Why you should sell the big four banks · Why you should sell the big four banks, y l e e ’:NZ at e ’ n ’-s s e e e . or d t . t l m r . , n, or CONTENTS ARTICLES PAGE Time

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Why you should sell the big four banks

Dear reader,

‘In banking,’ wrote ecologist Garrett Hardin in his excellent book Filters Against Folly, ‘up until

the very second when a government agent padlocks the doors, the officers of a failing bank have

to exude confidence. Exuding confidence is something bankers are good at. Nowadays they are

helped in this by “public relations” professionals.’

Hardin was spot on. Take the following two pieces of commentary from ANZ:

‘In a deteriorating global banking environment this is a creditable result ... What’s clear is that

we have a diversified set of businesses that have continued to perform well, with strong revenue

trends ... Our core Institutional businesses also performed well.’

‘This is a good result in a highly competitive market ... We had particularly strong results in Personal,

which was the highlight ... Institutional NPAT growth was double-digit, benefiting from net provision

recoveries but was weaker in revenue and profit before provisions.’

Both sound upbeat and encouraging. Yet the latter accompanied a record-breaking $2.1bn half-

year profit in 2007, while the former was attached to the recent $1.4bn half-year profit, which was

down 28% on 2008’s numbers (and 33% below 2007’s result).

The lesson is that the bankers’ desire to ‘exude confidence’ makes their commentary to shareholders

impossible to rely on for a frank assessment of their prospects. And, when you consider the

relationships and money flows involved in our interconnected financial economy (including huge

tax payments to governments), you realise that most people have a vested interest in talking up the

banks’ prospects. Hence, regular statements that Australia’s banks are ‘well capitalised and well regulated’.

The Intelligent Investor is among the few independent voices prepared to ask tougher questions and

ponder unpalatable future developments. Following share price rallies of more than 40% in recent

months, we recently took the decision to downgrade all four of Australia’s big banks to Sell.

In this report you’ll find the review explaining that move, as well as selected sector research that

we’ve published over the years. This report provides a crucial backdrop to the rather controversial

move of turning negative on the big banks. It is also supported by an interactive member forum

(conducted on Thursday the 30th of April) and a special podcast which will be available on The

Intelligent Investor website from Friday the 1st of May.

Many happy returns,

Greg Hoffman

Research Director, The Intelligent Investor

CONTENTSARTICLES PAGE

Time to act on the big four banks 2The bottom line on CBA’s balance sheet 4The bear case for the banks 7The bull case for the banks 10Danger lurks in the banking sector 14Is your bank going broke? 14Do you own too many banks? 19Understanding underwritten DRPs 21Online bank stock forum 22

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First published 28 Apr 2009

Time to act on the big four banks

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With share prices surging in recent months, the time has come for investors to act on the substantial risks in the banking sector.

As long term investors, we’ve prided ourselves on never having had a Sell recommendation on a big four bank. But neither pride nor ‘portfolio paralysis’ should have a place in a value investor’s playbook.

We’ve held reservations over the big banks for several years and recommended limiting portfolio exposure to a less-than-market weighting of 15% of a diversified portfolio. Today we go a step further.

This publication has sounded numerous warnings about the inherent risks of owning banking stocks, including Do you own too many banks? (page 19), Is your bank going broke? (page 14), Danger lurks in the banking sector (page 14) and The bear case for the banks (page 7). But it’s a topic worth re-visiting.

Commercial propertyIn a recent ‘closed door’ speech, a former CEO of one

of Australia’s largest financial institutions gave a frank assessment of where the banks’ troubles may lie. His view was that consumers had gotten the message on excessive debt and were trying to get their own balance sheets in order. Unlike us, he felt the odds were low that significant danger lurked in residential mortgage lending. Where he showed more concern was the commercial property sector.

The Australian Business Investment Partnership (or ‘Ruddbank’) initiative demonstrates that the federal government acknowledges this is a troublespot. Many Australian property groups engaged in a breathtaking orgy of speculative excess in the middle of this decade and the chickens are now coming home to roost. Ruddbank is a welcome backstop for the property groups, but will it be enough?

Table 1: Derivative positions of the big four banks DERIV. DERIV. NET NET ASSETS LIABILITIES POSITION AS % ($M) ($M) ($M) NTA

ANZ (30 Sep) 36,941 31,927 5,014 22.0

CBA (31 Dec) 43,661 41,811 1,850 8.6

NAB (31 Mar) 62,073 56,183 5,890 19.7

WBC (30 Sep, pre-SGB) 34,810 24,970 9,840 58.6

With $2bn of taxpayers’ money combined with $500m from each of the big four, Ruddbank will seek to add up to $26bn of government-guaranteed leverage on top of this $4bn in equity-like capital. Property groups, after being turned down by all commercial lenders, can approach Ruddbank to extend them credit. The idea is to prevent a funding crisis precipitating a more

widespread collapse in asset prices across the sector. It may or may not work. Either way, it’s a clear signal that the sector is in trouble.

As investors seek compensation for risk, the commercial property sector is watching capitalisation rates rise, that is pushing down asset prices and straining banking covenants. Ruddbank will act as something of a safety valve, with the Australian taxpayer on the hook in anything worse than a moderately bad scenario. But let’s consider the worst case.

Stagflation could lead to DuddbankImagine a ‘stagflationary’ Australia where a lingering

economic downturn collides with profligate government spending and central bank money printing to lead to higher interest rates. For the commercial property sector, this would be the worst possible outcome.

The resultant higher interest rates would lead to increased interest payments and higher capitalisation rates for the sector, sending valuations through the floor. At the same time, subdued economic activity would be feeding through to lower income streams as vacancy rates soared and rents per square metre plummeted. A rout of this magnitude would easily chew through tens of billions in loans, rendering Ruddbank a Duddbank without further capital injections.

The big four would be placed under enormous pressure as a result of such a scenario. And while this isn’t the most likely outcome, it’s far from unimaginable given current circumstances and government policy settings.

Financial derivativesBanks around the world are struggling with toxic assets

and bad debts. To date, Australia’s banks have only suffered flesh wounds from toxic assets. And we don’t think further direct losses are likely to be meaningful. Indirectly, though, they are all exposed through the incestuously interconnected world of financial derivatives.

We discussed this risk at some length in The bottom line on CBA’s balance sheet (page 4). The global financial system has not strengthened materially since then and the risk of a major default remains. And if a major financial institution were to find itself in strife to the point of default, there would almost certainly be serious ramifications for Australia’s big four.

Table 1 summarises the stated derivative-related balance sheet positions of each of the big four banks. It shows derivative assets, derivative liabilities, the net of those two numbers and then the net result as a percentage of net tangible assets (defined, somewhat generously, as shareholders’ equity less goodwill).

Reporting requirements may overstate the exposure

Latest research

The Intelligent Investor PO Box 1158, Bondi Junction NSW 1355 Phone: (02) 8305 6000 Fax: (02) 9387 8674 [email protected] www.intelligentinvestor.com.au 3

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somewhat (many of these positions would be ‘matched’) but, even allowing for that, the data indicates how exposed our major banks are to this area. And we think the risk of a significant derivative-related blow-up in the global financial sector is meaningful enough for bank shareholders to have it in the top five on their worry list.

Items on the ‘worry list’Shareholders should also worry about the confluence of

highly leveraged balance sheets and a tsunami of bad debts. We’d lay significant bets on the fact that there will be more large collapses before this downturn is done. But, as National Australia Bank’s half-year figures showed, bad debts are on the rise among consumers and small and medium businesses as well.

Our view is pessimistic. We believe a tsunami of financial stress is being unleashed across the country. For highly indebted consumers, job losses are likely to prove the last straw. And many businesses are gearing back up to try and ride out the crisis. This week, for example, mining contractor Macmahon reported that, since December, its gearing level has soared from 12% to almost 40%. When a company with projected revenue of $1.4bn has to triple its debt level in less than four months, it’s clear that extraordinary forces are at work.

While we’re regularly assured that Australia’s banks are ‘well capitalised’, the numbers aren’t definitive. At a recent conference in New York hosted by Grant’s Interest Rate Observer, portfolio manager (at FrontPoint Financial Services Fund) Steve Eisman said: ‘If there is one thing I have learned as an analyst of financial companies for almost 20 years, it’s that tangible common equity is the most important metric because it bears the first loss. I can’t emphasise this enough, and it is very crucial to track this ratio over time.’

The editor of Grant’s, James Grant, spelled out the calculation: ‘For an unfailing index of corporate health, subtract intangibles from assets and from equity. Divide the former by the latter.’ So how do Australia’s big banks shape up on this measure? We’ve summarised the results of the calculations in Chart 1.

Chart 1: Big 4 NTA/Total tangible assets

Judged on this measure, Australia’s banks are clearly more leveraged than they were a decade ago. Combine that with our rapidly deteriorating economy, and the probability of worse to come for the banks becomes easy to see. We fully expect the dividend cuts and capital raisings

of recent months to continue for at least the next 12 months as the banks’ internal modelling races to catch-up with the speed of the real world downturn.

Short-term fillipsOptimists view the Ruddbank scheme and first

homebuyers’ grant as welcome fillips for the banks. And, in the short term, that’s certainly the case. But dwell on these measures a while and they begin to look more like auguries—warning signs of trouble ahead. The fact that the government saw fit to intervene in open markets is itself an indication of major problems.

In assessing whether the outcomes of these policies might be favourable, the government’s fiscal stimulus packages provide pertinent case studies. Even though the numbers were large—announced measures to date total more than $52bn, or almost 5% of GDP—they have so far provided only limited support to the economy and certainly not the hoped-for psychological ‘circuit breaker’ for business and consumers.

Chart 2: Financials index (ex LPT) in 2009

The problem is that government measures are often completely overwhelmed by larger macroeconomic factors. Consumers have retreated into their shells—personal credit (excluding housing) has been falling since June last year—and businesses are reeling, fighting a simultaneous downturn in revenue and margins, as well as increasingly constricted credit availability.

At what price?Few of these risks are new. But three months ago, they

were balanced by the potential for capital gains from depressed share prices. What’s led to our change in recommendation is a massive shift in sentiment, with the banks’ share prices rallying more than 40% from their lows.

We believe this presents a great opportunity to take money off the table in a sector where the risks are now firmly skewed to the downside.

In crude terms, we think the chances that things get materially worse for the banks are better than even. And, in terms of the upside we may be forgoing if we’re wrong, we believe that share price rallies of 40% or 50% are unlikely from here, while falls of that magnitude are quite imaginable.

[ CONTINUED ON PAGE 4 ]

The Intelligent Investor PO Box 1158, Bondi Junction NSW 1355 Phone: (02) 8305 6000 Fax: (02) 9387 8674 [email protected] www.intelligentinvestor.com.au4

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Time to act on the big four banks [ C ONTINUED FROM PAGE 3 ]

Portfolio changes and recommendationsOur model income portfolio currently holds 205

Commonwealth Bank shares and 370 Westpac shares. Both have served us well since their purchase many years ago, delivering respectable capital gains and decent dividends. We think the prospects of those two themes continuing over the next few years are dim. As a result, we’re selling these holdings (at $35.71 for Commonwealth and $19.76 for Westpac). We’ll seek to put the proceeds to dividend-producing work over the coming weeks.

Many investors feel a strong attachment to their bank holdings, particularly those who’ve held a stock like Commonwealth Bank since its float in 1991. If, for tax or other reasons, you decide to hold on to your stock, at least you’ve now contemplated the substantial risks involved. And, for those deciding to stay aboard the big four, we reiterate our current preference for the more domestically-

focussed strategies of Commonwealth and Westpac. Our Hold recommendations across the big four are herewith downgraded to SELL.

Disclosure: Staff own shares in ANZ, Commonwealth and Westpac, but they don’t include the author, Greg Hoffman. First published 28 Apr 09.

Almost everybody who owns shares in a large bank is taking the numbers on faith. Their complex financial statements preclude outside investors from gaining complete comfort.

COMMONWEALTH BANK (CBA) $44.67

1 Oct 2008BLUE CHIP INDUSTRIAL

$52.5bn$37.35–$61.65

2 2.5

HOLD

In the investing world, taking matters on faith can be dangerous. This applies even to the most well-known and reassuring brands we come across in our daily lives. Americans, for example, were recently stunned by the collapse of Washington Mutual.

Before its demise, this 119-year old institution (which hadn’t actually been a mutual for 25 years) was the sixth-largest bank in the US. It is now (at least for the time being) the country’s biggest ever bank failure. A year ago investors were paying more than US$35 per share for it, implying a value of more than US$60bn. By way of comparison, Commonwealth Bank’s current market capitalisation is less than A$60bn.

This is part of the reason we’ve long advised conservative investors against having too much of their

portfolios in the banks. These institutions are riskier than many people imagine, and too many investors have been burned over the past year by recognising risks only after they’ve flared up.

Highly leveraged beastIn this, the first of a two-part analysis, we’re going to

sweep aside all the rhetoric and motherhood statements and put Commonwealth Bank’s balance sheet to the test. What we’ll show is that even this, the stodgiest of Australian financial institutions, is a highly leveraged financial beast which relies on a relatively thin $25.6bn slice of reported shareholders’ equity to support a towering mass of $487.6bn in assets.

