Australia-new Zealand Banks

The Inoculated Investor

http://inoculatedinvestor.blogspot.com/

Is it Time to Start Worrying about the Australian Banks? Pop Quiz. Which of the following countries had the largest increase in housing prices (as measured by countrywide indexes) from March of 2002 to the peak? A) Australia B) United States C) New Zealand If you guessed the US based on the dramatic fall in prices since the Case-Schiller reported peak in August of 2006 you would be wrong. In fact, in this dubious race to the top the US would actually come in third as measured by the Composite 20 Case-Schiller Index. Australian House Prices Weighted Average 8 Capital Cities

Peak: Mar-02

Mar-05

Mar-08

Mar-09

02-09 Increase

02-Peak Increase

Peak to March 09 Decline

House Price Index

74.3

101.3

131

122.2

64.47%

76.31%

-6.72%

Peak: US Home Prices

Mar-02

Aug-06

Mar-08

Mar-09

02-09 Increase

02-Peak Increase

Peak to March 09 Decline

Case-Schiller Composite 20

122.3

206.2

172.2

139.99

14.46%

68.60%

-32.11%

Year End

Year End

Year End

Peak:

New Zealand House Prices

1999

2002

2008

Q1 2008

02-08 Increase

02-Peak Increase

Peak to Q4 2008 Decline

House Price Index

227

282

568

616

101.42%

118.44%

-7.79%

AU data source: http://www.ahuri.edu.au/ NZ data from Reserve Bank of NZ (latest data available) US data from S&P

As the above data indicates, from 1999 New Zealand had by far the largest increase in housing prices, followed by Australia. However, as shown by the peak to decline data, the global recession and worldwide real estate bubble has not had anywhere near the impact on housing prices in these two countries as they have had on US prices. The inevitable question that results from this observation has to do with whether or not New Zealand (hereinafter NZ) and Australia (hereinafter AU) are in for a similar decline in prices but are just a few years behind the US in the process. If that is the case then the resulting shock to the local banks that serve this region could be just as dramatic as the impact that the ongoing housing price spiral has had on the US banking system. Specifically, the reason it is especially important to focus on housing in these countries is that, on average, among the seven banks I analyzed, 60% of their loan books consist of residential mortgages (and securitizations). Also, the primarily focus should be on AU, as 85%+ of the banks’ loan portfolios are made up of AU-located loans. Accordingly, this is the first of two separate pieces on the AU-NZ banks. The first of which will examine the economic trends facing the regional economies and housing markets and the second will delve more deeply into the individual attributes of the banks. The answer to the above question regarding the fate of house prices has a lot to do with the state of the local economies in the AU-NZ region. As we continue to see in the US, unemployment leads to foreclosures that then cause housing prices to fall further or stagnate and ultimately wreak havoc on the balance sheets of the exposed banks. In addition, the amount of leverage in the US system, especially when it comes to banks and home lending, has had a monumental influence on the extent of the real estate bust. In retrospect it is blatantly obvious that cheap credit and lax lending standards in the US led to a lending boom that inflated house prices well above the historical trend line. Also, reduced consumer savings rates resulted in homeowners having a much smaller savings cushion than was required to protect against unexpected events such as job losses. Therefore, in an attempt to assess the inherent risk of further declines, it is important to determine if the housing price boom in the AU-NZ footprint was fueled and perpetuated by similar use of leverage.

The Inoculated Investor

http://inoculatedinvestor.blogspot.com/

At first glance the data suggests the answer could be yes. I have accumulated a ton of data on the current states of these countries, so much so that it can be a bit overwhelming. Consequently, I am going to focus on what I feel are the most relevant and revealing facts. Let’s first take a look at Australia, the country that the banks in the region have by far the most exposure to: Australia

Mar-99

Mar-03

Mar-08

Mar-09

Personal Savings % of Disposable Income

0.80%

-2.30%

0.70%

1.60%

0.36%

Mar-99

Mar-03

Mar-08

Dec-08

99-08 Increase 91.88%

Household Debt/GDP Housing Debt/Disposable Income Data from Reserve Bank of Australia

35.27%

37.93%

63.84%

67.67%

Mar-99

Mar-08

Mar-09

99-09 Increase

66.50%

137.70%

136.50%

105.26%

99-09 Average

Low consumer savings rate? Check. Increasing household debt as a percentage of GDP? Yup. Skyrocketing housing debt as a percentage of disposable income? For sure. How about New Zealand? New Zealand

