There is an increasing amount of focus on the Australian residential property market. Last week, outgoing BHP Chairman Don Argus said: ‘I think the Australian Banking Sector has gone too far. You can look at some of them now as giant building societies.’ He was referring to the large exposure that the big four Australian banks have to residential property.
Last Monday morning, RBA Governor Glen Stevens took the unprecedented step of appearing on Sunrise, the popular breakfast program to, among other things, warn people against speculating on house price appreciation. ‘I think it is a mistake to assume that a riskless, easy guaranteed way to prosperity is just to be leveraged up into property. It isn’t going to be that easy.’
Stevens’ comments, and Argus’ for that matter, both reflect concern over the potential outcome of Australia’s multi-year infatuation with property. These two men join a long line of commentators who, over the past few years, have warned about the sustainability of rising house prices and their effect on the economy.
Despite this, the market refuses to buckle. The warnings are roundly ignored. Now, just a year ‘after’ the global financial crisis, things are apparently back to normal and house prices are surging around the country again.
But like the boy who cried wolf, the warning that you should have listened to will be ignored. This warning will more than likely turn out to be Stevens’, delivered on 29 March 2010. We shall see.
Property bulls cite a number of reasons why the market has solid fundamentals behind it. Strong demand driven by population growth and lack of supply (caused by government meddling at the local and state level) are the main ones.
What is mentioned less by the property bulls is the seemingly endless availability of credit supplied to the property market by the banks. As we have seen over the past few years, property price declines occurred in the US, UK, Ireland etc, because of a restriction of credit.
Indeed, as credit was drying up in Australia in 2008, house prices were beginning to register falls across the board. But plummeting interest rates (which fell to 3%) and taxpayer guarantees for bank borrowing ensured that the supply of credit remained plentiful. To absorb that supply, the government handed out up to $21,000 to first homeowners.
The policy was a resounding success. But success in economic matters depends on timeframes. A politicians’ timeframe is roughly to the next election. That is, the pollies are interested in short-term success. Unfortunately, a focus on short-term success can lead to long-term problems.
Here is one of our favourite quotes on the matter:
“Economics…is a science of recognising secondary consequences. It is also a science of seeing general consequences. It is the science of tracing the effects of some proposed or existing policy not only on some special interest in the short run, but on the general interest in the long run.”
Henry Hazlitt – Economics in One Lesson
So we await the long run secondary consequences of the government bailing out property owners (the special interest) in the short run. It should be interesting.
With so much space being devoted to the pace of interest rate rises and their effect on property prices, we thought you should know how exposed the big four banks are to the housing market.
We have gone through the big four’s balance sheets to come up with the data in the accompanying table. The National Australia Bank (ASX:NAB) is the largest bank by assets, followed by the Commonwealth Bank (CBA), Westpac (WBC) and ANZ (ANZ).
As you can see, loans and advances are a banks’ largest asset. In the table below we focus on Australian domiciled loans. The other main asset components are listed in the table.
We further break down the Australian Loans and Advances data to show Australian housing loans.
The ratios produced from this data are interesting indeed.
As shown in Australian lending as a % of total assets, WBC and CBA are most leveraged to the Australian economy with nearly 70% of their lending assets based in Australia. ANZ is next and NAB, with its large UK exposure, has less than 40% of lending assets in Australia.
Housing as a % of Australian Lending shows all four banks have around 60% of their local lending books exposed to residential property. From a broader risk perspective, both CBA and WBC appear highly exposed to property, with 45% and 43% of their total assets respectively comprising Australian residential property. ANZ and NAB have a greater strategic focus on offshore markets and so are less exposed to the local property market.
There are a number of reasons why the banks (especially CBA and WBC) have such large exposures to housing. According to the recently released Financial Stability Review conducted by the RBA, in the early 1990s business lending accounted for about 60% of total credit outstanding.
The deep recession at the time saw banks suffer heavily as high interest rates pushed businesses to the wall. Ever since the banks have been increasing their exposure to housing at the expense of business.
You shouldn’t be surprised though. The regulatory system makes it more profitable for banks to lend against housing than against a business.
Here’s how it works.
Regulators require banks to hold capital against their assets. This is the Tier 1 and Tier 2 capital ratio’s that banks mention when discussing their ‘capital adequacy’. However they don’t hold capital against their total assets. Rather, they are required to do so against their ‘risk weighted assets’.
In determining the value of risk-weighted assets, the banks are only required to include 50% of the value of a residential mortgage loan. (This assumes a loan to value ratio of 80-90% and no mortgage insurance). In other cases the requirement is only 35%. For business loans, banks need to include 100% of the loan value in their risk-weighted asset calculation.
So it’s far more capital efficient (and therefore profitable) for the banks to make housing rather than business loans. And surprise surprise, that’s what the banks have been doing.
Housing loans only require around 50% of their value to be included in the risk-weighted asset calculation because they are considered a very low credit risk. And that has historically been the case. Funnily enough, this was also the claim to justify the huge amount of speculation in the US housing market a few years ago.
As the great US economist Hyman Minsky was famous for saying, ‘stability breeds instability’. In effect the stability and ‘safeness’ of residential mortgages has led to this asset class being rewarded with a larger and larger amount of credit. This in turn has pushed up property prices, which has increased demand for property and credit.
If the past is prologue, then Glen Stevens’ warning will be widely ignored. It is the availability of credit that has the largest bearing on asset price bubbles, not the words of the man who tries to put a price on that credit each month. Even returning interest rates to ‘normal’, which is around 5% may not be enough to halt the renewed speculation around housing. 5% interest rates are hardly likely to deter the banks from continuing to extend housing credit either. As we will see, that is what underwrites their profits.
Our best guess is that an external credit shock will turn the tide for the property sector. We saw this in 2008 when foreigners were reluctant to continue lending to Australian banks to fund property purchases. We have little doubt that in a deleveraging global economy, another such episode will occur. (See the next essay for a discussion on Australia’s foreign debt and the role of banks).
The bulls will retort that the government will step in again, guarantee debt and support asset prices. We have no doubt the government will meddle again. But financial markets rarely respond the same way twice and we doubt that property investors will get lucky the next time the flow of global credit dries up.
But in the meantime, the banks are benefitting handsomely from the relentless rise of the property market. You can see from the expected profitability levels (see consensus ROE in the table) that CBA and WBC are the standouts. This is no doubt a reflection of their exposure to Australia and in particular the Australian mortgage market.
Even ANZ and NAB’s latest results show their Australian operations as the standout performer. However their different strategies (ANZ: Asian expansion, NAB: wealth management focus, large UK exposure) sees the market expect lower profitability from them compared to CBA and WBC.
So what does all this mean?
Well, this analysis clearly shows why CBA and WBC have been the standout profiteers in the banking sector. With a large focus on the booming Australian housing market, it’s no wonder their profits and valuations (see price to book measures in the table) are at a premium to their peers.
But it also suggests why you need to be cautious on the sector as a whole. At some point the abundant credit now enjoyed by the housing market will diminish. This will put pressure on prices and for the banks, loan volumes will decline, which will in turn lower profitability.
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