This leverage ratio of more than 19:1 means that not a lot has to go wrong for Commonwealth before shareholders’ funds are put at serious risk. So we’re going to comb through the group’s assets to see where the danger might lie. Before we start, though, we need to put this task in perspective. Commonwealth’s business and accounts are dominated by its Australian banking operations (encompassing more than 1,000 branches across the nation plus business and wholesale banking services). It also has life insurance, stockbroking and funds management arms, plus various international operations in New Zealand, Indonesia, Fiji and China.

Given this enormous scale and complexity, we must acknowledge the difficulty of analysing the resultant balance sheet. Any outside investor who says they fully understand the intricacies of Commonwealth Bank’s

Q & A Bendigo & Adelaide is in your hold basket. I would presume you would have also downgraded or am I wrong? Joe W

Greg Hoffman: Bendigo & Adelaide doesn’t have anything like the derivatives exposure of the majors, and its commercial exposure is much lower (at less than 15% of its loan book). On the fl ipside, if you were absolutely certain that we’re heading for a housing rout, it has a greater loan book skew towards mortgage lending.

First published 1 Oct 2008

The bottom line on CBA’s balance sheet


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balance sheet is either a fool or a liar. So, in the course of our analysis we’ll have to take some liberties, make assumptions and, in parts, admit defeat. With that caveat, let’s jump to it.

CBA balance sheet (abridged) at 30 June 2008 ($m)

ACCOUNTS ADJUST. ADJUSTED

VALUE

ASSETS

Cash and liquids 7,736 7,736

Receivable from 6,984 6,984 other fin. institutions

Trading assets (fair value) 21,676 (570) 21,106

Insurance assets (fair value) 20,650 (620) 20,031

Derivative assets 18,232 (2,188) 16,044

Loans, advances and 361,282 (3,183) 358,099 other receivables

Property, plant & equipment 1,640 1,640

Intangible assets 8,258 (774) 7,484

Other assets 41,114 (600) 40,514

TOTAL ASSETS 487,572 479,638

TOTAL LIABILITIES 461,435 461,435

NET ASSETS 26,137 18,203

Minority interests 518 518(ASB perp. pref. shares)

SHAREHOLDERS’ EQUITY 25,619 17,685

Shares on issue (m) 1,326 1,326

Book value per share ($) 19.32 13.34

You can see an abridged version of Commonwealth’s 30 June 2008 balance sheet in the table, and we’ll run through the assets line by line (we’ll assume the liabilities are correctly stated). The first couple of lines are pretty straightforward. Almost all the group’s $7.7bn in ‘cash and liquid assets’ and $7.0bn of ‘receivables due from other institutions’ are a regular part of the bank’s day-to-day cash management. Not a lot to worry about here.

Trading and insurance assetsOur first adjustment is required when we come to

$21.7bn worth of ‘trading assets’. The terminology might sound somewhat ominous but an investigation of the relevant accounting note (number 10) shows there’s little reason for concern. These assets include fairly innocuous securities such as certificates of deposit ($13.1bn), medium term notes ($2.4bn), local and semi-government bonds ($1.5bn), federal and state government bonds ($1.4bn) plus $3.3bn of other assorted standard-looking financial fare (bills of exchange, commercial paper, floating rate notes, eurobonds and the like). The question is by how much we should adjust this figure, if at all, in our analysis.

My experience inside banks (though I’ve never worked for Commonwealth) tells me that it’s probably a good idea to give these numbers a bit of a ‘haircut’ for safety, especially given the current turbulent environment.

In a worst-case scenario, the issuers of some of those

securities could fall on tough times and put Commonwealth’s money at risk. In the current environment, the medium term notes might be the main thing to worry about here—these are bonds issued by other banks as part of their regular funding programs. So we’ll leave the more prosaic securities alone but subtract a 10% margin of safety from the $2.4bn in medium term notes and $3.3bn of other securities. That means reducing the $21.7bn stated value by $0.6bn in round terms, leaving it at $21.1bn.

Insurance assets are the next cab off the rank, listed at $20.7bn. The accounting around these is complicated and somewhat confusing. Movements in the value of these assets are offset to a large extent by related liabilities.

There is a degree of risk for shareholders, though, if the investment future breaks somewhere south of the actuarial assumptions made. That being the case, let’s adjust these assets down by 3% to $20bn to allow a little breathing space.

DerivativesNow we move on to a potentially explosive area,

Commonwealth Bank’s $18.2bn of ‘derivative assets’. The sheer scale is noteworthy, with derivative assets representing fully 70% of the bank’s shareholders’ equity.

Note 11 to the accounts offers a mind-boggling summary of these instruments, which had a combined face value exceeding $1.4tr (that’s trillion, with a ‘t’), at 30 June. Of those, $2.6bn relate to derivative securities ‘held for hedging’. The lion’s share, $15.7bn (with a face value of almost $1.3tr), are designated under the purposes of ‘trading’ or ‘other’.

The bank’s valuation policy on these securities is to use market quoted prices or broker/dealer prices where possible, which is standard practice across the industry. But that doesn’t make it conservative. As we’ve seen in recent months, derivative markets can change quickly (and sometimes dry up altogether).

In cases where it holds derivative securities that are not quoted, Commonwealth applies its own ‘valuation techniques based on market conditions and risks at

HORSE SENSE—Munger on derivatives—‘I think we’ve got plenty of scandals coming. A lot of rot has gotten in to the fi nancial system—and of course, this recently caused vast unpleasantness. Someone at the Berkshire meeting asked me “What’s the next one?”, and I answered that my main candidate would be the derivative trading books of the world.

‘I think the accounting that’s been allowed by the accounting profession in the derivative books has been godawful. And I think the morals and intelligence of the people doing the trading has been godawful. And of course what’s really buried in those books is a very dangerous system with enormous clearance risks—and very optimistic assumptions which the accountants have allowed.’ Charlie Munger, Wesco annual meeting 2008.



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Balance Sheet date’. That can be safely translated as ‘we make an educated guess’.

So what to do with $18.2bn of these assets? Realistically, we have to admit defeat. No one can know what dangers, if any, might lurk in a derivatives book with a face value running to 13 figures.

One could take the $18.2bn on faith. Or perhaps it should be severely discounted, especially given the current circumstances in world markets. But what if Commonwealth’s traders have made canny bets in these markets and are currently recording huge profits for shareholders (after extracting handsome bonuses, of course)?

We simply cannot know. But, for the sake of this analysis, we’re inclined to knock more than 10% off and call it $16bn. This is far from a worst-case scenario, though, and undertaking this part of the exercise highlights how much more dangerous National Australia Bank’s foreign currency options trading scandal could have been back in 2004—the cost to NAB shareholders only ran into the hundreds of millions.

Loan bookNext we arrive at the biggest line on our abridged

balance sheet, ‘Loans, advances and other receivables’ of $361.3bn. In the jargon, this is known as the ‘loan book’, and any meaningful analysis of Commonwealth rests heavily on the assumptions made about it.

The largest section of this segment is $215.7bn of mortgages (more than 86% of which are domestic). In a nightmare scenario, it’s possible to imagine there being losses in this portfolio. But overall the quality looks strong enough not to make any adjustments over and above the bank’s internal provisioning at this stage.

Of more potential concern is the $93.2bn of commercial and industrial loans. On this, we note an interesting slide deep within the presentation to analysts that went with the latest results. It showed the bank’s top 20 commercial exposures by credit rating.

We were alarmed to discover that three of Commonwealth’s seven largest commercial exposures are rated below investment grade. These three potentially shaky loans total around $2.5bn, though we can’t tell if they are secured exposures or not. Further down the list, another $600m sub-investment grade exposure was declared ($600m at a rating of BB+). It strikes us that there may be a few potential bombs in this section of the loan book.

Other areas where losses might materialise include credit cards ($8.1bn outstanding) and leasing ($4.8bn). In America, vehicle leasing companies are under serious pressure as funding costs have risen and the value of their security (vehicle resale values) has fallen. While the Australian banks are a different kettle of fish to the average American auto leasing company, we suspect there’s a degree of risk in this business.

Making adjustments to the loan book is difficult. For

a start, the $361.3bn figure is net of $1.7bn in impairment charges already recognised by the bank. But we’d be inclined to anticipate some serious losses in the commercial portfolio.

These might arise from the bank’s exposure to the troubled New Zealand economy, or to the ailing property markets in New South Wales and certain sections of Queensland. That’s before considering the impact of any exposure to companies like A.B.C. Learning Centres or, perhaps, loans to precariously leveraged sectors like private equity, certain infrastructure funds or perhaps even hedge funds.

All things considered, we’re going to strip 3% off the $93.2bn commercial and industrial portfolio. We’re taking the same percentage off the credit card and leasing portfolios, which might be a little extreme but that allows us some leeway on the fact that we’ve let the mortgage book stand as is. All up, these adjustments will reduce the $361.3bn loan book by $3.2bn, taking it down to $358.1bn.

Other assetsWe needn’t worry too much about the $1.6bn of property,

plant and equipment—it’s all pretty standard stuff—but the next item down requires a little more scrutiny.

Commonwealth Bank carries almost $8.3bn of intangible assets on its books. Most of this ($6.7bn) is goodwill relating to its acquisition of Colonial back in June 2000. But there are some questionable items, such as computer software costs ($353m) and management fee rights ($311m), not to mention $110m listed under ‘Other’.

The auditors remain happy with the goodwill (which actually says something given the new tougher AIFRS accounting rules require annual ‘impairment testing’), so we’ll let that stand. But we can’t abide those capitalised software costs. We’ll also remove the ‘other’ and the ‘management fee rights’ just to be on the safe side. That brings our deductions to intangibles to almost $0.8bn.

With regard to the remaining $41.1bn of assets on the balance sheet, one point of interest is a $1.5bn asset relating to an overfunded defined-benefit superannuation scheme. We suspect some of that cushion has evaporated since 30 June. We’re going to adjust this pool of sundry assets down by $0.6bn, but prudence might suggest an even bigger markdown.

Adjusted totalAfter making all our deductions, we arrive at an

adjusted total asset figure of $479.6bn. Subtracting the stated total liabilities of $461.4bn lands us at net assets of $18.2bn, from which we need to subtract $0.5bn of minority interests. Our final figure, then, for Commonwealth’s adjusted book value is $17.7bn, or $13.34 per share. That’s some way below the $25.6bn (or $19.31 per share) that anyone accepting the accountants’ version of reality would be working with.

The bottom line on CBA’s balance sheet [ C ONTINUED FROM PAGE 5 ]


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As a rough cross-check, let’s compare our number with that arrived at by the bank’s regulator, the Australian Prudential Regulatory Authority (APRA). After making its own adjustments, APRA deemed Commonwealth’s ‘Fundamental tier one capital’ to be $23.8bn. This is the highest form of capital.

There are other forms of ‘residual tier one capital’ such as the PERLS income securities. Those securities might provide comfort for Commonwealth’s depositors and other creditors but we’re looking to APRA’s numbers for a guide to what ordinary shareholders might own, so we’ll exclude those.

The regulator then makes a number of hard-nosed deductions. These include all of Commonwealth’s goodwill, capitalised expenses, deferred tax and the superannuation plan surplus. It also applies discounts to a number of other assets, such as investments, and deducts a $587m safety buffer relating to the loan book (using more strenuous loss assumptions than the bank’s own boffins).

APRA’s ‘total tier one deductions’ come to $11.2bn. Subtracting these from the $23.8bn in ‘fundamental tier one capital’ leaves $12.6bn, or $9.50 per share. This is a rather austere assessment, but not a completely unreasonable one.

You can see from APRA’s adjustments and from our own the effect of so much gearing—how relatively small adjustments to a bank’s asset base can translate into very

large percentage adjustments to its shareholders’ equity, and hence to its intrinsic value.

Owning bank shares is not the same as owning Woolworths shares, for example. It would take quite a few years for Woolies to get into serious trouble, but a bank could easily manage it in weeks.

Worst enemyFrom our analysis, the major sources of danger for

Commonwealth are its corporate lending portfolio and its huge derivatives book. In relation to the lending portfolio, it’s the banker’s age-old worst enemy—bad loans—that should cause shareholders to lose sleep. On the derivatives front, problems could range from rogue traders to insolvent counterparties or improperly hedged positions.

Summing up the situation, it’s clear that a few surprises, or a sharp economic downturn (leading to higher defaults) could see Commonwealth in need of a capital infusion. This is especially so given that its high dividend payout ratio allows little room for manoeuvre.

Over the next fortnight we’ll present the second article in this series, which will be a conservative valuation of Commonwealth Bank shares.

Disclosure: Staff members own shares in Commonwealth Bank, but they don’t include the author, Greg Hoffman. First published 1 Oct 2008.

This article invokes time travelling bankers to highlight the way the industry has changed, and uses Westpac’s financial situation as a case study.

It’s not through lethargy or complacency that we’ve arrived at bland-looking ‘Hold’ recommendations on the big four banks. Our views arise from a raft of conflicting (and somewhat contentious) aspects.

