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BFCSA: Banks could do the RBA's job on rates ie Murdoch Spin

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Banks could do the RBA's job on rates

Australian Financial Review Mar 22, 2019 11.18am

Christopher Joye

 

Let’s talk about plummeting house prices, why the banks could cut rates for the RBA, and Unisuper’s hitherto undisclosed $1.3 billion bet on hybrids.

Home values across Australia’s five largest cities are about to pass through the 10 per cent peak-to-trough loss threshold, with the draw-down since their late 2017 apogee at 9.6 per cent.

That’s one line in the sand where credit rating agencies have warned residential mortgage-backed securities (RMBS), which are suffering from a toxic combination of rapidly rising leverage, climbing arrears, surging supply (new issuance), and radically reduced prepayment rates, are at risk of being downgraded.

(That also explains why while global credit spreads have been compressing sharply – contrary to most experts’ calls last year – RMBS spreads have not followed suit.)

In early 2017 we forecast a 10 per cent decline in national house prices, which 12 months later we revised to a 10 to 15 per cent loss on the presumption Labor comes to power and removes negative gearing while hiking capital gains tax 50 per cent.

(Most mainstream analysts revised their sanguine forecasts downwards shortly thereafter.) This contingency appears to be getting priced into the market.

Based on Core-Logic’s data, Melbourne and Sydney prices have fallen 10 per cent and 14 per cent, respectively, from their peaks, which coupled with the five city index results makes this the biggest correction in over 40 years.

A chief risk officer at a major bank says he would like prices to shrink another 10 per cent.

Yet it's important to understand that this orderly unwinding of our largest financial stability risk is arguably the best thing that could happen to the Aussie economy at a time when commodity prices are elevated, exports are booming, growth is solid, the federal budget is coming into balance, and the jobless rate has contracted from 6.4 per cent to just 4.9 per cent. (In January 2018 we projected that the unemployment rate would fall from 5.5 per cent to below the RBA's “full employment” threshold at 5.0 per cent, which it has now done.)

When the chief risk officer at a major bank tells you he would like prices to shrink another 10 per cent, you get a sense of just how valuable this mean-reversion is.

To be sure, it is shocking news if you own subordinated, non-bank RMBS issued in 2017 or 2018 with low-to-no-seasoning (i.e. full of recently originated mortgages) and lofty loan-to-property value ratios (LVRs), which derives its security from housing collateral that is declining every day.

Systemically important

On the other hand, it is positive news for a systematically important bank with government-guaranteed deposits, access to the RBA’s emergency liquidity facilities, and a home loan book sourced over decades with low LVRs that is being constantly refinanced with new assets.

That is why Standard & Poor’s has warned about the risk of downgrading recently issued junior-ranking RMBS at the same time as they are signalling they may upgrade the major banks’ hybrids and subordinated bonds once Australia's economic imbalances normalise.

In one new RMBS deal launched this week, S&P cautioned that a 10 per cent drop in house prices could smash a AAA rated tranche down six notches to A- and reduce the AA rated tranche down to a junk BB+ rating even after accounting for lenders' mortgage loss insurance (holding all other variables constant).

The derisking of major bank balance-sheets is a trade Unisuper’s CIO, John Pearce, has been aggressively capitalising on.

In a chat with this column he revealed that had pumped $300 million (previously reported as $200 million) into NAB’s latest hybrid (ASX: NABPF), which closed strongly above par on its first day of trade on Thursday at $100.76.

This would have bequeathed Unisuper a circa $5 million profit on day one assuming Pearce also negotiated a rebate on the sales commission as the key cornerstone investor in the deal.

UniSuper has invested a staggering $1 billion into four major bank hybrid deals in 2016.

Like the 92 per cent of other investors who pay tax, Unisuper will be able to continue to fully harness franking credits if Labor wins.

And at a credit spread of 4 per cent above the bank bill swap rate, Pearce judges that he is earning an “equity risk premium like return” with about one-third of the historic volatility of shares (and the protection associated with sitting one level up the corporate capital structure).

Pearce further revealed that he invested a staggering $1 billion into four major bank hybrid deals in 2016 when their credit spreads blew wider on the back of offshore weaknesses, which has been an outstanding trade.

He says ASX hybrid spreads have overreacted to the debate around Labor’s proposal to stop non-tax payers claiming cash refunds, which impacts only a tiny minority of investors and seems to be more than fully priced.

Current hybrid spreads are about 70 basis points wider than their January 2018 levels and 140 basis points higher than they were in 2007 despite the fact that the major banks have halved their risk-weighted leverage.

Banks could cut for RBA

While APRA is not eager to claim credit, the great Aussie housing correction was induced by its “macro-prudential” constraints on credit creation, which forced investment and interest-only loan rates up by between 25 and 50 basis points.

With these restrictions now removed, the smartest thing RBA governor Phil Lowe could do is to get banks to cut rates for him, preserving his monetary policy ammunition for a real crisis. The RBA hinted it might do exactly this in its latest minutes.

In contrast to claims Aussie banks have been imprudent lenders, the RBA’s view on this subject is crystal clear: they are too tough. Witness the RBA’s head of financial (in)stability, Michele Bullock, exclaiming this week that “my hope, now that the royal commission has finished and APRA has finished removing its [macroprudential] benchmarks, [is] that banks will start to lend again”.

In a direct appeal to the same folks the royal commission excoriated for lending too liberally, Bullock begged: “Please think very hard about whether your lending standards are too tight, and whether you can loosen up a bit.”