Q1 1991

Q1 1999

Q1 2009

Household Debt/GDP

59%

98%

156%

59%

1984

1999

2008

99-08 Increase

48%

103%

155%

50.49%

248%

335%

498%

48.66%

Household Liabilities/Disposable Income Housing Value/Disposable Income Data from Reserve Bank of NZ

99-09 Increase

Although I can’t find data on NZ’s personal savings rate, the trend in this country seems to be similar to the one illustrated in the above AU table: increasing household debt and liabilities as a percentage of GDP and disposable income. However, in terms of NZ, the most interesting component of the chart is the dramatic increase in housing value as a percentage of disposable income. What this indicates to me is that housing prices were rising significantly faster than incomes, a fact that could mean those prices are not sustainable. Finally, it is important to look at the US data and compare it to that of AU and NZ. If consumer leverage has been one of the most prevalent causes of the housing bust in the US then it is imperative to have an understanding of how levered AU and NZ households are in comparison. US

Apr-99

Apr-08

Apr-09

99-09 Average

May-09

Personal Savings Rate

2.50%

0.00%

5.70%

1.70%

6.90%

Jan-99

Jan-08

Jan-09

99-09 Increase

66.80%

98.09%

98.56%

47.55%

Household Debt/Disposable Income 92.17% Data from the St. Louis Fed and my calculations

Household Debt/GDP

133.48%

128.89%

39.85%

In relation to the increase in personal leverage in AU and NZ, the amount of debt taken on by US consumers over the past decade or so actually looks sort of moderate. Household debt to GDP increased only 47.6% from 1999 in comparison to 59% for NZ and an incredible 91.9% in AU. But, despite the increase in leverage in AU the personal savings rate has remained low, although it has crept up over the last year. The savings rate of 1.6% as of March compares to the 6.90% rate (announced today based on May data) for the US. The concern for any investors looking to gain some exposure to the Australian banks is that the global recession combined with a highly levered consumer and potentially unsustainable housing values causes consumers to start saving more. While the AU banks have relatively minimal exposure to commercial real estate and C&I loans, the effect on the economy of a significant boost in consumer savings would likely lead first to lower consumption (which makes up about 60% of the economies of AU and NZ) and then to higher unemployment and eventually more foreclosures. Another leverage metric that has been important to monitor during the financial crisis is the ratio of bank assets to GDP. The case of Iceland has provided a cautionary tale about the disastrous implications of having a levered banking system whose level of assets dwarf GDP.

The Inoculated Investor

http://inoculatedinvestor.blogspot.com/

Australia

Mar-99

Mar-08

Mar-09

99-09 Increase

Bank Assets/GDP

0.79x

2.08x

2.41x

205.34%

New Zealand

Apr-99

Apr-09

99-09 Increase

Bank Assets/GDP

1.34x

2.13x

58.42%

US

Dec-99

Mar-08

Mar-09

99-09 Increase

0.94x

0.96x

26.52%

FDIC Bank Assets/GDP 0.76x AU data from Reserve Bank of AU NZ data from Reserve Bank of NZ US data from FDIC.gov

Again, this table shows that AU has had the most significant increase over the past 10 years and now has bank assets at over 2.4x GDP. I am not suggesting that AU and NZ are at risk of turning into the next Iceland. However, this ratio provides a barometer of how important banking is to the economy. We have seen in the US what a banking crisis can do to the broader economy and as a consequence investors need to be cognizant of the potential impact of a retrenchment in credit on consumers and businesses. This is especially true when the banking assets represent an outsized portion of domestic production. Now that I have established that both AU and NZ have seen significant appreciation in housing values along with an increasingly debt-burdened consumer, the next step is to try to evaluate what the ultimate impact of this will be on the banks. In the US, the surge in unemployment has only exacerbated the housing price decline and has forced the banks to recognize large losses on real estate loans. So far, Australia has avoided going into a recession. This is clearly one reason why bank charge offs and non-performing loans have remained relatively contained to date. Referencing first quarter GDP data from an article in the newspaper The Age: “Australia has dodged a recession, with data out today showing the economy expanded in the first three months of the year. Gross domestic product for the March quarter grew a seasonally adjusted 0.4 per cent from the previous three months, the Australian Bureau of Statistics said, bouncing back from a revised 0.6 per cent decline in the final three months of last year. The relief, though, may be temporary as the main contribution to growth was from shrinking imports (adding 1.6 percentage points), not typically a sign of a robust economy. The main drag was business investment (shaving 1.1 points), a signal that the outlook for jobs is likely to darken further. ''We've dodged the recession bullet for the time being, but in reality we've had five quarters of sub-trend growth and unemployment has gone up in that period,'' Commonwealth Bank chief economist Michael Blythe said.” Additionally, AU unemployment at 5.7% (according to May data) pales in comparison to the 9.4% (and rising) rate in the US. However, AU unemployment is up substantially from the May 2008 rate of 4.3%. Plus, as there were some major (and for the most part unheeded) economic and housing bears in the US in 2006 and 2007, it appears that there are also some concerned parties emerging in AU as well. Quoting another piece in The Age: “Home prices will fall by double digits by the end of next year, denying Australians a key source household wealth, according to a JPMorgan analysis. The value of Australian homes will drop 14 per cent by the end of 2010, pushed down by a falling employment levels, JPMorgan said. The bank expects the jobless rate, currently at 5.4 per cent, to hit 9 per cent in that time.” Interestingly enough, the JP Morgan forecast is not even as bearish as the prognostications of this AU National University professor (via The Age):