In this article we’ll present the negative case, which explains why we haven’t had a positive recommendation on a retail bank since 2004 and why we’ve consistently recommended you limit your portfolio’s exposure to this sector to no more than 15%. Key points include higher leverage, the rampant growth of financial derivatives and the reliance of Australia’s retail banks on residential mortgage lending and the low level of risk they presume it entails.

Next issue we’ll look at the bull case which, in preview, is substantial. There’s plenty to be optimistic about: Fattening margins due to the banks’ enormous pricing power in the current environment; surging market share resulting from lower competition in areas like mortgage lending; consolidation through mergers; and government

deposit and funding guarantees. Firstly, though, we’re going to look down before we look up.

Historical perspectiveBack in the mid-1800s times were different for bankers:

‘The farmers usually wanted money before their clip or their crop was on the way to market and before they had the ideal security, a bill of exchange. The only security they could offer in return for a loan was their livestock or their land. But to English bankers they were unsound securities, for they could easily deteriorate by drought and could not quickly be sold if the bank suddenly wanted money. A bank could lend its own capital on such securities, but it was wrong to lend its depositors’ money: so said the English banker.’

So wrote Geoffrey Blainey in Gold and Paper: A history of The National Bank of Australasia. Reviewing those words, we wonder what a time travelling mid-1800s banker might have thought of Westpac’s balance sheet and loan book in 1989, just before Australia sank into its last official recession.

The bull and bear case for the banks

First published 26 Mar 2009

The bear case for the banks


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Examining the left hand side of Table 1 alongside his 1989 equivalent, our conservative banker would be shocked at the low level of cash and bullion backing—‘only 21.5% of shareholders’ funds!’ he might exclaim, ‘is this bank really sound?’

Table 1: Westpac balance sheet comparison ($m) 30 SEP 1989 30 SEP 2008

Assets

Cash (inc. bals at central banks) 397 4,809

Bullion 969 –

Due from other financial instit’ns 14,051 21,345

Trading securities 9,085 39,534

Investment securities 1,201 4,160

Derivative financial instruments – 34,810

Statutory/regulatory deposits 828 927

Loans & accept. (net of prov’ns) 71,656 313,545

Life insurance assets – 12,547

Other investments 204 –

Fixed assets 2,697 505

Other assets 7,531 4,377

Goodwill & other intangible assets – 2,989

TOTAL ASSETS 108,619 439,548

Liabilities

Deposits & other public borrowing 62,932 233,730

Bonds, notes & commercial paper 2,594 96,398

Acceptances 10,546 3,971

Due to other banks 13,343 15,861

Derivative financial instruments – 24,970

Trading & other financial liabilities – 16,689

Life insurance liabilities – 11,953

Other liabilities 10,165 7,486

Sub. & conv. notes, bonds & deb. 2,684 8,718

TOTAL LIABILITIES 102,264 419,776

SHAREHOLDERS’ EQUITY 6,355 19,772

Total Assets/Equity 17.1 22.2

Equity as % loans & acceptances 8.9% 6.3%

Deposits as % loans & acceptances 87.8% 74.5%

It would be a fair question given the events of the ensuing four years when Westpac proceeded to provision some $6.4bn for bad and doubtful debts—equivalent to its entire 1989 balance of shareholders’ funds. Spiralling bad debts eventually forced Westpac into its famous 1992 capital raising at $3 per share, almost 60% below its 1987 record share price.

Examining the 1989 loan book (see Table 2), we could only hope the banker didn’t have a weak heart. Almost one third of Westpac’s book resided in loans secured over property-related assets (either mortgages or construction loans). And, being a stickler for detail, our banker would

surely have spotted—and frowned upon—this footnote on page 86 of the 1989 annual report:

‘Some lending to borrowers in the commercial and financial sectors in Australia for the purpose of financing construction of real estate and land development projects cannot be separately identified from other lending to these borrowers given their conglomerate structure and activities. In these circumstances the loans have been included in the commercial and financial category.’

In other words, Westpac’s official exposure to property, significant as it was, was still understated in its annual report. As the property downturn unfolded, the bank provisioned some 8.9% of its total 1989 loans and acceptances in the following four financial years.

Now let’s use our time machine to bring both bankers into the present day. What might they make of the right hand side of Table 1, that is, the balance sheet published by Westpac as at 30 September 2008?

For a start, they’d surely note the sale of the bank’s bullion and a large portion of fixed assets (mostly the property the branches reside in). Even allowing for some changes in the business (such as life insurance assets and liabilities), they’d consider Westpac a more leveraged animal heading into this downturn.

Table 2: Westpac loan book comparison 1989 ($M) % 2008 ($M) %

Government & public 1,518 2.5 736 0.2authorities

Agriculture, forestry 1,830 3.0 9,916 3.1& fishing

Commercial & financial 24,802 40.1 64,388 20.4

Lease finance 4,927 8.0 – –

Instalment loans 8,704 14.1 11,393 3.6& other personal

Real estate—mortgage 15,758 25.5 171,390 54.3

Real estate—construction 4,351 7.0 4,752 1.5

Property – – 34,018 10.8

Property, business – – 16,081 5.1 & other services

Other – – 2,816 0.9

TOTAL GROSS LOANS 61,890 100.0 315,490 100.0

Total assets to shareholders’ equity (or ‘gross financial leverage’) was 30% higher in 2008, being 22.2 times compared to 17.1 times in 1989. And even taking a more precise measure of leverage—equity as a percentage of traditional banking assets (that is, loans and acceptances)—Westpac’s ratio in 2008 was almost 30% weaker, having fallen from 8.9% in 1989 to 6.3% in 2008.

Derivatives in the spotlightThen there’s the issue of financial derivatives—which

didn’t grace the 1989 balance sheet at all. With $34.8bn of derivative assets offset by $25bn of derivative liabilities,

The bear case for the banks [ C ONTINUED FROM PAGE 7 ]


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$9.8bn of the bank’s $19.8bn of shareholders’ equity (or 49%) is accounted for by derivative assets. These are often problematic to value and certainly a far cry from an asset like gold bullion.

So our 1989 banker might well be astounded by the shape of Westpac’s latest balance sheet (let alone his 19th century counterpart, who’s likely lying prostrate on the floor with smelling salts). The bank’s assets are plainly more leveraged than they were in 1989 and the nature of many of those assets is more ephemeral. But what of the loan book?

The result would be devastating if Westpac were to write off 8.9% of its loan book over the next four years, as it did in the four financial years from 1990 to 1993 (see Table 3). Taking 8.9% of Westpac’s $313.5bn of loans and acceptances as at 30 September 2008 would imply $27.9bn of provisions.

Even spread over four years, this would be debilitating for a bank with only $19.8bn of shareholders’ equity ($3bn of which is goodwill or other intangible assets). By comparison Westpac’s post-1989 provisions roughly equalled its 1989 shareholders’ equity. Today, the figure would exceed equity by 41%. That’s the downside of the same higher financial leverage which super charged the banks in the good times (hence the terrific returns shareholders enjoyed in the golden period from mid 1992 until late 2007).

Today’s banker, in her new ultra-modern office in Sydney’s Kent Street, would baulk at that calculation. ‘Some 54.3% of Westpac’s loan book is now accounted for by residential mortgages,’ she might object. ‘This is a low-risk business,’ the 2009 banker would explain, ‘our financial models show that even under stressed conditions—such as 13.4% interest rates and an 8.1% unemployment rate—we’re likely to lose only $201m on our $145bn Australian mortgage portfolio’. She may even brandish slide 73 of Westpac’s Investor Discussion Pack released in October last year to buttress her argument.

‘Hmmm...’ our bean counters from the past might muse, ‘this sounds almost too good to be true.’ For centuries bankers have sought the golden goose of low-risk yet lucrative loans. But the basic law of risk and return tends to preclude any such business model on a large scale.

Have modern Australian banks really broken the nexus between risk and reward? Have they genuinely hit upon a business model where they reap handsome profits from both fees and interest payments while bearing negligible risk? We suspect our 19th century banker would be sceptical, if not his late 20th century counterpart.

In last year’s special report, What’s your house really worth?, we put forward the argument that, on the whole, Australia’s residential property market is substantially overpriced. And we’re hardly on the lunatic fringe. Others to issue warnings include The Economist newspaper and the International Monetary Fund (see World Economic Outlook: Housing and the Business Cycle, April 2008).

Yet Westpac believes that a 20% fall in the housing market would result in it losing only $57m. And it’s not alone. Slide 105 of Commonwealth Bank’s half-year profit presentation declared that ‘under most stressed conditions, expected loss totals $331m = 3 months home loan net income’ (they are in the banking business, clearly, not the communication business).

Are risk models reliable?We stand aloof from the assumptions in the banks’

risk models (they aren’t disclosed and are likely too complex for ordinary humans to comprehend in any case). But to us and (we imagine) the bankers of yesteryear, it beggars belief that Australia could experience a severe decline in residential property prices and the banks emerge relatively unscathed.

Without examining the (presumably commercially confidential) models used by the banks, it’s difficult to know where any blind spots may lie. But having witnessed the chickens of Wall Street come home to roost on arcane risk models, we’re inclined to be sceptical rather than trusting.

To that end, a paper published in the University of Chicago’s Journal of Business in 2005 provides food for thought. Titled The Link between Default and Recovery Rates: Theory, Empirical Evidence, and Implications (Altman et al), it posits: ‘If the economy experiences a recession, [recovery rates] may decrease just as default rates tend to increase. This gives rise to a negative correlation between default rates and [recovery rates].’

Table 3: Key historical statistics for Westpac 1988 1989 1990 1991 1992 1993 1994

Net interest income ($m) 2,619 2,873 3,160 2,874 2,592 2,628 2,761

Prov. for bad & doubtful debts ($m) (275) (579) (1,192) (1,119) (2,802) (1,292) (695)

Non-interest income ($m) 1,273 1,570 1,681 1,743 1,756 1,841 1,555

Total operating income ($m) 3,617 3,864 3,649 3,498 1,546 3,177 3,621

Net profit/(loss) ($m) 693 801 684 476 (1,562) 39 705


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What if things don’t go wrong for the banks? In this review we step through some numbers which will help us estimate Westpac’s future profit under relatively benign conditions.

In part one of this analysis—The bear case for the banks—we travelled back in time and observed how banking has changed over the years. We focused on a detailed comparison of Westpac’s financials from the time of Australia’s last recession, compared to its current financial position. And we analysed what sort of impact an experience similar to that of the 1990s recession might have on Westpac.

In this review we’ll consider the other side of the coin—the arguments you’ll hear the bulls put forward. And there are some strong ones. We’ll pick up where we left off, with Westpac, and take a look at four important

ways it might be able to increase its profitability; growing its loan book, increasing lending margins, increasing non-lending income and reducing expenses. Finally, we’ll mix some of those bullish assumptions together and see what profits and the share price might look like in 2012.

Chart 1: 30 years of Australian credit growth (%)

The bear case for the banks [ C ONTINUED FROM PAGE 9 ]

Expectations misplacedMost risk models, the authors contend, base

expectations on long-run averages. But this is a mistake when problems become more widespread. The paper (itself an extension of an earlier report for the International Swaps and Derivatives Association) is focused on US corporate bonds but the relationship is an interesting and logical one.

Applying it to the Australian mortgage market, if repossessions surge and all banks are trying to liquidate properties at the same time, their own actions are likely to significantly depress the price of the very security they’re relying on to recover their loan. And if they’re counting on mortgage insurance to save their skins in a disaster scenario, perhaps they should think again.

A former CEO of a large insurance company once confided in us that ‘mortgage insurance is one of the stupidest kinds of insurance’. The problem is that no insurer could be sufficiently capitalised to pay out all claims in a severe financial storm. ‘Unlike in the real world, where you can adequately spread your risk over different events,’ our experienced observer explained, ‘in the financial world, too many variables tend to correlate when things go wrong.’

Something smells funnyWe can’t say categorically that Australia’s banks are

making grave errors in their risk modelling. But we can say that something smells funny when the most a bank thinks it can lose on a $145bn mortgage portfolio in stress is $201m, or 0.14% of the portfolio. In fact, it sounds eerily similar to the thinking in North America before its real estate collapse.

At the least, it’s sensible to countenance the possibility that the banks have underestimated the risks, or perhaps the correlation of certain economic and financial factors under extreme scenarios. That being the case, the recent rally in bank stocks may provide a great opportunity to revisit your portfolio’s weighting in this sector.

Share prices could halve (or worse)From their recent low points, the share price of each

of the big four banks has surged: ANZ by 42%, Commonwealth by 45%, National by 32% and Westpac by 36%. And even though they remain far below their high points of late 2007, it’s naive to believe that their prices can’t halve from here.

It doesn’t take much to imagine a further worsening of corporate bad debts, an Australian property rout leading to greater-than-expected mortgage losses or a huge derivatives explosion (perhaps triggered by the insolvency of a major multinational financial institution). Pile any one of those risks on top of balance sheets which have relied upon progressively higher levels of leverage, and the result would be catastrophic.

