By Mark Draper

With unemployment at 3.5 per cent and likely to rise, the full force of higher interest rates yet to be felt in loan losses, and talk of recession, how should investors be viewing the banks?

Those who remember the 1990s recession that pushed Westpac to the brink due to large commercial lending losses would be comforted to know that Australian banks today are largely focused on residential mortgages.

Matt Haupt, a portfolio manager at Wilson Asset Management, believes this is positive as, in times of stress, residential mortgages are the safest place to be. He says that even in severe downturns, residential loss rates are low.

Bad debts are a risk to banks, and the bears on the sector point to the risk of an expensive Australian housing market falling over, thereby increasing bad debts.

Hugh Dive, chief investment officer at Atlas Funds Management, quotes from Westpac’s recent profit result where the bank forecast two scenarios: The base case was for a 7.8 per cent fall in residential prices and 4.7 per cent unemployment; and the worse case scenario was a 27 per cent fall in property prices and 11 per cent unemployment.

Westpac has credit provisions of $4.9 billion versus expected credit losses in the base case of $3.4 billion, and a worse case scenario producing expected credit losses of $6.8 billion.

Dive believes it is hard to see a 27 per cent fall in property prices as they have already fallen 8.4 per cent over the last 12 months. Providing employment holds up, he thinks the banks are adequately provisioned.

Dive says that at this point in the cycle, the Australian banks are more conservatively positioned than they were during the GFC.

For example, the average loan-to-valuation ratio on CBA’s mortgage book is less than 50 per cent, according to its most recent profit report.

There would need to be some big property falls before banks actually feel the pinch, but possibly the newer private credit funds may be where the “excitement” will occur when bad debts tick up, as they have been taking on the credit risks the banks have declined.

The other most important number is net interest margins. NIM is earned by lending out funds at a higher rate than by borrowing these funds from depositors or money markets. CBA’s margin was the highest in recent reported results at 2.1 per cent, while National Australia Bank was sold off heavily on the day of its result after reporting its margins had fallen by 0.04 per cent in the second quarter of 2023.

Haupt believes that bank margins have peaked in this cycle. Rising interest rate environments are good for bank margins, and margins were expected to keep rising until the Reserve Bank of Australia stopped increasing interest rates.

However, aggressive competition for mortgages and deposits started to kick in late last year, resulting in falling margins.

Dive agrees that margins have peaked, but notes that Westpac, CBA and NAB have dumped cashback offers for new mortgages and increased their variable rate by 0.1 per cent, which indicates a lessening of the aggressive competition.

The big question is how the banks achieve profit growth against a backdrop of a cautious consumer and falling margins.

Haupt believes bank profitability has peaked and the best days are behind us. He says it feels like investors have to wait for the cycle of falling interest rates to start and finish before he can get excited about margin expansion – and this feels a long way off.

Migration and the reopening of the Chinese economy, however, are likely to be tailwinds for the banking sector as they should contribute to growth in lending.

Other risks to the banks include the Australian Competition and Consumer Commission inquiry into deposits, competition and liquidity.

Dive says the ACCC is likely to find that banks have historically been slow to increase deposit rates when interest rates rise, but this has changed, and he doesn’t see this as a material risk.

Haupt says that liquidity issues arise when there is a loss of trust in the financial system. A credit crunch impedes the ability of banks to roll over existing funding and access new funding. He believes this risk is low.

So, while the banks appear well provisioned for problems in their home loan books, profit growth is likely to be difficult to come by for a while.

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