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Why RBA needs to pull its head in, and why we sold out of NABHA

Christopher Joye

Coolabah Capital

In my column today I write that RBA governor Phil Lowe needs to pull his head in. It's fine for him to tell the banks to loosen their lending standards, but he isn't the one being sued by ASIC on the basis of an entirely fallacious interpretation of Labor's 2009 responsible lending laws (click on that link to read, or AFR subs can click here). Excerpts only:

Lowe is likewise not on the receiving end of a Hayne royal commission that has thus far adopted a no less erroneous take on the laws, which completely contradicts the rational interpretation of the federal court. The banks are justifiably assuming a worst-case scenario whereby ASIC and the royal commission's "activist", or non-literal, reading of the laws are somehow validated by the courts, even if this is a very low-probability contingency…

It should not be forgotten here that it was Lowe's RBA who bequeathed us the mother of all housing bubbles with its irresponsibly low cash rate, which Lowe is frustrated he cannot now raise because it would exacerbate the housing correction.

Ordinarily with a 5.1 per cent unemployment rate, which the RBA and Treasury say is consistent with full employment and recovering wages growth, the central bank would be normalising its cash rate off its record low towards the neutral level that is neither contractionary nor expansionary. But the RBA cannot do this because it risks a destabilising housing downturn.

Thank heavens for APRA, the world's leading banking regulator, which, notwithstanding the RBA's historic poo-pooing of the efficacy of "macro-prudential" constraints on credit creation, aggressively reined in lending back in December 2014…

Most doubted that APRA's boss, Wayne Byres, would be successful with these endeavours. The RBA's argument was that lenders would find a way around the regulatory perimeter. Credit rating agency Standard & Poor's claimed that these measures had not worked around the rest of the world and would be unlikely to get traction in Australia. Boy, were they wrong.

One of the least recognised policy triumphs in recent times has been APRA's orderly deflation of the worst housing bubble ever recorded (based on the house-price-to-income and household-debt-to-income ratios).

While APRA has been criticised by the royal commission for not being tough enough on some of its non-core policy objectives, the fact is that it is globally lionised for consistently avoiding catastrophic bank blow-ups and establishing what are on the key equity capital measures among the strongest banks in the world.

This is also a legacy of the 2014 financial system inquiry's inspired recommendation on the need to build "unquestionably strong" capital ratios. Helpfully a key author of this work was the Treasury's John Lonsdale, who is now APRA's deputy chairman.

After the New Zealand central bank's decision to force the major banks to raise another $5 billion in common equity to further bolster their first-loss, "going concern" capital, there is little doubt that our largest deposit-takers will be without peer internationally when it comes to minimising the ex ante risk of default.

All of this extra equity is going to reduce the amount of hybrid, or additional tier one (AT1), capital the banks need to hold, which may be one reason the banks' ASX-listed hybrids have been booming over the last week.

CBA and Westpac's new hybrid deals (CBAPH and WBCPI) have both traded above their $100 par price, which is remarkable when you consider the explosive increase in credit spreads after their November bookbuilds. The bottom line is that the 3.7 per cent in spread these securities pay above the 2 per cent quarterly bank bill swap rate looks very attractive compared to the 1.25 per cent spread on offer in 2007, or the 2.3 per cent spread investors accepted in mid-2014.

Another sector that has started performing is the subordinated, or Tier 2, bond market that was smoked by an APRA "discussion paper" in November. While this implied as much as $140 billion of new Tier 2 issuance, which would double global supply, smart investors have started to realise that the pragmatic solution is a Tier 3, or non-preferred senior, bond product.

In contrast to Tier 2, this can be comfortably funded in global markets while affording APRA similar "gone concern" recapitalisation, or equity conversion, rights. The most important thing for APRA to secure is this recapitalisation capacity – it should be indifferent to how it is ultimately funded as long as the result is more equity.

One interesting angle is that NAB may seek transitional relief for its perpetual $2 billion hybrid, NABHA, to serve as loss-absorbing capacity for another, say, five years. NABHA is, after all, bailed into preferred equity automatically if NAB's total capital ratio falls below 8 per cent and/or its Tier 1 ratio is below 4 per cent. In a bank resolution event, APRA can cancel these securities or vary their terms. Contrary to expectations, if NABHA is allowed to serve as transitional Tier 3 capital it may not be replaced for many years, which is why I have removed it from my portfolios.

Read full column here.

Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs $7 billion with a team of 33 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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