That’s the bear case. And if there weren’t any offsetting factors, we wouldn’t be recommending anyone hold even 15% of their portfolio in these stocks. But there are countervailing arguments, important positive factors and many future paths which could lead to the banks doing very well from here. And that will be the topic at hand next issue.

Disclosure: Staff members own shares in ANZ, CBA and WBC but they don’t include the author, Greg Hoffman. First published online 26 Mar 2009.

First published 9 Apr 2009

The bull case for the banks


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Let’s start with total loans and acceptances (or the ‘loan book’ to use the jargon).

Chart 1 plots more than 30 years of Australian credit growth. Since the mid-1990s, rarely has this country’s credit growth ticked below 10% on an annual basis. Today it is rapidly plunging, with the reading for February below 6% growth.

A backdrop of slowing system credit growth makes it difficult for the big banks to grow their loan books strongly. And it’s from this base that a bank generates interest income.

In our projections, we’ve assumed Westpac can grow its loan book (including St George) by 6% per year through to 2012. That compares to annual growth (excluding St George) of 9.3% since 1987 and 12.6% since 1999. But that doesn’t make it a particularly conservative assumption.

For perspective, Westpac’s loan book shrank from $78.9bn in 1990 to $76.0bn in 1995—the result of bad loans written off over that period and system credit growth which averaged a little over 4% per year. But we’re trying to formulate a (realistic) bull case here, so we’ll plump for 6% annual growth in the loan book from 30 September 2008 through to the same point in 2012. Suffice it to say that— absent a sudden inflation surge—we don’t think robust credit growth is the strongest argument on the bull side.

The knights who say ‘NIM’Net interest margins are another story. This is the

spread between what a bank collects from its loan book and the interest it pays to depositors and lenders. And it’s an area where the big banks have a better than even chance of pleasantly surprising their shareholders.

When competition was hot, the banks’ net interest margins (NIMs) shrank almost every year. You can see the result for Westpac in Chart 2. It shows a fat NIM of 4.78% in 1987 being whittled down to a low 2.29% in 2007.

Chart 2: Westpac’s historical net interest margin (%)

So will the future look anything like the past 20 years, with continually shrinking NIMs for the banks? We don’t believe so, due to the interplay between two key factors: increased market share and an accommodating central bank.

Foreign banks have been scaling back their Australian operations and several non-bank lenders dependent upon wholesale funding have been stopped in their tracks. Not content with that, the majors have turned the screws even further through mergers and acquisitions.

Commonwealth Bank stole BankWest from an embattled HBOS late last year and also picked up a stake in Aussie Home Loans, which in turn had acquired the Wizard brand. Westpac snaffled both St George and RAMS Home Loans, while ANZ came close to buying Suncorp’s banking operations last year (before the government guarantee delivered a reprieve to the Queensland group).

As pointed out in our review of Mortgage Choice (see page 9), the big four banks now control 83% of the mortgage market, up from just 60% a year ago. The only thing holding the banks back is that their funding costs, the netting part of the net interest margin, are also on the rise.

But there is also positive news on that front. Chart 3 shows that retail deposits are Westpac’s largest source of funding. And, in October last year, the Australian federal government moved to guarantee retail bank deposits. As part of the same ‘Guarantee Scheme’ it also offered an arrangement to guarantee wholesale funding. This move was a coup for the banks, lending them the taxpayers’ collective credit rating.

Chart 3: Funding composition by contractual maturity

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Twenty years ago, retail deposits made up a much higher percentage of Westpac’s funding than the 52% they do today. And, just two years ago, it would have been a walk in the park for a well-rated bank like Westpac to fund much of the gap between its deposits and loans in short term inter-bank money markets. But those markets have experienced violent swings since the credit crisis began. Banks have become less trustful of one another—fearful that even an overnight loan to some institutions might be at risk—and the cost of borrowing in wholesale markets has soared.In this situation, the government’s wholesale funding guarantee assisted greatly. Since 28 November, for a fee, the banks have been able to issue bonds and other securities to wholesale investors with the federal government’s financial imprimatur.

Credit flows more freelyWhile frost covered the ground of credit, Australian

banks managed their funding requirements in two ways. The first was by raising additional equity and debt capital from shareholders (such as the Westpac SPS II offer). The


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second, and more common, alternative was issuing swathes of bonds in the wholesale market under the auspices of the government guarantee.

In a sign that more ‘normal’ conditions might be returning to credit markets, this week Commonwealth Bank announced the first significant wholesale bond issue in Australia without the government guarantee since the scheme was introduced. If this trend continues, the increasing flow of credit would be a positive for the banks.

So there are glimmers that the pressure on the banks’ cost of funds is easing a little. But even if it doesn’t, the banks have shown that their now dominant market shares are allowing them to pass all of the increased costs through to their customers, and then some.

Net effect: customers wear the painHaving bulked up through this period of turmoil (with

the grudging support of the Australian Competition & Consumer Commission), the big banks really began flexing their market share muscle in the second half of 2008. Despite higher funding costs, NIMs began rising, and we expect that trend to continue for at least the remainder of 2009.

Westpac’s numbers illustrate the importance of this point. The bank’s 5 basis point (0.05%) increase in net interest margin in the six months to 30 September 2008 might look negligible, but apply it across Westpac’s $434bn loan book (including St George) and you’re looking at an additional $217m in annualised pre-tax profit from this slight-looking margin improvement. Working that through after tax adds more than five cents to Westpac’s earnings per share.

Lower interest ratesThe Reserve Bank (RBA) set the scene for this display

of market power by slashing official rates from 7.25% in August last year to 3.00% currently. That allowed the banks to gouge higher margins without looking completely rapacious.

Chart 4: Official cash rate—RBA to the rescue!

The latest 25 basis point (0.25%) rate cut serves as an example. Commonwealth Bank drew consumer advocacy and political fire for only passing on 10 basis points of the cut to mortgage borrowers. But when the RBA cuts by

100 basis points—as it did in October, December and February—and the banks only pass on 80, everyone seems content (except the savers, of course).

So when it comes to estimating future NIMs, we need to balance higher wholesale funding costs (and make a call as to the timing and extent of any easing in the current tight conditions) against increased market dominance and the ability to not pass through rate cuts to borrowers in full.

In our numbers, we’ve assumed Westpac’s NIM stabilises around 2.4% over the coming years. But this is a critical assumption and an area where we hold some hope for positive surprises, which would see profits rise markedly (although the banks will presumably need to temper their urge to increase margins given the risk of Government backlash). It’s a strong point for the bull argument.

Non-interest incomeNon-interest income is the next item on our agenda.

This is a mélange of fees, commissions and income from trading, wealth management, insurance and ‘other’ sources. It’s grown at 6.7% annually over the past 21 years and 7.8% annually since 1999, though both figures are boosted by the acquisition of BT Financial Group in 2002.

We’ve assumed a more subdued (though not overly conservative) growth rate of 4% for 2009 and 2010, rising to 6% growth in 2011 and 2012. Although this is lower than historical growth rates, Westpac’s funds management operations will report substantially lower revenues this year and lower loan book growth will likely translate to fewer loan applications (and associated fees).

ExpensesTo estimate expenses, we turn to the ‘cost to income

ratio’. Westpac’s total operating expenses (costs) totalled some 46.1% of operating income in 2008, up from 44.7% in 2007. But the St George acquisition should see this ratio come down substantially. In fact, CEO Gail Kelly believes the combined group can get to a ‘sub 40%’ cost-to-income ratio.

This seems eminently achievable and is another key area where the bull case is strong. The banks have a great record of squeezing efficiencies from technological progress—think ATMs, phone banking and, more recently, internet banking. In our bullish projections we’ve assumed a 42% cost-to-income ratio in 2009, heading progressively lower, to 37% in 2012. But even lower numbers are possible.

‘Impairment expenses’ or, more plainly, ‘bad debts’, are the second important component of expenses. This is the area where most of the differences of opinion arise between the bulls and the bears. No one can argue that the changes in the competitive landscape aren’t a huge positive for the banks. The only argument is over how much damage has already been done and how much capital it will take to replace money lost on loans made in the boom times.

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Being the bull case, we’ve assumed that 2009 is the peak year for bad debts in this credit cycle, representing 0.55% of year-end total loans and acceptances. We’ve then stepped this percentage down to 0.3% in 2012.

Bringing it all togetherTable 1 shows how all of this comes together. After

totting up the results of our assumptions for income and expenses, we’ve applied a 30% tax rate to estimate net profit out to 2012. We’ve then divided that by an estimated number of shares outstanding to arrive at projected earnings per share (EPS) figures.

From the EPS figures, we’ve estimated dividends per share by applying a hefty 75% payout ratio (prudence would suggest a lower figure). You can see the resulting PERs and dividend yields based on today’s price in Table 1.

So how do these relatively—though not supremely—optimistic numbers stack up against the risks discussed last issue (and in previous features such as Is your bank going broke? and Do you own too many banks?)?

If bad debts expenses are kept under control, it’s easy to imagine Westpac generating EPS of $2.28, and the share price well in excess of $27 in 2012. That would provide a capital gain of 35% over the next three and a half years, or 9% per year, plus dividends. Adding dividends, the return moves into the 15% per year ballpark.

That sounds attractive for a dominant, government-protected business. But when weighing up the bull and bear cases, we lean to the bear side. Our opinion is that 2009 will not be the worst year for bad debts and, despite the potential upside, a less-than-average portfolio weighting of 15% in the sector remains our preferred

position. If bank holdings total more than 15% of your portfolio, you should consider this a Sell recommendation down to that level.

Income portfolio leading by exampleThe Westpac shares held in our Income

portfolio were purchased in 2001 at $13.49 and have served their purpose admirably. But the portfolio’s sector weighting (including the Commonwealth Bank position) has shot up in the recent rally to more than 20% of the invested portfolio. We’re taking advantage of this bout of euphoria to halve the Income portfolio’s stake in Westpac by selling 371 shares at $20.00 each. We’ll consider where to redeploy the cash in coming weeks.

Disclosure: Staff members own shares in the big four banks, but not the author, Greg Hoffman. First published 9 Apr 09.

Table 1: How the bullish assumptions play out 2009 2010 2011 2012 (IN MILLIONS EXCEPT PER SHARE DATA)

Loans & acceptances ($) 460,040 487,642 516,901 547,915

Net interest income ($) 11,041.0 11,703.4 12,405.6 13,150.0

Non-interest income ($) 4,365.9 4,540.6 4,813.0 5,101.8

Operating expenses ($) 6,470.9 6,335.2 6,543.1 6,753.1

Impairment charges ($) 2,530.2 1,950.6 1,809.2 1,643.7

Tax ($) 1,921.7 2,387.5 2,659.9 2,956.5

Net profit/(loss) ($) 4,484.0 5,570.8 6,206.5 6,898.4

Shares on issue 2,939.1 2,968.5 2,998.2 3,028.2(growth at 1%p.a.)

EPS ($) 1.53 1.88 2.07 2.28

DPS ($) 1.14 1.41 1.55 1.71

PER on 2009 price (x) 13.1 10.7 9.7 8.8

Yield on 2009 price (%) 5.7 7.0 7.8 8.5

Banking—A brief retrospective of trust

‘Imagine, for a second, how fi nance began, with small loans within families and between trusted friends. As the circle

of lenders and borrowers grew, fi nancial transactions were able to muster larger sums and to spread risk, even as

promises became harder to enforce. Paul Seabright, an economist at the University of Toulouse in France, observes that

trust in a modern economy has evolved to the miraculous point where people give complete strangers sums of money

they would not dream of entrusting to their next-door neighbours. From that a further miracle follows, for trust is what

raises the billions of dollars that fund modern industry. ’ The Economist: A special report on the future of fi nance, 24

January, 2009.

‘Let us possess the public confi dence so long only as, by a faithful discharge of the honourable trust reposed in us, we

may show ourselves worthy of it. Whenever any one man may say with truth “the bank has broken faith with us”, be then

our ruin, and ours only, the immediate consequence.’—Inscription on early bank notes issued by the Bank of New South

Wales. From Westpac: The bank that broke the bank by Edna Carew.


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First published 29 Jan 2008

Danger lurks in the banking sector

First published 21 Jun 2006

Is your bank going broke?

Banking remains a cyclical industry but the length of the most recent upswing has lulled many investors into thinking it isn’t. And that’s positively dangerous.

As it was with his predecessors, the new PM has a plan to fight inflation. We wish him luck—the only solution to the problem is one his constituents won’t like.

For all the talk of commodity prices and the price of fuel, fruit and vegetables, the problem is actually quite simple. People are borrowing too much money, and when there is too much money chasing too few goods, prices rise.

As we said in the first feature of last year, Dear Glenn, you have a problem, the Reserve Bank tries to control how much we borrow, and thereby inflation, by adjusting interest rates. Debt-addicted consumers aren’t particularly price conscious but the Reserve Bank board has made it perfectly clear that it is going to do whatever it needs to do to slow credit growth. And that’s bad news for the banks.

The first, and most obvious, problem is that as credit growth slows, bank revenue growth also slows. Secondly, and more importantly, as credit growth slows loan defaults increase. Both of these factors can be seen at work in the graph to the right. Notice how big bank profits declined as credit growth fell in the early nineties and then rose as the credit boom expanded thereafter.