The Inoculated Investor

http://inoculatedinvestor.blogspot.com/

“Professor Quentin Grafton said house prices could not continue to grow at a faster rate than incomes and consumer prices. This "property bubble" was about to deflate, he said, and first-timers, encouraged through government grants to buy at the top of the market, could be over-committed when hit by job losses and, later, higher interest rates. "First home buyers who don't have much of a deposit and can barely afford their mortgage payments on the current interest rates, they'll be in trouble," Professor Grafton said. "I wouldn't be surprised if overall we get a 20 per cent decline in nominal house prices over about the next two years." Meanwhile, the current news (via Bloomberg) is slightly worse in New Zealand: “New Zealand’s economy shrank for a fifth straight quarter as consumers and businesses cut spending, extending the worst recession in more than three decades. Gross domestic product fell 1 percent in the three months to March 31, matching the revised fourth-quarter decline, Statistics New Zealand said in Wellington today. The drop exceeds the 0.7 percent median estimate in a Bloomberg survey of 11 economists. The currency has gained 12 percent in the past three months, which “risks derailing” the economy’s recovery because it is cutting export income, Prime Minister John Key said this week. The economy then faced “multiple blows” from collapsing world trade and tight credit conditions, the Organization for Economic Cooperation and Development said in a report this week. Household spending, which makes up 60 percent of the economy, fell 1.4 percent in the first quarter, the most in 18 years, today’s report showed.” Despite this uplifting news, as of Q1 2009, the unemployment rate in NZ was only 5%, well below the 1990-2009 average of 6.3%. So, while the outlook over the next few quarters is not particularly rosy, at least at this point the unemployment situation NZ and AU looks manageable. Having said that, the concern for both the economies is that the derivative effects of the global recession put more pressure on the already leveraged consumers and already suffering businesses. Thus, I think it is important to outline additional headwinds for these economies as well as structural components that may mitigate job losses, housing price depreciation and larger write downs for banks. Economic Headwinds: 1. Currency Appreciation: Both the Kiwi and the AU dollar have appreciated significantly against the US dollar recently. As of June 26th, the AU dollar was worth .797 US dollars, up from .697 on January 2nd, 2009. This represents a 14.3% strengthening. Similarly, the Kiwi has appreciated from .578 US dollars in the beginning of January to .637 today, a 10.2% increase. As mentioned in the Bloomberg article above, the weakening dollar has made the exports of AU and NZ more expensive on a relative basis. Both of these resource rich countries depend on exports to keep their economies growing and unemployment in check. The longer the current dollar weakness persists the more likely it will be that AU and NZ businesses are forced to cut costs in order to remain competitive, a circumstance that will undoubtedly increase unemployment.

2. Deficit Spending: According to this article in The Age, AU Prime Minister Rudd recently indicated that by 2013 or 2014 public deficit could be at 13.8% of GDP. While that is on par with the 12% of GDP the US deficit is estimated to be this year, the economy of AU depends a lot more on volatile commodity prices so increased leverage is always a risk. AU is also a country that recently got used to having a budget surplus so any deficit could force consumers to limit their spending as they begin to anticipate taxes being raised in

The Inoculated Investor

http://inoculatedinvestor.blogspot.com/

the future to reduce the deficit. Also, while the rating agencies have recently stated that the AAA rating of AU is safe, increased borrowing and the current account deficit of over $5 billion AU dollars could eventually prompt a ratings downgrade. In that event the cost of borrowing would increase and could limit the fiscal flexibility of the government when it comes to stimulating the economy or averting a crisis.

