Corona crisis threatens big four dividends

Glenn Freeman: Welcome to this edition of "Ask the Expert." Now, we're talking Australia's banks. And given that they account for around 20% of the ASX 200, they are very important to the Australian economy. And Nathan Zaia, our equity analyst, is talking to us about how they're holding up.

Nathan, thanks for joining us today.

Nathan Zaia: Thanks, Glenn.

Freeman: The big question on everyone's lips will be how will bank dividends hold up given the big hits that they've taken.

Zaia: Yeah, I think, what's going to dictate what happens to dividends is going to be what happens to earnings. So, we recently lowered our dividend expectations across all banks, so for most of the majors up to 25%; for CBA, a be a little bit less just because they've paid one-half and they have 6 billion in capital above their minimum requirements. But it's really going to come down to how big an impact does this economic slowdown have on their loan losses. And that is where there's a lot of uncertainty and a lot of variability can come out in their earnings profile. We don't think that can hold our ratios where they are. So, dividends are probably going to fall even faster than earnings, unfortunately. And I mean, it's disappointing for shareholders that rely on these income streams, but there's not much the banks can do about it really.

Freeman: Do you have any idea at this point how long the cuts could be in place? Or is it still just open-ended like everything else at the moment?

Zaia: We think it's probably going to be for the next maybe two years of earnings. So, we've assumed – so, it all comes down to how large the loan losses are, in our opinion. So, we've assumed they increase in FY 2021 to about 30 basis points of loans, and put it into perspective, they are running about 13 basis points. So, for Westpac, that means their bad debts have gone from 800 million to over 2 billion. So, that's what we're assuming in the next couple years. So, on those numbers, we think dividends fall, and then gradually we think those loan losses do normalize. We don't think this is permanent. And I think that's what the share prices are kind of reflecting. They're trading at 0.6 and CBA 0.8 times our fair values. We don't think this is a terminal issue. We think the things will recover gradually. And I think dividends start recovering post that. But in saying that, you know, could things be a lot worse than we're currently forecasting in our numbers now? Yes, it's very possible. These are very uncertain events and we don't know exactly how we're going to come out of it.

Freeman: In recent days, we've seen the regulators in the large developed markets tell the banks to stop paying dividends. Could we see something similar happen here in Australia?

Zaia: Yeah, I think, what the central banks are worried about is, they really don't know under the accounting standards as well how large an impact these increased provisions or looking forward, how much stress that there's going to be on your loan book, what that does then to capital ratios. So, they don't want to put banks or they don't want banks to get in a position where they're so worried or needing to protect that, that they stop lending too, because then that would have an even greater impact on the economy during this period where people are struggling, they can't even get access to capital. So, I think APRA is very mindful of that and that's why they have come out and said, the banks 10.5% unquestionably strong or meeting that. For the time being, so long as you're meeting 8%, then that's fine. So, that gives them a lot of buffer to continue lending during this period.

Freeman: So, just moving across into the housing, how will the house price slowdown affect banks? And how well-equipped they are really hold off, and which of the backs is most exposed?

Zaia: Yeah. So, I mean, the majors all have huge exposure to the mortgage market. Westpac has a bit more in the investor side as well, whether that becomes more problematic or not. I mean, with house prices alone, it does mean if someone defaults, just getting rid of that property or selling that property and repaying your loan or even if the bank repossesses, there's probably less equity in it than there originally would have been. So, there is some impact. But I don't think that is where a lot of the earnings pressure is going to come from necessarily where house prices are. I mean, average LVR across the banks in their mortgage books is like 60% odd. So, it's going to take a massive fall before that equity buffer is gone.

Freeman: Nathan, we've seen the banks allowing some borrowers to defer their repayments. But can banks afford to do this given – can we get to the earlier point about just how important they are to the local economy and the threat of recession hanging over us?

Zaia: Yeah. Well, I think, from the bank's point of view, they would rather – a borrower can put off paying their interest now. So, it's a small hit to their top line, because remember, it's not going to be everyone deferring. They'd rather do that than have people defaulting. And when they default on the loan, that's a lot worse than just deferring your payments. So, the hope is that you can defer your payment now, your job comes back, and you keep paying your mortgage.

Freeman: Nathan, are we going to see any capital raising by the banks?

Zaia: So, we think the banks are very undervalued at the moment, and they will come through this. These near-term hits to earnings don't really have too much of an impact on their long-term value. But if they do need to raise capital now at these depressed levels, that's where there can be some dilution to our fair values. At the moment, we don't think they need to.

Freeman: On the positive side, Nathan, we haven't made any massive cuts to the fair value estimate for the banks, have we?

Zaia: No, that's right, Glenn. If you think about it, like, this might be a few billion dollars in short-term earnings that gets wiped off the banks. But if you think about their total enterprise value and the fact that we think, in the long term, what their earnings might have looked like in five years ago pre this pandemic, it's probably still the same. I mean, their loan books will still grow, and they'll still be earning interest on that, loans will normalize. So, it's scary in the short term, and we can't predict where share prices will go. As the news comes out and is worse and worse, share prices might fall more. But that's the thing we want to stress, like, taking a long-term view, this really isn't detracting from their valuations.