdown was a direct result of unregulated broker activity, as is global warming!! Over the last couple of weeks I have had many questions on the above but today I would like to talk about the financial markets as its impact is upon us right now. Most of the questions I have received regarding the state of our financial markets ask "what exactly happened" and "how did this happen" and of course "what's going to happen". I thought it may be useful to pull together and summarise some of the recent commentary on the subject and try and form a view of how we may be affected.

This problem certainly demonstrates how globally intertwined our financial systems are. A problem that originates in the US through unprecedented mortgage defaults creates the collapse of mortgage origination firms and hedge funds and sends global equity markets into free fall. The upshot is that nobody wants to buy debt securities today without bigger risk margins, causing an increase to funding costs for all lenders including ours in Australia.

How did this happen? It seems that many different but related factors came together to create this disaster. A US property boom which made home ownership difficult was made easier by sub-prime lenders freely extending substantial levels of credit to people who in reality had no capability of repaying the loans. These people may or may not have had a poor credit history but regardless did not have capacity to repay the quantums that they borrowed. These people were offered loans on low start up interest rates of 1 or 2% pa reverting to a standard rate after a couple of years. All this was underwritten not at the rate to which the loan reverted; rather it was underwritten based on the reduced honeymoon period rate. Add to that, the loans were typically fixed rate don't feel the recent impacts of 16 US interest rate rises taking rates to about 7% pa.

When the mortgage reaches the end of its low interest rate start-up period it "resets". Of course at reset date these people have no way of meeting the new and higher repayment amount. The resets started to occur earlier this year and are continuing still now, in fact they will keep occurring until next year. Apparently there were some 7 million of these loans written! To magnify this problem further property prices have started to fall and any equity in these homes are beginning to disappear and in many cases moving into negative equity.

Why has it affected us in Australia when we don't have a default problem? Without going into the complexities of the capital markets, global lenders to Australian banks or non-banks have been spooked by the issues in the US and as a consequence are either demanding greater "risk" premiums in the form of higher interest or indeed not lending at all. Essentially in an environment of fear and loss it is easier and safer to park money in cash or government bonds and wait.

This phenomenon is not unique to RAMS or other non-bank lenders as all Australian banks and lenders these days securitise mortgages or raise money as corporate debt from the capital markets. If we have a look at the ABS stat's (see following table) it tells us that today only about 20% of a banks funding comes from their retail deposits hence all lending institutions are impacted in some form.

RAMS is an example of a local good quality Australian mortgage business that is in great shape one day and literally the next day has a serious funding problem. RAMS was funding the majority of their loan book on a short term basis when the markets collapsed and all the investors ran for cover. RAMS now has to replace short term funding along with its new loans with a higher cost source of funds. Investors who have come out of hiding now want a higher margin for the higher perceived risk.

To illustrate this higher cost of funding Macquarie Bank earlier this month finalised the sale of a $500 million mortgage backed debt issue of which $485 million of AAA rated paper achieved a margin of 40 basis points or 0.40% over the 30 day swap rate, (being the rate that banks lend and borrow between each other). Six months ago the same paper was achieving a margin of 16 to 17 basis points. This means that the cost of wholesale funding is up 20 to 25 basis points. Similarly Westpac issued 1 billion of medium term notes the other week at a spread at 51 bpts versus 11 bpts, the historical levels. Add to that, the 30 day swap rate has increases to 40 bpts above the RBA cash rate from 12 bpts which means that all mortgages, bank and non-bank are now another 28 bpts higher as well. If I was to explain that graphically it is as follows and clearly shows that the current borrower rates are unsustainable as lenders are losing money.

So why haven't all institutions moved their rates yet? This is an interesting question because if we look at when the Reserve Bank lifts or lowers rates the banks are quick to pass on the interest rate rise or reduction. It is almost like there is an unwritten rule amongst them that when the Reserve Bank moves they all move uniformly and at the same rate.

Under today's situation the same law doesn't seem to apply. We have seen some banks and non-banks move but the ‘Big 5' seem to be holding, presumably because each bank is concerned if they are the first to move and the others don't follow they will be competitively disadvantaged and also will be left out there alone to bear the fire of the media and the customer.

This is not a good situation; I can't imagine what it is costing the banks while they are trying to work through this latest of margin erosion albeit ANZ has estimated the cost at around $20 - $25 million per month. I am very supportive of the banks moving rates to reflect the increased cost of funding and would be happy for us, their business partner, to help explain this to the customer.

In fact the sooner the rate move is made the better because the event that is causing the problem is fresh in the mind of the general public right now so the explanation for the rise is easy communicated and understood. Secondly, how will a new borrower feel about the bank that repeatedly tells them that everything is OK with rates and then puts them up anyway, do you think the borrower will feel cheated?

At the end of the day I do not want to bear the brunt of margin erosion that we would be happy to assist alleviate by helping to explain the facts to borrowers and thereby making its passage easier.

What is the lending environment going to look like after all of this?

We will certainly see the end of heavily discounted sub-prime and low-doc lending. We have over the past couple of years been in an unusual period where higher risk lending has been priced at near prime rates. As such we should not view the repricing of credit that is happening or about to happen as unjust but rather back to where it should have been. Investors will slowly re-emerge, they need to invest, and mortgages are still good investments but in future they will price them more carefully for risk.

For the standard full doc borrower I expect rates will be higher as well but not to the extent of the riskier end. Overall, the market will re-emerge with logical and sustainable risk/reward pricing albeit a number of smaller under capitalized players may well disappear through this period.

greenfs said:

I for one have recently cashed out some of my portfolio based upon the realisation that IMHO a more permanent market correction is now on the horizon.

Click to expand...

Same here - I have exited from every industrial holding (except for my market darling), all at or close to record highs, simply because while the overall market keeps progressing, its only the resources sector that can really justify its prices. At some time soon the realisation will hit, cash flows slow, and downgrades start to flood the market.
So yes, I am cashed up for that scenario, but i think they'll be plenty of time to analyse who'll come out of it better.

How prophetic those words of wisdom from greeny!(where are you???). Just goes to show that the information is always there - you just have to be observant, or know an insider

Now, when do we start shorting again?