One for the books? It appears Credit Suisse Equities research has decided that banks have over done it with their leverage play on the housing market and it’s time to “underweight banks in anticipation of job cuts, payment shocks and declining house prices”.
- The Consensus is that banks are a “quality yield” play. After all, banks have sailed through very turbulent times post-financial crisis. They have maintained their strong credit rating and high dividend yields, and reduced their dependence on offshore funding. Further, policy makers seem to have done a remarkably good job of keeping the domestic economy insulated from deteriorating global macro conditions.
- However, we believe that banks are only bond proxies to a point. We are shifting to an underweight position on banks. Valuations are not attractive, and there are downside risks to earnings and dividends as de- leveraging risks intensify. We are particularly concerned about payment shocks on interest-only loans (which make up roughly a third of the mortgage book), as well as the effects of rising unemployment.
- Risks are concentrated on over-geared housing investors. Leveraged investors are struggling to make money because net rental yields of 3.2% are well below mortgage rates of 6.4%. At most, investors can only afford to be 50% geared. However, the data suggest that borrowers are 60%+ geared, with a lot of this gearing on interest-only terms. Essentially, investors are subsidising losses on their property portfolios out of wages, in the hope of future capital gains. But their ability to keep doing this will be stretched if house prices do not rise, and if payment shocks hit.
- We are quite pessimistic about the prospect of house price inflation. Housing is 20%␣40% overvalued by historical standards. Also, housing demand is extremely low, because potential buyers are very concerned about unaffordability and rising unemployment. If demand remains low relative to supply, house prices could fall substantially. Average home equity could fall disproportionately, making the re-financing of loans more difficult.
- The over-gearing situation does not have to end disastrously. If the RBA cuts rates deeply (e.g. to 1.5%), it could stabilise debt dynamics and house prices, buying households time to work out their over-indebtedness. However, the RBA does not seem to be contemplating deep rate cuts despite the slowdown in train. Also, the lack of pass-through of RBA cuts is becoming a problem.