Banks are in the business of managing risk, but we think investors are underestimating the risks being taken.

What are the chances of an Australian bank going broke in the next ten years? The mere suggestion might seem preposterous, but it was only a decade and a half ago that a number of smaller financial institutions went belly up and Westpac was leaning over the precipice.

The evidence we have may only be anecdotal, but we’re willing to wager that the number of people meeting their debt repayments by borrowing more is large, and getting larger. It’s one of those strategies that works until it doesn’t.

Profiting from the credit boom

After 16 years of mostly consistent profit growth it’s easy to believe otherwise, but banking remains a cyclical industry. And, while it’s impossible to know where the top is, we’re certainly not at the bottom. We’ve been recommending that the big banks constitute no more than 15% of your portfolio for a number of years now and, if anything, that argument is strengthening. We won’t be revising it until we see the cycle turn.

Steve Johnson

The banks have had it very good for a very long time, with a cocktail of unbroken economic growth, low unemployment and low interest rates producing double-digit loan growth and few bad debts. But the credit cycle will turn at some point and, when it does, some banks may be found wanting. The question is, which ones?

Well to begin with, we should say that it’s unlikely that any of the Australian banks—particularly the majors—

From the archives

Comparative informationCOMPANY ASX CODE PRICE AT REVIEW FUNDAMENTAL RISK SHARE PRICE RISK OUR VIEW AT THE TIME

Adelaide Bank ADB $13.12 3 3.5 Take Part Profits

ANZ Bank ANZ $25.29 2 2.5 Hold

Bendigo and Adelaide Bank BEN $12.50 2.5 3.5 Hold

Bank Of Queensland BOQ $13.55 3.5 4 Sell

Commonwealth Bank CBA $41.40 2 2.5 Hold

National Australia Bank NAB $33.33 2.5 3 Hold

St George Bank SGB $28.06 3 3.5 Take Part Profits

Westpac WBC $21.85 2 3 Hold


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will actually go broke. It is, however, quite possible that one might find itself in such a precarious position that it’s forced to recapitalise or submit to a takeover by a rival at a substantially discounted level.

The recapitalisation route was the one taken by Westpac in the early 1990s, when it was forced to raise $1.2bn at $3 a share. And that seemingly low price wasn’t the nadir. The stock eventually hit $2.40, or roughly half its price of three years earlier.

Capital bufferTo protect those with whom it does business, a bank

is required to maintain a buffer between its assets and liabilities, in the form of the capital that certain stakeholders, primarily shareholders, have at risk. The required level of buffer is set as a percentage of the bank’s risk-weighted assets (RWA). The regulator, the Australian Prudential Regulation Authority (APRA), categorises a bank’s assets (generally speaking the loans it makes) and determines how much of each asset will be counted for the purposes of RWA. For example, most housing loans are weighted at only 50% of their face value.

The regulator deems an appropriate level of capital that must be held in relation to a bank’s total RWA. And, like assets, not all capital is created equal. The most important slice of a bank’s capital is known as ‘tier one’. If the bank were to blow up this amount, it would be insolvent. The tier one capital for each of the banks is listed below in Table 1.

As you can see, there are some hefty amounts involved—hence our view that it’s unlikely that an Australian bank will actually go broke. The more relevant figure is the buffer between the amount of tier one capital actually held and the minimum stipulated by APRA, based on our estimations. If a bank were to lose this amount, then it would need to raise more capital in short order and shareholders would most likely see the value of their investment fall significantly. So how exactly might the banks lose such sums?

Game of riskThe banking game is all about risk: the taking of risk;

the laying-off of risk; the measurement of risk; and, perhaps most importantly, the appropriate pricing of risk. For the purposes of this review, we’ve lumped the risks into two main categories: credit risk and operational/market risk.

Credit risk refers to the possibility that the money a bank lends out won’t get repaid. This is the basis for one

of the most critical trade-offs in banking: if a bank’s lending criteria are too tight, then it won’t make many loans and it therefore won’t make much profit; but if the lending criteria are too lax, then it will make a lot of loans, but too many of them will end up being written off.

Operational risk refers to the danger of a bank making a stuff-up in its general operations. This can range from employee fraud to the incorrect calculation of interest, forcing a bank to reimburse depositors. We’ve combined this with market risk, which is the possibility of a bank making losses on the various financial securities it holds. Let’s look more closely at the different categories.

Credit riskOne of the few benefits of the banks almost self-

destructing in the early 1990s is that they are unlikely to repeat the exact same mistakes. In those dark days it was the banks’ high exposure to particular areas—mainly property developers—that almost sent them to the wall. Following that experience, the banking boffins have introduced sophisticated statistical models that limit their lending exposure to any particular industry.

But this sounds a little like the man who wanted to know where he was going to die so that he might never go there. Although these models should ensure the banks won’t get into exactly the same troubles as in the past, they will no doubt find entirely new ways to trip themselves up. It wouldn’t be a great surprise, for example, to see problems appearing with recent innovations such

as margin lending, and low-documentation and no-deposit mortgages.

One of our greatest concerns is with residential property lending. The national economy is operating on two levels at the moment, with resource-rich states powering ahead while the more populous states of Victoria and New South Wales lag behind. The NSW property market is dominated by Sydney, a market that gathered a fulsome head of speculative steam a few years ago and has since come off the boil. According to figures from the Australian Bureau of Statistics, the NSW market has already fallen 7% and, with the state’s economy under pressure, there is plenty of scope for further declines.

This is a concern for banks such as St George and Westpac (the former Bank of New South Wales), which have deep roots in the state. Despite attempts to diversify into other states, both banks—and especially

Table 1: Capital ratios COMPANY TIER 1 CAPITAL RWA TIER 1 % OF RWA ESTIMATED MIN. % ESTIMATED MIN. CAPITAL CAPITAL BUFFER

Adelaide Bank $538m $8,059m 6.68% 6.00% $484m $54m

ANZ $15,811m $230,653m 6.85% 6.00% $13,839m $1,972m

Bank of Queensland $658m $7,705m 8.53% 7.00% $539m $118m

Bendio Bank $640m $8,014m 7.98% 7.00% $561m $79m

Commonwealth Bank $15,290m $202,667m 7.54% 6.00% $12,160m $3,130m

National Australia Bank $24,311m $301,824m 8.05% 7.00% $21,128m $3,183m

St George $3,458m $50,955m 6.79% 6.00% $3,057m $401m

Westpac $12,327m $181,823m 6.78% 6.00% $10,909m $1,418m

[ CONTINUED ON PAGE 16


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St George—have a disproportionate concentration of home loans in NSW.

Low-doc lendingAnother major concern in the property market relates

to the rapid increase in new lending products such as low-documentation (‘low-doc’) loans. It seems that just as the risk of defaults in the property mortgage market are increasing, the credit policies for this sector are declining.

We discussed our concerns with low-doc lending in our review of Adelaide Bank in issue 181/Aug 05 (Take Part Profits—$12.35). Surveys have found that many of the borrowers involved are either understating the income they report to the tax office or overstating their income to the lender for the purposes of securing the loan.

It’s the latter that’s a worry for the banks. It’s bad news when the bloke to whom you’ve just lent half a million dollars, on the basis of his earning $150,000 a year as a self-employed businessman, turns out to be earning only a third of that amount and is paying child support for three kids.

Recent research indicates that low-doc loans experience default rates of about two and a half times the level for normal mortgages. And those figures are based on a benign economy and property market. If the economy took a turn for the worse, this ratio would surely blow out further.

There’s nothing inherently wrong with offering a higher-risk product, of course, as long as it’s priced appropriately. The problem is that the premium the banks currently get for these loans is negligible, and sometimes non-existent.

The regional banks were the pioneers of this type of loan, so it’s no surprise that they’re the ones most heavily involved. Adelaide Bank has 31% of its portfolio in low-doc loans, but St George and Bank of Queensland also have large exposures. This is a key reason behind our negative view of Adelaide bank and our downgrade of St George.

Aggressive growthAnother concerning trait displayed by some banks is

the aggressive pursuit of market share. Banking history has proved that it’s very hard to increase lending more quickly than general economic growth, without sacrificing loan quality. This is a lesson that Bank of Western Australia learned painfully just a few years ago.

Again, it is mainly the smaller banks that are the culprits in this regard. Bank of Queensland, Bendigo Bank and Adelaide Bank are all trying to establish markets outside their home states and are growing their loan books much faster than the majors. From a strategic perspective, the smaller banks probably feel compelled to ‘achieve scale’ and ‘remain competitive against the majors’. But it’s a strategy that involves taking extra risk and it leaves these banks susceptible to credit problems.

Self-insurance is no insuranceIn order to gain the 50% RWA concession for housing

loans mentioned earlier, a bank can’t lend more than

80% (60% for low-doc loans) of the value of a property without the loan being covered by insurance. So, if a homebuyer wanted to purchase a property for $500,000, then the bank could only lend $400,000 if it wanted to maintain the concessional treatment of the loan (which it almost certainly would).

Relatively few homebuyers these days have a $100,000 deposit for their home, though, so insurance is increasingly being used to bridge the gap. The way it works is that, at the outset of a loan, the borrower is required to pay a single premium on behalf of the lender, to pay for insurance covering the latter against a shortfall in the payments of interest or principal on the loan.

For the last decade, providing this type of insurance has been one of the most profitable games in town. With such a buoyant economy, defaults have been few and far between and, where they’ve occurred, rising property prices have prevented a loss. But of course there’s a systemic element to all of this and, like Henry Longfellow’s little girl, when the mortgage insurance market is good, it is very, very good, but when it is bad, it is horrid.

Some of the banks have decided they want a piece of this action and have started to ‘self-insure’ their loans. We think the term ‘self-insure’ must have been devised by a particularly creative public relations consultant. It came to the fore in the banking industry when National Australia Bank announced that one of its Irish banks had been defrauded of $50m. When asked who would wear the loss, the bank explained that it was ‘self-insured’ rather than simply admitting that it had no insurance.

The banks that ‘self-insure’ their loans are effectively selling their 20% buffer for an upfront premium, and it may come back to bite them. Of course, ‘self-insured’ mortgages aren’t being effectively insured and you might wonder why APRA would therefore allow such mortgages its RWA concession. As it happens, APRA seems to be wondering the same thing and last year it proposed changes to tighten up the regulations.

In the meantime, the banks that are ‘self-insuring’ mortgages are increasing their risk, and we would suggest that it’s for relatively meagre rewards. St George is most heavily involved, but ANZ and Westpac also have exposures.

Aside from this issue of self-insurance, and considering again the systemic nature of mortgage risks, there is also the question of how third-party insurers might cope if there was a major collapse in property prices. If they failed to pay up, then the risks would fall back on the banks. This is an example of counterparty risk—something we look at further a little later.

Margin lendingThe final area where we can see potential future credit

problems is in margin lending. This is where the banks provide loans secured against a share portfolio. As with mortgage lending, this has been highly profitable while the sharemarket has been booming, but things could unravel quickly if there was a sharp decline.



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This shouldn’t be a problem, though, so long as the banks don’t allow the margin loans to make up too much of their overall loan book. There is only one bank where we think this is the case: Adelaide Bank has about 16% of its loans tied up in this form of lending, and this is another red flag for the South Australian bank.

Table 2: Risky business RISK AREA BANKS AT RISK

NSW property market St George, Westpac

Low-doc lending Adelaide Bank, St George, Bank of Qld

Self-insured mortgages St George, Westpac, ANZ

Aggressive growth Bank of Qld, Adelaide Bank, Bendigo

Margin lending Adelaide Bank

All the banks are exposed to credit risks, because that’s the nature of banking, but we’re particularly nervous about Adelaide Bank and St George. Table 2 shows which banks are most exposed to the different risks.Trigger event

It’s important to remember that we’re looking at this from the perspective of what could go wrong, not necessarily what will go wrong. But investing is a balance of risk against reward, so it’s important to understand all the dangers.

Rising interest rates would make life harder for the property market, but it would take more than a small increase in rates to cause a rash of mortgage defaults. Unemployment is the real worry. If your income disappears then you have to start making mortgage repayments out of your savings and, for most people, there’s only so long that can go on—particularly if you also happen to have a margin loan and the sharemarket takes a big hit.

A combination of higher interest rates and increasing unemployment could well trigger a dramatic slide in property prices. And with prices soaring in recent years, the banks are highly susceptible to any downturn. A more propitious scenario would see the economy remaining steady while property prices stabilised. Only time will tell which situation will eventuate, but it is worth keeping an eye on the key economic indicators of unemployment, inflation and official interest rates.

Operational/market riskRelatively small losses from operational risks such as

employee theft occur frequently in banking (the case of the manager of a Commonwealth Bank branch in Western Australia stealing more than $20m to bet through IASBet is a recent example). But it is trading room incidents that have the potential to cause real damage. The most striking Australian example is NAB’s rogue traders. This matter has been back in the press recently as the culprits face court proceedings for inflating profits by $42m.

You may remember, however, that when this incident occurred the bank reported losses of $360m. So, if the traders were only responsible for $42m, where did the other $318m go? The answer is that the lion’s share of it—$175m—arose on the revaluation of the trading

book. And it’s here that operational risk comes face to face with market risk.

