‘Bad loans are made in good times’, warns asset manager

Perpetual portfolio manager Anthony Aboud believes the current levels of bank dividend payments “are simply unsustainable” and that the most obvious response would be for three of the big four to cut dividends.

The asset manager said that NAB, CBA and Westpac are all paying out more in dividends than they are generating in organic capital. ANZ is the exception.

Perpetual also noted that “bad loans are made in good times” and that markets seem to miss the point that banks are cyclical businesses.

“We are currently at a relatively low point as far as bad loans are concerned," said Mr Aboud. "During these periods of cyclically high profits, the banks should be putting capital aside for the bad times. If they don’t do it themselves, the regulator will likely force them to.”

Mr Aboud believes the APRA will require banks to increase the amount of capital they hold, which should reduce their capacity to keep up future dividend payments.

“There are many different tools which APRA uses to enforce the amount of regulatory capital required to be held. The main ratio that the regulator and banks focus on is the common equity tier 1 ratio (CET1 ratio). In Australia this is required to be above 8 per cent although most banks mandate a buffer of at least 8.8 per cent,” he explained.

Perpetual believes the big issue is whether or not risk weightings will continue to move higher or the minimum CET1 ratio will be set at a higher rate.

“I believe that both scenarios are extremely likely given market conditions and regulatory pressures,” Mr Aboud said.

“Both of these options require the banks to increase the amount of equity held and aside from issuing more shares, their most obvious response to that scenario is to cut dividends.”

Mr Aboud argued that many Australians don’t appreciate that banks are cyclical businesses, “given the 24-year bull run in property prices that the banks have enjoyed”.

In a weaker economy, he said, that not only is the probability of mortgage default higher, but also the value of the collateral behind those loans is likely to be lower.

“That means provision for bad and doubtful debts is likely to increase sharply in a weakening market — with a consequent drop in bank earnings.

“My view is that good long-term capital management policy for cyclicals like banks should be to put some capital aside during the good times so they do not need to raise equity at depressed prices (resulting in dilution when the share price is at its worst).”

Perpetual said that “very little” capital is being put aside by CBA, NAB and Westpac for a rainy day.

The warning comes after the number of housing loans in arrears has extended its rise for the seventh consecutive month.

According to Standard & Poor’s Performance Index (SPIN), 1.21 per cent of prime residential mortgage-backed securities (RMBS) were in arrears during May – up from 1.14 per cent in April, and from 1.07 per cent 12 months prior.

“Most of the increase in arrears for the month was in the more severe category of 90-plus days overdue,” S&P noted.

“The larger upward movements were in the major banks and other bank categories, while non-bank financial institutions was the only sector to see a decline in arrears in May.”

[Related: Housing downturn would wipe out major bank capital]