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Elephant in a china shop

The elephant in the china shop, mixing destructive metaphors, is how our banks survive the covid induced economic crisis. How much of the combined $2.7 trillion loan books, to the point, get written off? And what does it mean for bank dividends?

Uncertainty and chaos are two main by products. And it matters little what shaped economic recovery is postulated, V, U, L or W, the pain to shareholders, particularly those with overweight bank positions, will be real and hurtful.

APRA already has said it doesn’t contemplate following New Zealand’s approach mandating its banks. But in plain language it is suggesting banks contemplate suspending dividend payouts. And Bank of Queensland echoes this mantra when reporting its results saying it has suspended a decision on making a dividend announcement. And we have March 31 half year results coming up from majors Westpac, NAB and ANZ. So expect a similar on trend dividend message. Also the capital tops up provisions of BASEL are temporarily suspended. Nevertheless financial stability is paramount, and the final call despite official pressure, will need to be the individual board’s call on future dividend policy.

With NIM (net margin interest) under pressure it is hard to see what other levers bank boards have to pull other than directing the train into Lower or No  Dividendstan for the next couple of years. 

Board’s assessments of bad debts are made a little more complicated by accounting standards which require each bank to forecast expect credit losses (ECL’S). This requires  a range of unbiased probability weighted potential  outcomes. And I am reminded of Mark Twain’s “lies damned lies and statistics “when it comes to these formula inputs.

In the current crisis, determining what that bottom up analysis looks like is equivalent of predicting the necessary length of a piece of string. It is simply unknown.  Longer term those losses will become more apparent.  And the question of the write downs will be “how much.”

The interesting point is does this represent a “woke” moment when the market finally pivots way from financials to resources; as we have lengthy postulated, in the replacement search of relatively high paying dividends.

The market is usually the best bet on where it sees the potential of bad debts and dividend impact. All of the major bank stocks this week are down by a further 4-5%. And there is likely to be more falls to come.  Clearly the historical dividends paid by the banks are unsustainable, so investors would be wise to avoid falling into the bank value trap based on a repeat of past earnings.

Using ANZ as an example, it paid $1.60 in dividends last year. Clearly the market does not believe this is a sustainable 10% yield. Furiously polishing our crystal ball and assuming a payout ratio  of about 70%, we reckon at best ANZ can pay is a forecast  annual dividend of around $1,00 a share . And the figures look equally as bad for other majors. The best current suggestion on loan books write down is close to $3 billion – about 10% of current loan book size.

 And that means with so many swing factors like the unemployment rate, the shape and speed of the economic recovery, it’s extremely difficult to have much confidence in immediate forward bank earnings estimates. They will look cheap on valuation, for the first time in a long time. ANZ, NAB and WBC now trading below book value for the first time since 1993. And that possibly represents fair value. But avoid rushing in. There is a recession coming.

The biggest single issue facing banks and highlighted by the Bank of Queensland result is the pressure on NIM. There may be some some short term relief in not passing through immediate interest rate cuts. But if the RBA needs to cut rates again, banks could have negative jaws conniptions, where the cost line eats up earnings. Already many deposit products are approaching zero interest rates. Reinforces the message on lower or suspended dividend payouts. Lower bank   valuations will have a big impact on the ASX – banks are some 35% of the total index. Think of the possible index fund selling as this unfolds.

The overall level of credit impairment is difficult to quantify. But it’s not a pretty picture. The government estimates 6 million of approximately 13 million workers in Australia will be on wage subsidies over the next six months. While there are short term credit holidays, longer term that will require provisioning and a large jump in in delinquencies as those holiday periods expire.

We are seeing at the same time, earnings upgrades coming through for key resource stocks like BHP with revised upwards price target of $36. And some of the single iron ore exposure is rubbing off onto FMG. Both stocks offer a significant safety haven over the next 18months for bank holders looking for the sanctuary of safer dividend waters.

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