Zero sum gameNAB’s traders were betting on risky currency contracts

on behalf of NAB itself rather than its clients. Trading of this nature is a zero sum game. Like a game of poker, one party’s profit is another’s loss. When you throw in transaction fees, being the cost of employing well-paid traders and operating sophisticated trading rooms, these deals actually result in a net loss for the parties involved. So if all the big banks are involved in this ‘proprietary’ options trading and they all expect their traders to bring home a profit, you have to wonder who is wearing the losses. In late 2003, it was NAB.

To make matters worse, it can be hard to determine just how profitable (or unprofitable) these trading activities are. Each of the thousands of transactions the banks enter into is revalued on a daily basis. But, for some complex transactions, there is no reliable market price.

These ‘over-the-counter’ (OTC) contracts are revalued using assorted assumptions. And it hasn’t been unusual for the two parties involved to use different assumptions—allowing both sides to show a profit ‘in the run’, that is, before the contract comes to an end.

When NAB went through and reviewed all its trading contracts, it discovered that the new, more conservative assumptions meant that many of the OTC contracts weren’t as profitable as they had appeared. This led to the additional writedowns.

Really bad daySo the big question is what hidden disasters remain

on the trading books of Australia’s banks? Unfortunately, the short answer is that there’s no way of telling without actually going in and reviewing all the contracts. There is, however, one figure the banks quote that gives an indication that there may be out-of-control traders on deck. It’s known as ‘value at risk’ (VAR).

Whilst it’s not the technical definition, VAR has been summed up nicely by The Economist magazine as the amount a bank could lose ‘on a really bad (but not really, really, really bad) day’.

Basically, VAR is a statistical measure that calculates how much money a bank could expect to lose on its trading book at a certain confidence level. Australian banks typically express these amounts at a 99% confidence level, so the VAR quoted in their financial reports is the expected maximum extent of their losses on 99 days out of 100.

So, on average, a couple of days a year, they will lose more than this amount. And it’s that ‘wild card’ figure that is the real concern. The chances are that not even the banks themselves would be able to predict the maximum possible loss were a ‘left-field’ event suddenly to strike financial markets.

It’s always easy in hindsight, but a review of the VAR figures for the trading desks of the big four banks for the 2003 financial year shows that NAB was easily the biggest player in this area. This fact was reinforced by the 2004


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figure (which encompasses the trading period for the rogue traders) which showed the VAR increasing to a maximum of $55m during the year.

Table 3 shows the average VAR for the big four banks during the 2003 and 2005 financial years. It shows that, after having an average VAR of almost five times its nearest competitor in 2003, NAB is coming back to the pack. While NAB’s problems are fresh in the banks’ minds, traders are likely to remain under strict scrutiny. But we’re concerned about the proliferation of complex derivative contracts in global financial markets.

Table 3: Value at risk BIG 4 BANKS AVERAGE VAR 2003 2005

ANZ $1.7m $2.2m

Commonwealth $4.6m $11.3m

National Aus. Bank $22.0m $14.0m

Westpac $4.8m $7.7m

Contagion riskAnother risk the banks face in relation to their trading

activities is counterparty risk. The whole world of derivative contracts is based on the premise that, if you a make a profit on a contract, the other party has the money to pay up. But what if it doesn’t?

The doomsday scenario for counterparty risk is that a default by an obscure bank sets off a chain reaction that knocks over financial institutions around the world. Let’s say an Italian company goes to the wall and puts a major European bank under pressure. That bank can’t meet some sizeable trading losses it has accrued and defaults on those contracts. Several of those contracts are with a major American bank which is already struggling under the weight of a property market correction. That bank then goes to the wall and defaults on a number of large transactions it has in place with a major Australian bank. The Aussie bank is struggling with mortgage and credit card defaults and suddenly finds itself under pressure—and all because of a profligate company in the far-off land of spaghetti and pizza.

This is known as ‘contagion risk’ and, while it might seem far-fetched, it wasn’t all that long ago that the US Federal Reserve intervened in the collapse of hedge fund Long Term Capital Management, because of the destabilising effect it would otherwise have had on the US (not to mention global) financial system. As the global economy becomes more integrated, the contagion risk for financial institutions grows larger.

Once again, this risk is hard to measure. The bigger banks with their large trading desks are more exposed than the regionals but, if the doomsday scenario were to hit, there’s no telling where the problems might surface.

To sum upThe Australian banks have many economic positives.

But we feel they’re a riskier proposition than most investors seem to think, and this prevents us from bestowing any of

them with a buy recommendation. With a few exceptions, though, we still think they’re worth holding—although we’d suggest that you make sure you don’t hold more than about 15% of your portfolio in this sector.

Going back to our original question, we think St George is probably the most exposed of the larger banks to a financial shock. Although it doesn’t have as much exposure to trading activities as the big four, its decision to self-insure a high portion of its mortgage portfolio is a concern. We respect Gail Kelly and her team, but this issue sits uneasily alongside St George’s premium stock price, and we’re downgrading the bank to TAKE PART PROFITS.

Of the four big banks, NAB still probably faces the greatest risk. After the litany of disasters it has been through, it will still require a few more trouble-free years before we’re convinced the mess has been totally cleaned up. We’re also somewhat surprised by the risks that Westpac seems to be taking on. The bank has been one of our favourites for some time, partly because of the good sense that chief executive David Morgan continually preaches about lending risk. Yet Westpac has one of the highest levels of VAR, self-insures part of its mortgage book and has recently decided to accept housing loans without insurance up to a loan-to-valuation ratio of 85%. We’re not hitting the panic buttons just yet, but our eyebrows are slightly raised. For now, each of the four majors remains a HOLD.

As for the regionals, Adelaide Bank looks the most susceptible to a shock, with its high percentage of low-doc loans, above average credit growth and high exposure to margin lending. We also re-emphasise our long-running (and so far misplaced) negative view of Bank of Queensland. Its aggressive push beyond its traditional borders raises the risks to a level not compensated by its extravagant share price.

Disclosure: The author of this article, Brad Newcombe, owns shares in Westpac. First published 21 Jun 06.

HORSE SENSE—Warren Buffett: —‘In the end

banking is a very good business unless you do

dumb things. You get your money extraordinarily

cheap and you don't have to do dumb things. But

periodically banks do it, and they do it as a fl ock,

like international loans in the 80s. You don't have to

be a rocket scientist when your raw material cost is

less than 1–1/2%.’

From a recent interview with CNNMoney.com.



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First published 6 Jul 2004

Do you own too many banks?The big banks have rewarded their shareholders handsomely since their difficulties a dozen years ago. Can the party continue?

The big banks have rewarded their shareholders handsomely since their difficulties a dozen years ago. Can the party continue? You’ve held them for years. They’re probably among your most successful investments ever and they may well represent a large portion of your portfolio. We’re talking about bank shares.

Since the troubles of the early 1990s, the big banks have performed spectacularly, providing regular, rising dividends and tremendous capital gains. That’s why this article’s title question may well be relevant to you. Are Australian banks the ultimate buy-and-hold investments or is there a time to sell? And, if the answer to that last question is yes, is now an appropriate time to do so?

In our search for an answer, let’s first examine the factors behind the banks’ dozen years of success and then consider the arguments for and against bank stocks in mid-2004. The first factor, and in our view the most significant, was the trend towards lower interest rates. For those with variable rate (or ‘floating’) mortgages, lower interest rates equated to lower interest payments. This soothed the debt burden on countless borrowers, which meant fewer defaults, making banks that much more profitable. Falling rates also tend to lead to higher asset prices (see Shoptalk on page 20). In essence, while lower interest rates make tomorrow’s dollars more valuable, higher interest rates make them less so. This has implications for buyers of all assets, including property.

The property market, in turn, has important flow-on effects for the banks. Let’s take the example of an investor who, in 1990, borrowed $200,000 on a variable rate mortgage to buy an investment unit. As interest rates dived over the following decade, the loan became much easier to repay. That’s one plus for the local banker. It’s difficult to default on a loan that is getting easier to repay. But there’s another benefit.

40 years of interest rates (10 year bonds)

As falling interest rates equate to rising asset prices, including those of houses and units, even if our fictitious borrower were to default on their loan after, say, two or three years, there’s every chance that the property has risen in value in the meantime. So, when the bank comes to dispose of it, it should recoup the balance of its initial loan.

Let’s now invert the scenario. If interest rates were to rise substantially, today’s low-rate borrower would find mortgage repayments a growing burden. And, were they to default, the bank may find that the loan’s security proves to be a mirage. Instead of the dual benefit provided by falling rates, rising rates could inflict a double dose of bad news on the banks. Anyone who remembers the ‘negative equity’ media headlines of the early 1990s would have seen this phenomenon play out in practice. Back then, many unfortunate borrowers were caught in the situation of owing more to the bank than their property was worth and the banks were in big trouble, too.

Big cyclesWhat, then, are the chances of rates rising substantially?

As the graph above shows, interest rates tend to move in big, long cycles. The period from the early 1960s through to the early 1980s saw long-term interest rates rise from less than 5% to more than 16%. And it could happen again. Two decades of savage interest rate rises would be a nightmare for today’s highly-geared property investor and, as a consequence, today’s profit-hungry banks, especially with housing loans constituting more than 50% of their total lending books. In industry jargon, defaults would soar and recovery rates would plummet.

If we could say for sure that the property market is heading for catastrophe, we’d have no hesitation in recommending you sell every last bank share in your portfolio. Sadly, crystal balls and other oracular ornaments are not tools we possess. And, in any event, there are other factors besides falling interest rates and a friendly credit environment that have helped the banks record stunning financial results.

Lack of competitionOne factor is the relentless march of technology. The

banks have benefited enormously from the growing use of automatic teller machines, telephone and internet banking. It has enabled them to cut costs through branch closures and massive staff reductions. The fact that they have been able to do this in the face of much consumer resentment provides some clues about the industry’s structure.

Dominated by the National, Commonwealth, ANZ and Westpac, the Australian banking industry is, to all intents and purposes, a cartel. The Oxford Australian Dictionary defines a cartel as ‘an informal association of manufacturers or suppliers to maintain prices at a high level and control production, marketing arrangements, etc.’ The banks’ senior executives would certainly argue that there is vigorous competition in the industry but too many customers know otherwise.

Buying banking services today is a lot like buying petrol—you simply shop around for the best deal because you know the product is pretty much homogenous. The banks know it too and their soaring economic


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Do you own too many banks? [ C ONTINUED FROM PAGE 19 ]

returns bear testament to the fact that real competition is anything but red hot in this industry. So, if the banks are in for a difficult time, it’s more likely to be due to an external, secular shift than savage competition eating into profit margins.

On this point, a November 2003 discussion paper from the Australian Prudential Regulation Authority (APRA) is noteworthy. APRA, the banking regulator, cited the explosion of ‘Low Doc’ loans, especially those being promoted through mortgage brokers and other third-parties. It offered this sobering commentary: ‘While it is too early to assess the risk of loss on these non-conventional loans, it should be remembered that the market for these loans has expanded at a time when housing prices have risen significantly and interest rates have been very low. Many of the loans are also at relatively high loan-to-valuation ratios. Experience overseas indicates that these loans have a higher default rate than “conventional” home loans’.

It’s another warning sign which those heavily invested in banks should not ignore. Regulators are usually the last bodies to raise the alarm (and they often only manage it after the fact), so it’s worth taking note of comments such as this.

In our review of Telstra in issue 145/Feb 04 (Hold for Yield—$4.73), we highlighted the company’s aggressive accounting policy in relation to the capitalisation of software development costs. APRA, in a policy position paper from June last year, also noted the banks’ use of this little trick to boost profits. In a table on page 8, APRA highlighted the fact that Australia’s domestic banks have a comparatively high level of capitalised expenses in relation to their total capital base.

Incentive to capitaliseA bank’s capital base is its financial backbone, which

means any weakness should be duly noted by shareholders. APRA showed that capitalised expenses represented 5.5% of Australian-owned banks’ capital bases compared to 1.2% for credit unions. Why the difference? It may have something to do with the fact that credit unions don’t have publicly traded shares (and the associated executive options) and there’s therefore less incentive for them to puff up their numbers. The regulator also says that financial institutions prepare their accounts on a ‘going concern’ basis, while regulatory standards are ‘biased more heavily towards a liquidation basis’. In other words, the regulator is interested in the assets on which hands can be placed in the event that a financial institution

gets into trouble. The general thrust of its findings is that most capitalised expenses do not fall into this category, yet the banks have been allowed to count them in their capital base which, interestingly, is the figure relied upon by many analysts to assess their financial strength.

While we’re discussing the issue of financial strength, we should also point out that banks have become a lot more leveraged than they were a decade ago. Each time a prospectus for a fancily-named income security lands in your letterbox (you know the ones—Westpac FIRsTS, Commonwealth PERLS, ANZ StEPS and now St George SAINTS—see page 16), it is a plea from the bank for more capital. With so much pressure to increase their earnings per share, they don’t like to issue new ordinary shares. So they issue these substitutes instead.

