Since peaking in March 2015, the share prices of our major banks have been plummeting. I fear there is more bad news ahead with the markets beginning to catch up with factors that will limit the banks’ ability to grow their mortgage books as quickly as they have in recent years.
It is perhaps unique to the Australian stock market that four banks have such a heavy influence. The Commonwealth Bank, Westpac, the National Australia Bank and ANZ explain 27 per cent of the S&P/ASX 200, and in 2016 it pained us greatly to be significantly underweight as they rallied.
Of course, value investors are often early to the party and early to leave, and what we could see back in 2016 is now coming to pass. Our underweight position – we hold less than 7 per cent of our domestic portfolios in the banks – is now paying off as the market begins to catch up with the idea that a weakening property market, and heavily indebted consumers, will limit the banks’ ability to grow their mortgage books as quickly as they have in recent years. And that’s even before we take into account the impact from the Royal Commission.
By way of background, bank profit growth is predominantly a function of loan book growth and the net interest margin, which is the difference between interest earned on lending less interest paid on funding.
For the banks, both are under pressure.
In response to the 2014 Financial System Enquiry report, the Australian Prudential Regulation Authority (APRA) imposed new capital requirements requiring the big four banks (which account for more than 80 per cent of the mortgage market) to have more capital. This meant that for any given level of profit, a bank is required to hold more capital. That’s a bit like me telling you to write a cheque for millions of dollars to put back into your business without expecting any additional profit to be made.
In 2014, APRA also acted to tighten standards for interest-only loans, and mortgages more generally. APRA required serviceability assessments for new loans to be more conservative and added an interest rate ‘buffer’ of at least 2 percentage points above the relevant benchmark rate (with an interest rate floor of at least 7 per cent). And the test had to include other existing debt (which can be large for property investors). Borrowers need to be able to afford a substantial rise in interest rates to qualify for a loan.
And when APRA tightened loan serviceability requirements, it also limited the growth of investor lending (to 10 per cent annually). This lending growth cap has since been removed; however, mortgage commitments to investors have slipped to the lowest since January 2012, and as we will see in a moment, the outcomes of the Royal Commission will ensure lending growth to investors remains muted.
In July 2015 APRA also announced, with effect from 1 July 2016, changes to the treatment of residential mortgages for banks that are able to use the internal ratings-based (IRB) approach to credit risk for capital adequacy purposes (mainly the big four banks). In essence, for every dollar of equity the banks hold, they simply cannot lend as much to residential mortgages.
In early 2017, APRA further tightened standards on interest-only lending. Among other things, banks were required to limit new interest-only lending to be no more than 30 per cent of new mortgage lending. Just two years prior interest only loans were 45 per cent of all new mortgages written. As an aside, many of the old interest only loans will be restricted from renewing at maturity and will have to move on to more expensive Principal & Interest terms.
When laid out this way, it is clear that it has become much tougher for would-be property buyers and investors to obtain a large loan. And one of the largest drivers of mortgage book growth is something called ‘churn’. Churn is the growth in the total value of loans that comes from a smaller and older mortgage being paid off and replaced with a bigger, newer mortgage. As house prices rise, churn is a major driver of mortgage system growth. When circumstances for house price growth are tougher, churn-driven growth can dry up and severely dampen growth for the banks.
The more recent Royal Commission has uncovered banks were loose in their application of income and expense assessments before granting new mortgages. The result is that more stringent assessments are being executed which is resulting in more applications being rejected (30 per cent rejected today versus just 5 per cent last year according to anecdotal reports). It is also the case that the process of approving loans is now taking longer, which also throttles growth.
It should come as no surprise that auction clearance rates have plunged. Oh, and don’t forget the foreign Investment slump from 40,149 approvals in 2015/16 (A$72.4 billion), to just 13,198 approvals in 2016/17 (A$25.2 billion).
More rigorous responsible lending, "reasonable inquiries" & "reasonable steps" to verify borrowers' income and living expenses following the Royal Commission, and more risk averse bank boards combined with Scott Morrison’s threat of “jail time”, will continue the step down in mortgage book growth rates.
Meanwhile higher short-term global interest rates and the migration of interest-only mortgages to lower margin principal & interest loans will ensure lower net interest margins for the banks as well.
Unsurprisingly the banks have seen their shares fall. CBA and Westpac shares are down 18 per cent from their highs, NAB is almost 20 per cent lower and ANZ is 13 per cent lower.
The effect of credit tightening tends to be slow moving. While mortgages are initially met comfortably, the payment of other bills such as electricity, gas and the car registration are pushed out to the fifth week, instead of being paid on time, in the fourth week. This continues month after month and eventually delinquencies accelerate.
There is little doubt the train has left the station and it’s on its way to its destination. Only if and when it arrives will the banks again represent bargains.
The Montgomery Funds own shares in the Commonwealth Bank of Australia and Westpac.
If you would like to read more articles by me, please click here.