Strip AMP Apart, Unwind Byzantine Banks

Christopher Joye

Coolabah Capital

In my AFR column I open-up with both barrels on vertically-integrated institutions (click on that link to read for free or AFR subs can click here for direct access). Excerpt enclosed:

"Arguably the apogee of the “vertical integration” of Australia’s financial system, which this column has aggressively railed against for years, came in early 2014 when the banks convinced the Coalition to roll-back the Future of Financial Advice (FoFA) laws. They did so to allow them to pay bonuses to financial advisers pushing in-house products under the most sensitive “personal” advice—as opposed to “general” advice—services. The Coalition’s misguided FoFA changes almost passed through the Senate, which at the last minute rejected them thanks to advocacy by this column and others like it. After the banks lost the FoFA war they realised they would never be able to fully harness the financial planners they had acquired as sales channels. The vision of having the in-house planner push the bank’s platform, cash deposits, loans, super fund, and in-house managed funds that the super fund would then allocate to, was dashed. Confident planners likewise recognised that they would be better off positioning themselves as true independents where they had the freedom and flexibility to select the solutions that were, in fact, in the best interests of their clients. There has since been a mass exodus of planners out of the financial oligarchy and a slow unwinding of the vertical integration process, with the banks all looking to dispose of their fund managers, advisers, life companies, and wealth businesses. A flaw in David Murray’s otherwise fine Financial System Inquiry was that it failed to address the risks of vertical integration and conflicted remuneration. The Royal Commission and Productivity Commission have nonetheless enthusiastically picked-up this baton, and will belatedly bequeath us with the much more narrow banking system, focussed on simpler core competencies around savings and loans, which we have needed for years. While our banks will ultimately have lower credit risks, they will also produce skinnier returns for shareholders. This is one reason why this column has repeatedly argued that the major banks’ market capitalisation multiples of their book values, which in the case of CBA and Westpac rose to a world-beating 3 times, were completely unsustainable. Since 2015 I’ve explained that as regulatory change and heightened competition forced the majors’ returns on equity to approach their circa 10 per cent cost of equity, their price-to-book value multiples must, by definition, approach one.  CBA, Westpac and NAB’s price-to-book value multiples have since plummeted to 1.6 times today, while ANZ’s multiple has fallen to just 1.3 times. The Royal Commission has also lifted the lid on the intrusive nature of APRA’s surveillance of bank lending standards, which identified far-reaching shortcomings in the banks’ internal controls notwithstanding Australia has among the smallest mortgage default rates in the world despite home loan rates that have typically been elevated relative to overseas peers. Counter-intuitively, this surveillance also documented the conservatism of smaller lenders like the Bank of Queensland, which comes out of APRA’s review looking positively parsimonious relative to its bigger bank brethren. And yet historically regional banks have reported mortgage default rates that have been loftier than the major banks. So what gives? My hypothesis it that it has been an artefact of adverse-selection driven by the regulatory dysfunction we first identified in April 2013, which permitted the major banks to leverage their home loan books more than 70 times while regionals were capped at less than half this number. For very low-risk home loans with modest loan-to-value ratios (LVRs), the majors’ competitive advantage was actually far greater. Whereas regional banks were stuck applying their minimum 35 per cent risk-weights against these products, the majors’ risk-weights could fall below 10 per cent. (The leverage ratio is simply the risk-weight multiplied by the banks’ equity ratio.) In September 2014, Westpac reported it had more than $260 billion of home loans with average risk-weights of between 4 per cent and 8 per cent, implying they were leveraged between 147 times and 294 times. The majors could, therefore, charge ultra-cheap rates and still earn extraordinary returns, which allowed them to dominate the low-risk (and low arrears) sectors, shunting the regionals into higher LVR categories with correspondingly higher risks. Thankfully APRA has come to understand these problems and is ow seeking to minimise them. The credit assessment flaws APRA unearthed also afflict the loans that underpin residential mortgage-backed securities (RMBS), which is an increasingly popular asset-class. This week CBA’s fixed-income research team published a note highlighting that mortgage pre-payment speeds—or the proportion of borrowers who are ahead of their scheduled payments—“are falling rapidly”. This has been fuelled by several factors, including: rate increases on interest-only loans as APRA forced banks to reduce their origination of these products; falling home sales, which are a key trigger for prepayments; tighter lending standards that restrict a borrower’s ability to refinance into a new loan; and the ongoing decline in Aussie house prices, which makes it harder to roll into another product as LVRs climb. “With household debt to income at a record level, borrowers’ ability to make pre‑payments are likely to be stretched, especially if and when mortgage rates start to increase,” CBA’s researchers opine.  “We expect unscheduled principal payments to continue to fall…[given] spare cash just isn’t as plentiful.” This is important for RMBS, which is valued on a static assumption regarding borrowers’ conditional prepayment rate (CPRs). As CPRs fall to near decade lows, the weighted average life (WAL) expected of RMBS pools are rising beyond what investors assumed. The RBA has further shown that this sensitivity between WALs and CPRs increases as one move downs into more subordinated RMBS tranches. A decrease in CPRs also increases required risk premiums, all else being equal. This means that the $40 billion plus of RMBS that bank balance-sheets and other investors have blindly bought in recent years should be worth less for a given reduction in CPRs, which is another reason why we have exited the sector." Read the rest of the article here.


Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs over $8 billion with a team of 26 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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