Investors may feel good about owning these warmly-named ‘income securities’ but the bank is actually making itself a riskier proposition. These securities are not ordinary shares. In fact, they have some of the features of debt. The bank is effectively gearing itself up by substituting these hybrids for traditional equity. The trouble is that, if things turn ugly, it is a lot more difficult for management to stop payment on the income securities than it is to cut the ordinary shareholders’ dividends. In the event of lower profitability, with less flexibility to reduce the banks’ payout to income securityholders, ordinary shareholders will have to bear almost all of the pain.

Derivatives are another Pandora’s box. We included some insightful comment on the topic from Buffett and Munger in our recent special report and National Australia Bank has provided a recent, relatively minor, example of what can go wrong. We could spend pages on the topic

HORSE SENSE—'The pursuit of fashion to the point of mania has indeed been the hallmark of fi nancial institutions—and especially banks—throughout the ages'. Sir Kit McMahon, deputy governor of the Bank of England and, later, chairman of Midland Bank.

SHOPTALK—Why are assets worth more when interest rates are lower?—We'll try to answer that question with another: How much would you pay for the promise of a certain $100 payoff in 12 months' time? With current interest rates around the 5% mark, you answer would probably be close to $95. That's the amount you would have to invest in the bank today to collect $100 in one year. But what if interest rates were 18%, as they were in 1990? Then your answer would most certainly be a lot less than that and most likely around $85—the amount you'd need to invest at 18% to collect $100 in 12 months.

For example, let's say you took out a $100, 20-year term deposit in 1990 at a rate of 15%. With current interest rates almost one-third of that fi gure, you would certainly be able to sell it for a lot more than the $100 you put in to it. That's because it would still have six years to run at that very attractive rate of 15% per annum. The same maths applies to most income-producing assets, including property, where the stream of future rental payments is worth more in a lower interest rate environment.


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but suffice to say that it’s an area of risk that is growing, not receding. A subscriber with a great deal of industry experience recently said: ‘Remember the terrible trouble finance companies got into in past recessions? Like Australian Guarantee Corporation, Custom Credit, Industrial Acceptance Corporation and a host of others. They’re all gone and the class of business that they wrote is now done by the banks. Maybe the banks do it better but I worry that they might be “only” half as bad.’

Rapidly falling property prices, calls from the regulator to dispense with aggressive accounting policies and rapidly rising interest rates could prove to be the banks’ perfect storm. Certainly, there’s the potential for bank shares to fall significantly from current levels. A particularly astute subscriber recently commented that ‘the last 10 years have been banking nirvana. And these stocks now represent so much of the index that it’s scary.

Traditionally, when one sector becomes a large portion of the index it has been the beginning of the end—look back to the resource stocks in the 1980s and the media sector in the 1990s. Today the banks are the obvious candidates.

Stranglehold on the industryIt’s a salient point and one we cannot ignore. But how

do the rather negative ruminations in this article square with our non-negative current recommendations on the

banks? We suspect that in 10 years’ time the big four banks will still have a stranglehold on the Australian banking industry. We also expect the banks to continue to benefit from technological advances. Those positive forces remain in the back of our minds and, when looking at the banks individually, it’s quite easy to be impressed by their financial results, but we are conscious of the pitfall of not seeing the forest for the trees, which is why we’ve penned this lengthy article.

Some subscribers have come to rely very heavily on the banks and we therefore want to give a categorical answer to one of the questions posed at the beginning of this article: banks are not the ultimate buy-and-hold investments. This is an industry which can turn ugly very quickly. The other question—whether it’s a good time to sell bank shares—is more difficult to answer. We feel that any subscriber who has more than, say, 15% of their portfolio in the banks should seriously consider biting the bullet, paying the capital gains tax and cutting back on their holdings. Things may not turn bad, but we feel the probabilities of a downturn are growing rather than diminishing and, as we like to say around our office, it often pays to panic early.

Interests associated with The Intelligent Investor still own a few big bank shares (but significantly less than 15% of our portfolios).

First published 25 May 2004

Understanding underwritten DRPsA subtle change in the way some companies implement their DRPs has caused us to revisit them.

Dividend reinvestment plans (DRPs) were the subject of Investor’s College in issue 129/Jun 03, but several companies, including National Australia Bank and Bank of Queensland, have recently implemented ‘underwritten’ dividend reinvestment plans. In this article we’ll explain why they’re doing it and what it means for investors.

Before we do, a quick recap. DRPs give shareholders the option of taking their dividends in the form of extra shares rather than cash. So, instead of a few extra dollars in the bank account, you get a few extra shares. It’s been a popular way for small shareholders to add to their holding without having to find additional funds. We say small shareholders because, in the past, DRPs limited the number of shares that could participate, which excluded all the larger shareholders. Several companies have recently removed the cap and implemented underwritten DRPs. So what exactly does that mean?

It means that the company will issue new shares to pay for the entire dividend amount. If you, as a shareholder, choose to participate in the DRP, the company will issue the shares to you. If, however, you choose to take cash, the company will issue shares to someone else and use the cash it gets from them to pay your dividend. That ‘someone else’ is usually an investment bank, and the bank guarantees

to buy all the additional shares the company needs to issue—hence the term ‘underwritten’.

If you’ve read the explanation above and are a bit confused because it looks like the company doesn’t actually pay out any cash, there’s no need to be confused—you’re right. Underwritten DRPs are a sneaky way for companies to look like they are paying a dividend without actually paying one at all. Take a look at the table above and you’ll see that it doesn’t matter how many shareholders participate in the DRP, the net effect is that not one cent comes out of the company’s coffers.

The most logical explanation for a company not paying a dividend is that it needs the money itself. A recent example is National Australia Bank (see issue 152/May 04). As a result of its misdemeanours, the banking regulator, APRA, has decided that National should have more capital for each dollar of loans it makes (see issue 131/Jul 03 for an explanation of capital adequacy). Basically, National needs to get more money from, or give less money to, its shareholders. And it can do that in one of three ways. It could simply ask for more money by way of a rights issue or share placement (haven’t shareholders suffered enough already?), it could suspend the dividend payment (imagine the furore) or, as we have explained, it could implement an underwritten DRP. The National chose the third option



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Understanding underwritten DRPs [ C ONTINUED FROM PAGE 21 ]

and nobody batted an eyelid. You can see why underwritten DRPs are becoming more and more popular. Management calls this ‘actively managing your capital base’, in our version of the English language it’s called ‘not paying a dividend’. And that’s why companies are doing it.

So what does it mean for investors? The first point to note is that, from the taxman’s perspective, you still receive a dividend. Whether you participate in the DRP or not you will have income and franking credits to put in your tax return. Secondly, if you do participate in the DRP, you will maintain the same percentage shareholding you had before. You will have more shares, but the total number of shares will have increased in the same proportion, so you’ll end up owning the same portion of the pie.

Thirdly, not participating and choosing to take cash will,

excluding tax effects, have the same effect as selling a few shares. You’ll have more cash in the bank but will own a lower percentage of the company. This is because the company is issuing more shares to pay for the dividend—this means the total amount of shares is increasing but you’re not receiving any.

To decide whether to participate in an underwritten DRP or not, follow the same logic as a normal DRP. If the shares are cheap, then by all means participate—you want to maintain your shareholding in an underpriced company. Otherwise, you are probably best off taking the cash, owning a smaller percentage of the company and putting your money to work elsewhere. Just keep in mind that the companies are having their DRPs underwritten because they need the cash—a potential red flag.

NAB underwritten DRP examples

(a) Shares on issue before dividend payment 1,506,492,075

(b) Dividend per share $0.83

(c) Total dividend (a x b) $1,250,388,422

(d) Assumed share price for share issue $28.50DRP PARTICIPATION 100% 50% ZERO

(e) No. of shares participating in DRP 1,506,492,075 753,246,037 zero

(f) $ amount of div paid to shareholders $1,250,388,422 $625,194,211 zeroparticipating in DRP (e x b)

(g) No. of shares issued to shareholders 43,873,278 21,936,639 zeroparticipating in DRP

(h) Cash div paid to shareholders not zero $625,194,211 $1,250,388,422participating in DRP

(i) Shares issued to third party to pay dividend (h/d) zero 21,936,639 43,873,278

(j) Total new shares issued (g + i) 43,873,278 43,873,278 43,873,278

(k) Total value of new shares issued (j x d) $1,250,388,422 $1,250,388,422 $1,250,388,422

Net cash distributed by NAB (k – c) zero zero zero

Questions and answers published 30 Apr 2009

Online bank stock forumThe big banks are close to many investors’ hearts. Very

long-term holders have enjoyed impressive capital gains and growing dividends. But those who purchased their holdings in the middle part of this decade have had a different experience—they’ve suffered capital losses and known only faux dividends (due to underwritten DRPs—see page 21).

At The Intelligent Investor, we’ve held reservations over the banks for years. Barack Obama hadn’t even been elected to the US senate the last time we issued positive recommendations on the banks in 2004.

Having converted those long-held reservations into recent recommended action in Time to act on the big four banks (see page 2), we thought it worthwhile following up that call with one of our interactive live forums.

Our team was online between 2.30pm and 3.30pm answering questions and responding to comments:

Just to clarify, is the downgrade for the banks a case of 1) possible insolvency if the derivatives trigger, 2) reduced investment performance going forward, or 3) better/less riskier opportunities elsewhere? Or all of the above? Seems to me that companies are no place to be invested in if case 1) occurs due to ramifications on businesses large and small both here and O/S. Col K

Greg Hoffman: Welcome everyone. This question is a good starting point for today’s proceedings because it gets to the heart of things. To be clear (and this is a theme we’ve received a few other questions on), we do not expect the banks to become officially insolvent (as an interesting



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side point, virtually every bank is technically insolvent—a theme I’m happy to elaborate on if anyone is interested in the discussion). A major derivative explosion and resultant counterparty failure would be much more likely to trigger a large, dilutive capital raising.

Imagine a scenario where there was an overnight collapse of a European institution, which leads to several other global financial institutions being placed under severe stress. The share prices of Australia’s banks would likely open trading at significant discounts to their previous closing prices. But the exact impact would not be immediately known. Any bank that was heavily exposed to the failed institution, or those significantly weakened by it, would likely seek to shore up their position by raising capital in short order. But this would be done at depressed prices, thus heavily diluting the intrinsic value per share.

On point 2, the banks have been badly behind the curve since this downturn began in terms of estimating the quantum of bad debts. I expect this trend to continue, and ANZ’s results provided support for my view this week:

‘ANZ now expects that full year provision levels will be somewhat higher than originally anticipated at the time guidance was provided in February.’

They’ve been caught by surprise in the two months between the 26th of February and the 29th of April and I think that’s an industry-wide trend we’ll see. I’m quite sure we won’t be seeing too many announcements from banks this year saying they’ve over-estimated their bad debts.

It’s now clear the banks’ earnings have been overstated for several years, mostly through inadequate provisioning but also through aggressive accounting such as capitalising IT expenses. That is now catching up with them and the dilution created by asinine policies such as underwritten DRPs is also exacerbating the issue at a per share level.

In short, on both points 1 and 2, we think that substantial dilution through capital raisings is the likely outcome (rather than sudden financial oblivion). Finally, on point three, you’re dead right about the opportunity cost, with a plethora of good opportunities elsewhere.

Your article on the "big 4" was thought provoking. You often mention keeping your exposure to this sector below 15%. Do you mean exposure to the "big 4" only or keep general financial sector exposure below 15%. Perhaps some of smaller banks and fund managers have a high level of derivative exposure as well?! Leon B

James Greenhalgh: Hi Leon. Our general view prior to our recent ‘mass downgrade’ was that members shouldn't have more than 15% of their portfolios in the commercial bank sector (ie the big four and regionals). Clearly with the recent downgrade, we're advocating members hold much less than 15%.

Any decision about portfolio weightings in this area is clearly a personal decision. If you held 15% in the banks before today, and 10% in Macquarie (an investment bank) as well as 10% in fund managers, say, then that 35% total weighting to 'financials' is probably a little high. As an aside, the fund managers we recommend don't have much in the way of risky derivatives exposure, with the possible exception of Perpetual.

Some members may choose to reduce weightings gradually, or move from 15% to 10%, or from 15% to 5%,

say, depending on their level of comfort (or from 15% to zero!). I'm known around the office for being slightly less bearish on the sector than our other analysts (most of the commercial banks in the staff portfolio belong to my family), but I expect to reduce my current weighting to banks a little over time (they are already less than 10% of my total portfolio).

What about the mid-tier banks? Do the same issues apply to them as to the big 4? Mike K

Greg Hoffman: Bendigo & Adelaide doesn’t have anything like the derivatives exposure of the majors, and its commercial exposure is much lower than the majors (at less than 15% of its loan book). Similar comments and metrics apply to Bank of Queensland. So I’m somewhat more comfortable with these two at this stage. On the flipside, if you were absolutely certain that we’re heading for a housing rout, these two have a greater loan book skew towards mortgage lending than the majors.

With regard to Suncorp, you can read about the problems in analysing it and our specific reservations in Suncorp a basket case (issue 242) and Clouds draw nearer for Suncorp (issue 256).