While UBS’ prediction of a credit crunch has never remotely come to pass – with year-on-year housing credit growth remaining firmly positive at around 5 per cent – the banks did become (rationally) more risk-averse during the royal commission following the interim report’s insinuation that they had collectively run afoul of Australia’s responsible lending laws.

This column countered that the commission’s reading of the laws was wrong, a position the Federal Court has subsequently embraced. Specifically, the court confirmed our analysis that the banks could rely on independent proxies for borrowers’ living costs, and not verify their expense claims, and still comply with the laws. In his final report, Hayne deferred to the courts and hinted that the government might need to rewrite the laws.

Funding costs

In its latest minutes the RBA disclosed that “members had a detailed discussion [about the RBA’s] operations in repurchase and foreign exchange swap markets and their role in achieving the board's target for the cash rate”, which smart participants inferred could be a signal it may help normalise bank funding costs.

This is a complex subject, but in short strokes there has been an enormous $70 to $80 billion increase in foreign demand to borrow money from the major banks via so-called secured repurchase (or “repo”) arrangements in recent years.

The secured short-term repo rate is meant to sit very close to the RBA’s target cash rate, but it has consistently spiked to GFC-like spreads above it at the end of each quarter since late 2017. This is because banks have been hitting limits as to how much they can lend via repo, and have sought to reduce their exposures when they report their quarterly balance-sheet ratios.

While the RBA can ultimately control repo costs by lowering the rate at which it lends to banks via its own repo facilities, it has thus far allowed market forces free rein.

The banks’ problem is that their cost of borrowing, proxied by the unsecured bank bill swap rate (or BBSW), must ultimately price above the secured repo rate. As repo rates have climbed, so too has the BBSW rate, inflating the banks’ funding costs across all their wholesale liabilities, which are set at a margin above BBSW.

Conditions have recently started to normalise in both the repo and BBSW markets, with no quarter-end effect evident in March. The BBSW rate has fallen from 2.1 per cent to 1.8 per cent, which should lower the banks’ cost of funds.

The RBA drew attention to this development, highlighting that “the marginal cost of banks' wholesale funding had declined a little”, although in total credit spread terms it remains miles above the levels observed in January 2018 and the post-crisis "tights" in 2014.

This is somewhat paradoxical, because the banks have dramatically derisked their balance-sheets since 2014, which, all else being equal, should reduce the cost of their debt capital.

Market share

If the banks start competing more aggressively for mortgage market share, there is a decent chance they will begin discounting lending rates, which in concert with extra fiscal stimulus care of the federal election could do the heavy lifting for the RBA.

Another opportunity to minimise the banks’ funding costs was highlighted by APRA at a debt conference during the week. In an update on its proposed total loss absorbing capacity (TLAC) policy, APRA acknowledged that using illiquid and volatile Tier 2 bonds to fill a $100 billion plus gap in its TLAC target has no global precedent and is likely to be subject to severe capacity and pricing constraints.

Kapstream’s Steve Goldman told the conference that if APRA implemented this policy using Tier 2 debt, the spreads on these bonds would likely jump a massive 50 to 100 basis points higher than the sharp 40 basis point spike observed in November when APRA’s consultation paper was released.

This is consistent with independent surveys of global investors, which found that using Tier 2 to plug APRA’s TLAC hole would cost the banks between 2.5 and 3.0 times their current senior bond spreads.

Importantly, APRA noted that its consultation process had identified cheaper and more liquid alternatives. In particular, there is a strong global consensus that a more cost-effective and scalable way to raise TLAC capital is through so-called Tier 3, or “non-preferred senior”, bonds, which APRA can still bail into equity when a bank goes bust.

Based on investor surveys and recent local transactions, NPS would cost the major banks between 1.25 and 1.50 times their senior bond spreads if it was issued in accordance with global best practice, or about half the cost of funding TLAC via Tier 2.

The global NPS market is roughly 10 times the size of the Tier 2 market, which would allow the banks to comfortably meet APRA’s target of increasing their bail-in-able funding by 4 to 5 per cent of their risk-weighted assets.

Total capital ratio

On APRA’s numbers, this would boost the major banks’ total capital ratios to slightly below the middle of their global peers (notably not near the top quartile). While APRA is targeting “unquestionably strong” core equity ratios around the top quartile of offshore peers, it has adopted a more reasonable, middle-of-the-road target for the banks' TLAC ratios.

Some officials had thought Tier 2 would be a simpler solution compared to NPS, but this is only true insofar as it might save the regulator from having to draft a new prudential standard.

Participants universally agree that Tier 2 is more complex for the banks to fund than NPS, which is cheaper and has substantially greater market capacity. For investors, NPS comes with superior credit ratings, ranks above Tier 2 in the capital structure, and crucially attracts far larger portfolio limits because it is classified as a senior, not subordinated, debt. This means that is has much better secondary market liquidity. Some might quibble that NPS is subordinated to old-style senior bonds, but then the latter are themselves subordinated to deposits, which in turn rank below secured covered bonds. It is all about the relativities.

Since Basel 3 Tier 2 bonds were only first introduced in Australia in 2013, and have never been bailed-in, they are also no more proven a product than NPS, which is a bigger market globally than Tier 2. This is especially true of Aussie bank Tier 2, which global investors have repeatedly criticised for having vague bail-in rights that mean it could be used as "going concern", rather than legitimate "gone concern", capital, which has made them expensive for banks to issue into the foreign jurisdictions that are expected to provide the vast bulk of our TLAC funding.

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