When it comes to reading the tea leaves behind the COVID-19 shutdown, investors are more interested in a 'glass-is-half-full' perspective as the economy starts to ratchet up again. Nowhere is the sentiment more evident than in the 'catch-up' rally experienced by the banking sector early last week, with the big four up between 4.9% and 8.6%.
But the Australian Prudential Regulation Authority (APRA) has brought some sobriety to the bank rally. In a speech to international bankers last Wednesday, APRA Chair Wayne Byres warned that it's "dangerously naive" to assume bank shares will continue on an upward trajectory – given that an economic snap-back is unlikely, and that the real troubles for the financial sector remain ahead.
The banks account for 20% of the S&P/ASX 200 Index (ASX: XJO)'s market value, and have historically delivered both massive profits and generous dividends, which has made them surrogates for fixed income. They have consistently offered investors what the vast majority of listed stocks can't: growth and income.
However, the great virus crisis (GVC) of 2020 has only added to a litany of issues that have been plaguing the big four for a while. These include the requirement to hold significantly more capital than ever before, plus a tsunami of additional regulatory risks.
Are bank dividends still a suitable surrogate for fixed income?
The net effect of the issues above is that the mouth-watering dividends investors could previously bank on now look decidedly less certain. The market is now rightfully questioning whether Australia's multi-decade obsession with the big four banks is still warranted if their dividend levels are unsustainable.
For income investors who have treated bank dividends like annuities, this is a tough question to ask, especially with cash and bank deposits offering miserable returns.
Unlike the global financial crisis (GFC), the banking sector, and especially the big four, will not emerge from the GVC as unscathed. Federal government pressure on banks to extend questionable loans to help companies survive the GVC has forced the big four to hike their provisions (estimated at around $20 billion) for loans going sour.
Unsurprisingly, with an estimated $65 billion of retail property loans sitting on their books, the bulk of banks' impairments will come from the commercial property sector, where landlords and the tenants in currently embroiled in massive arm wrestle over mandated rent relief. In the meantime, sectors where impairments are expected to be greatest include education, and tourism.
$210 billion in un-serviced loans
It's estimated that around 274,000 ($56.5 billion) of the 703,000 loans ($210-plus billion) that have been deferred are business loans, personal loans and credit cards, with residential loans making up the rest. The reality check for businesses and mortgagees alike is that they will have to start repaying debt once the hibernation stage of the COVID-19 crisis ends.
However, adding to the banks' problems is the strong likelihood that the 'repayment holiday' will go on a lot longer than anticipated. The longer the repayment of these loans are stalled, the more nervous banks will become about them being repaid, especially with the costs of deferring business loans continuing to mount.
But unlike the GFC when the official cash rate was set around 6%, today's ultra-low borrowing costs makes it easier for banks take a 'wait-and-see' approach to potentially problematic loans. This explains why only a fraction of the estimated $210 billion in loans currently in deferral are expected to end up defaulting.
Adding another layer of comfort for banks, the much anticipated crash in residential property prices hasn't materialised, with property prices having risen slightly in April.
The lure of banks without dividends
The single biggest issue for investors is whether the big four remain an alternative to dismal term deposit rates. At face value, this looks like a no-brainer. After all, with the RBA's official rate of 0.25%, deposit rates will be 1.25%, which means that after inflation and tax, investors are out of pocket by around -1%.
However, with shareholders likely to receive either a much lower interim dividend or no dividend at all – due in part to the high bar that's been set by the prudential regulator – the argument for holding bank shares becomes much less compelling. What's also adding to banks' troubles right now is the estimated 10% freeze on mortgages, plus a 15% hold on SME loan repayments.
Australia and NZ Banking GrpLtd (ASX: ANZ), and Westpac Banking Corp (ASX: WBC) have deferred their dividend completely. Macquarie Group Ltd (ASX: MQG) paid a dividend 50% lower at $1.80, while National Australia Bank Ltd. (ASX: NAB) paid an interim dividend of 30 cents, down 64% on FY19.
Then there's the Commonwealth Bank of Australia (ASX: CBA), which hasn't had to report yet but is also expected to take a scalpel to its dividend in August.
Before the recent rally, the market responded to expectations that ANZ and Westpac would mimic the Bank of Queensland Limited (ASX: BOQ)'s decision to shelve dividends. Both banks share prices fell sharply.
While the recent rally offers cold comfort, the sobering question for shareholders and investors is how long will bank dividends be deferred for, and will a lower dividend policy become the new norm?
Have banks been oversold?
Intuitively, the short answer is a resounding no. Banks know better than anyone it's going to be impossible to sustain investor support without the appeal of above-average dividend yields.
The banks entered the GVC with the most robust balance sheets ever, courtesy of APRA's tighter regulatory and lending measures. So, it could be argued they've been oversold on the expectation that the fallout from COVID-19 will be a protracted affair. But assuming COVID-19 has only a short-lived effect on book quality, as many are predicting, the banks look well positioned for a near-term rebound.
Based on its bottom up analysis, Goldman Sachs suggests the banks can sustainably earn a highly respectable 10% return on equity in the current environment. The good news for investors is that this implies a 72% dividend payout ratio. However, factoring in dividends at 50% – in line with global forecasts – might be more in keeping with banks' short-term profitability.
While the broker's numbers suggest the sector should trade on 1.3x – around 24% above where it's trading now – not all banks have the same appeal.
Look out for a deep dive into how to value the big four banks tomorrow morning, in which I'll discuss the evaluation criteria specific to banks, and highlight some standout bank shares to consider.