I am a fully self funded retiree reliant on dividends and in the market for 20 years. Can the big four ride through to the next 3to 4 years and return to normality. The majority of analysts for Commsec have a hold on the banks with little as sells How does this sit with your judgment as I don't know what action to take. Your change to sell has given me heartache.

James Greenhalgh: You can easily make a bull case for the banks—and Greg did just that in the article of that name (see page 10). And, some people are slightly less concerned about the risks in the derivatives books, or the mortgage lending market, than Greg is (I'm one of these people, and this is why I'm unlikely to sell all of my family's bank holdings). I do however acknowledge there are significant risks that I can't be fully aware of as a shareholder, that these risks have been rising, and that banks are riskier businesses than the steadily increasing profits and share prices of the past decade and a half would indicate.

A couple of other points need making. First, it's psychologically hard to let go of stocks that have been good to you, or that fulfil other needs (such as the dividends you mention). But that brings to mind a response Gareth gave to 'KC', a holder of Macquarie CountryWide (MCW) back in 2007, on the Ask the Experts forum. Companies can change over time, and ignoring those changes can prove very costly. MCW's unit price has fallen 86% since Gareth wrote his response to that member.

Second, there are a lot of people who have vested interests in not criticising the banks. Clearly Commsec, being owned by CommBank, is one of these, and that is the case for a great deal many broking analysts. It's just hard for them to turn negative on big, popular stocks like these (although I know some broking analysts have also switched to sell on a couple of the major banks recently, so we're not alone).

In the end, whether you sell or reduce your holdings


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Online bank stock forum [ C ONTINUED FROM PAGE 23 ]

in the banks is a personal decision. As a shareholder in three major banks, I am seriously contemplating reducing my holdings. Whatever you do, it's important to be fully aware of the risks.

I'm aware, for example, that dividends will probably fall further, and that billion dollar capital raisings/rights issues are possible, if not probable. If you're prepared for those outcomes, then you may choose to ride it out over the next 3 or 4 years. Share prices are already well off their highs, in anticipation of something like this, after all.

But if you think the commercial property market is in dire trouble (this is my biggest fear), or that derivatives are going to blow up, or that residential property prices are set to slump, then it's possible our banks could go the way of the US or UK banks. That means shareholders would be wiped out.

These are the factors you should base your decision on. Basing a decision on past share price growth, or past dividend payments, is incorrect, as these might not be the same in the future.

Having held CBA since it was privatized, and added more with dividend re-investment thereafter, I'm loth to sell. But I've take 1000 "off the top". Still hold several thousand. Now, is the situation so dire as to consider going further, with hope of replacing at lower prices later? Eric M

Greg Hoffman: This is a crucial issue, Eric. And while we’re unable to provide individual advice, I think we could do with a feature or Investor’s College article on this topic. The ‘dollar cost averaging’ approach is often talked about in relation to buying shares, but I often use a similar approach when I sell or lighten big positions (where brokerage costs don’t make multiple trades prohibitively expensive). It’s something for everyone to consider and we’ll aim to provide an article discussing it in more detail over the coming fortnight.

The other issue we want to tackle is the question of ‘if I sell my banks, where should I put the money?’ Because that’s now on a lot of people’s minds.

I hold income securities in NAB (NABHA) and hybrid preference shares in CBA (PERLS3) and Westpac (WCTPA). Is there risk to the stability of these instruments? Do you assess bank income securities and hybrid shares to be at risk and therefore a sell recommendation along with bank shares?

Steven Johnson: We're not overly concerned about the creditworthiness of these securities—as Greg said in a previous response, the likely downside is a substantial capital raising rather than complete wipeout. But there are plenty of alternatives in the income security market at the moment and you might want to weigh up the value you're getting in bank income securities versus other options like the Southern Cross SKIES.

Two things—last week I was shocked to read that the US Gov't was pressuring a group of banks to forgive about $5 billion that was owed by Chrysler in favour of

other creditors (retired auto workers). I would assume that the banks had security and the other parties did not. Also, with our Treasurer trying coerce banks onto low interest rate for home BORROWERS, while simultaneously banks have not dropped rates for businesses he seems to be politicising banking—this ended badly for Chifley 60 years ago. If Swan can explain to me satisfactorily how a bank account paying 0.1% interest before the Reserve Bank drops "interest rates" by 2% can pass on this lower cost of funds then I might believe in miracles too. I decided to sell a fifth of our Westpac (WBC), and pay down margin loan. Is your article suggesting I sell all and pay CGT or only part? The derivatives that you mentioned in your article. I know the word but it really is like a "Black box" to me. Most of it seems to be more like commodity trading than traditional banking. Can you explain please?

Greg Hoffman: Some interesting observations there. With regard to your holdings, we’re unable to provide specific advice. Levels of risk tolerance and capital gains tax positions are just two issues that are different for everyone, and we’re only able to provide our view of a stock’s pricing compared to our assessment of value, the rest we must leave to the discretion of our members.

On the topic of ‘what is a derivative?’, Warren Buffett put it nicely in his chairman’s letter a few years ago:

‘I view derivatives as time bombs, both for the parties that deal in them and the economic system. Basically these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices, or currency values. For example, if you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives transaction, with your gain or loss derived from movements in the index. Derivatives contracts are of varying duration, running sometimes to 20 or more years, and their value is often tied to several variables.

‘Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counter-parties to them. But before a contract is settled, the counter-parties record profits and losses—often huge in amount—in their current earnings statements without so much as a penny changing hands. Reported earnings on derivatives are often wildly overstated. That’s because today’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed for many years.’

Greg, thank you for your article recommending selling the banks. What are then the implications for MLT and AFI which are still heavily weighted with banks? Should I sell some? Michael L

Gareth Brown: We don't cover Milton so I'd rather not comment on that one. As for Australian Foundation Investment Company, it changes the equation somewhat. At last count, AFIC had approximately 25% of its assets invested in the big four banks. We've been recommending



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a maximum of 15% for years, and so we weren't comfortable with that level of exposure before we downgraded the banks to sell.

On the flipside, even if the banks halve in value from here it won't kill AFIC. So it all depends on your situation. It makes sense to consider your holding in the banks through AFIC as part of your overall exposure to banks.

I'm interested in your rationale for treating the Big 4 as a single group (and hence, recommending sell uniformly across all four). Is there a case to move to the 'least worst' of the banks, keeping some exposure to financials, and if so, which is the least worst in your view?

Gareth Brown: We view the big four as something of a oligopoly, and banks tend to be more highly 'correlated' than other businesses—it's hard to imagine one of the big four having a big blow up without it significantly influencing the others. We'll post a chart this afternoon showing the share price performances over the past twenty years, it tends to confirm the theory that they're closely correlated. Greg's put a lot of thought into this matter and thinks it should be dealt with this way.

That said, in the second last sentence of Greg's review he stated the two banks he thinks are the least worst (WBC and CBA for their domestic focus).

If one wished to retain ownership of banking shares, which bank (no pun intended) do you see as the safest? Ross O

Greg Hoffman: That’s a good question, Ross. As I wrote in the review, we’re more comfortable with the domestically-focussed strategies of Commonwealth Bank and Westpac. However Westpac (pre St George accounts) had the highest net exposure to derivatives, that represented by far the highest percentage of net tangible assets (NTA). So I’d probably conclude that, in most scenarios, Commonwealth is the safest bet. The risk would be if we somehow managed to avoid a rout in commercial property (or other business loans) while sailing into a sharp housing downturn. Under that combination, Commonwealth would likely fare relatively poorly compared to the others.

Warren Buffett is happy with his 7% holding in Wells Fargo Bank. Do any of the big four Australian banks compare favourable with Wells Fargo? Mark P

Gareth Brown: No, we think they're sufficiently different. That belief was hardened after reading a recent Buffett interview about Wells Fargo. Our banks may display some of the low cost funding attributes that Wells has, but the differences on the lending side are stark. Wells is somewhat of a one of a kind, and is prospering despite the US housing collapse, while our housing market hasn't even collapsed.

How does Macquarie fit into the picture? Are you looking at reviewing it any time soon to see how the 'perfect (financial) storm' will affect them? Mike K

Greg Hoffman: Macquarie Group is such a different beast to the big banks. Of course there are correlations in many parts of the business, but they’re not one-for-one. The upside for Macquarie is also much larger in any

upturn (it has lower-risk/higher margin services which are hitched to corporate activity, for example). It faces its own issues, though, as I wrote in Macquarie: More capital, Guv? (issue 267). And, in the interests of disclosure, I’ve sold 37.5% of my family’s Macquarie holding into this latest rally (and may sell a little more). This is more a portfolio allocation issue than a negative judgment on the company, though (it remains the largest holding in the portfolio, though now much closer to the number-two placed Infomedia).

Is there a case to be made for not covering the banks at all? They are at least partly unknowable and with limited analytical resources would the time be better spent covering companies that you can be more confident about getting a grip on. There would seem to be plenty of work out there even if you ignore the banks.

Gareth Brown: It's an interesting argument. We agree with you on the partly unknowable factor, but we would happily buy bank shares again at a price that we think compensates us for that. So we don't want to lose touch with them. Also, because banks are very intertwined with the economy, our work on the banks tends to also pay off elsewhere. But I like the way you're thinking.

As I own all 4 majors and they comprise approx 37% of my portfolio and have provided good cash flow/dividends, your sell recommendation is a worry. I am a retired banker of 40 years and therefore perhaps unrealistic/biased in my beliefs. Would your alternative stock picks be simply those in your income portfolio for my 37% in major banks?

Gareth Brown: I understand the concern, and in a way I'm glad it's got members a bit worried. Given our views, 37% is a big weighting to one sector and we certainly wouldn't be comfortable having that much of our wealth invested in this one sector. What we're trying to show here is that while banks have offered good dividends and profits in the past, that might be changing. The decade leading up to 2007 was a perfect environment for banks, and they took full advantage of the boom by lowering credit standards, which is now coming home to roost. We think everyone with significant bank investments should at least consider the potential for strife and make sure they're comfortable with that possibility.

As for what to put the proceeds into, Greg will discuss that matter in an upcoming review. Cash is an option, as are some of the other blue chip stocks we have on our buy list. It might be a case of settling for a lower upfront yield but one that is less at risk.

You're predicting a rout on commercial property (with possible flow on into residential). Given that commercial property is one of many industry segments covered by the banks, any decline in commercial property values is reflected in the banks returns but diluted due to broader exposures. Given the lessening of competition in the bank sector in Australia (withdrawal of foreign banks, gobbling up of smaller players) there must be a point at which you get back in. Have you quantified this yet?


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Online bank stock forum [ C ONTINUED FROM PAGE 25 ]

Greg Hoffman: I want to be clear about what our review was and was not saying. We aren’t predicting routs in commercial property, or even residential property (nor do we think that one necessarily leads to the other—either one could be an independent event). Our catchphrase has long been ‘preparation, not prediction’. We think it’s wise to be mindful of the possibilities and probabilities. We then

try to weigh them up in our assessment of intrinsic value.There is certainly a price at which we’re buyers of the

big banks, but it’s a long way south of here after their recent hefty gains. As always, it’s a matter of weighing up price against value.

That’s it for today. Thank you all for participating in what’s been an interesting and thought-provoking forum.

WARNING This publication is general information only, which means it does not take into account your investment objectives, financial situation or needs. You should therefore consider whether a particular recommendation is appropriate for your needs before acting on it, seeking advice from a financial adviser or stockbroker if necessary. Not all investments are appropriate for all people.

DISCLAIMER This publication has been prepared from a wide variety of sources, which The Intelligent Investor Publishing Pty Ltd, to the best of its knowledge and belief, considers accurate. You should make your own enquiries about the investments and we strongly suggest you seek advice before acting upon any recommendation.

COPYRIGHT © The Intelligent Investor Publishing Pty Ltd 2009. The Intelligent Investor and associated websites and publications are published by The Intelligent Investor Publishing Pty Ltd ABN 12 108 915 233 (AFSL No. 282288). PO Box 1158 Bondi Junction NSW 1355. Ph: (02) 8305 6000 Fax: (02) 9387 8674.

DISCLOSURE As at 30 Apr 2009, in-house staff of The Intelligent Investor held the following listed securities or managed investment schemes: AEA, AHC, ALL, ANZ, ARP, AWE, BBG, BEPPA, CBA, CDX, CHF, COH, COS, CRS, CXP, DBS, FLT, FPA, GFF, GNC, HVN, IAS, IDT, IFL, IFM, IVC, KRS, LMC, LWB, MFF, MMA, MQG, NABHA, NHF, OEQ, PTM, RDR, RHG, ROC, SAKHA, SDI, SFC, SGN, SHV, SIP, SKC, SOE, SOF, SRV, STO, TAH, TGR, TIM, TIMG, TIMHB, TLS, TRG, TRS, WBC, WDC, WHG and WIL. This is not a recommendation.

DATE OF PUBLICATION 30 Apr 2009.

Why you should sell the big four banks · Why you should sell the big four banks, y l e e ’:NZ at e ’ n ’-s s e e e . or d t . t l m r . , n, or CONTENTS ARTICLES PAGE Time

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