3. Demand for Commodities: According to the Australian Bureau of Agricultural and Resource Economics (ABARE) and ABC News, AU’s commodity exports are expected to fall by at least 18% as a result of the reduced prices of iron and coal. While many commodities have seen a rebound from recent lows, the global recession could continue to dampen demand and keep inventories high. As a result, there is certainly the risk that commodity prices fall further and cause GDP growth to turn negative. Since commodities exports have been the growth engine for AU GDP recently, there is no question that prolonged depressed prices could have negative derivative effects on consumer spending and house prices. Mitigating Factors 1. Housing Supply: According to data released on June 23rd, the US currently has a 9.6 month (a number that may grossly understate reality) housing inventory glut. Although there is not a whole lot of data out there for AU and NZ, according to the same article in The Age that contained the JP Morgan forecasts, the Housing Industry Association is predicting a 188,000 house shortage by 2010. The effect on house prices of the difference between a huge oversupply and a shortage cannot be underestimated. One of the main reasons that the US market has experienced such dramatic pricing declines is overbuilding. The good news for AU is that it looks like that has not been a problem. So, even if the unemployment rate continues to rise and foreclosures ramp up, it is very possible that prices will not fall precipitously as a result of the new supply only offsetting the shortage.

2. Low Interest Rates: I could not find aggregate data for mortgage rates in AU but the Australian Government 10 Year should serve as a relatively good proxy for how low rates in AU are on a historical basis. The 10 Year is currently at 5.25%, down from 6.53% in May of 2008 and well below the ten year average of 6.62%. Low rates inevitably spur home buying that will help stabilize housing values. In addition, when combined with the drop in prices from the peak, low interests rates help make housing more affordable. Finally, with a manageable CPI inflation of 2.5% as of March, the Federal Reserve Bank of AU could potentially cut rates below the current 3% rate to help stimulate the economy and lower mortgage rates.

3. Stimulus and Other Government Spending: In February, the AU Senate approved a $41.5 billion Australian dollar fiscal stimulus. Programs include $28.8 billion for schools, roads, and housing over the next four years. In addition, there is $12.7 billion earmarked for tax deductions for small firms and cash hand outs to workers and students. This stimulus, which amounts to about 3.7% of trailing 12 month GDP, could really help soften the blow of rising unemployment and create new jobs. The AU Federal Government has also started a program that provides first time home buyers with substantial grants. Specifically, the plan allocates $14,000 for existing homes and $21,000 for new homes. When this program is combined with low interest rates it most certainly stimulates home buying and could help mitigate a fall in housing prices. I know that the preceding analysis contains a lot of information and the outlook for NZ-AU region is incredibly dynamic. The plethora of moving pieces that includes commodity prices, unemployment, consumer spending, currency fluctuations and government stimulus makes it very hard to predict exactly how the next year is going to play out. Another reason is that there is a lot of data I would like to have but can’t seem to find. Even after sifting through the lengthy filings of the banks I have limited data on average loan to value ratios. The only large bank that even mentions LTV is National Bank of Australia (NAB), which indicates that as of 1H 2009 the average LTV of the loan book was 63%. If the bearish forecasts regarding housing prices come true, knowing what kind of LTVs were used in underwriting housing loans would give me a sense of how many people could be under water. I also do not have any data on the types of loans that were most prevalent. From what a gather the exotic Option ARM and Negative Amortization mortgages that have plagued the US housing market were not prevalent in the AU-NZ region. But it would be very beneficial to know the ratio of fixed interest mortgages to variable interest loans. Finally, since I am not an expert on these countries, I don’t know anything about foreclosure and bankruptcy laws in these countries. Without that information it is hard to anticipate the magnitude of losses on bank balance sheets if housing prices continue to decline and unemployment accelerates.

The Inoculated Investor

http://inoculatedinvestor.blogspot.com/

What we do know is that housing prices have come down from their recent peaks. In that way the housing markets look a bit like the US market looked in late 2006. Back then it was obvious that there had been a substantial easy credit and leverage fueled appreciation in house prices but it was impossible to know how severe the downturn would eventually be. While the AU market seems to not be facing the same supply glut problem, there are a number of issues that could directly or indirectly put pressure on housing prices. The list of these includes an over-leveraged consumer, falling commodity prices and increasing unemployment. So, are the NZ and AU housing markets on the same precipice that the US market was on in late 2006? The honest answer is that I don’t know. (I hope you weren’t expecting anything definitive.) However, the risk factors are certainly present and any investor who is evaluating a position in an Australian bank with significant exposure to the local housing markets (namely, all of them) needs to be aware of the potential downside. In my next piece I will tackle the individual fundamentals of the banks and attempt to determine if their valuations match the risk profile. Also, I will try to ascertain if some banks are more uniquely exposed than others to factors that could lead to write downs and losses. Until then, I hope this analysis has been eye opening and informative.