December 2010 Source: Balmain Author: Jonathan Stacey - Analyst Balmain
Following the Global Financial Crisis (GFC) the major Australian banks have tightened their control over the Australian financial economy. In 2009 fixed interest rates offered by banks on Australian term deposits rose significantly as banks both in Australia and globally competed to refinance debt. The increase in term deposit rates, compounded by the Australian Government Bank Deposit Guarantee, reduced the competitiveness of non bank income investments. Clearly the increased cost of capital puts pressure on bank profits which logically flows through to interest margins charged to borrowers and paid to depositors. The Big 4 (ANZ, CBA, WBC & NAB) have commenced reducing interest rates offered on longer term deposits, whilst increasing mortgage rates in the short term. This could set the stage for the comeback of non bank income investments.
Today around 55% of the Big 4 banks’ funding comes from their Australian deposit base1. Between January 2007 and September 2010 Australian deposits at the Big 4 increased 89% to $977 billion2. The bulk of bank funding remains short term, as can be seen in Chart 1.
Chart 1 – Aggregated bank funding maturity analysis from 2003 to 2009 for consolidated banking groups: Australia and New Zealand Banking Group, Commonwealth Bank of Australia, National Australia Bank, Westpac Banking Corporation. Data Source: Big 4 Banks Annual Reports
Post the GFC, wholesale funding became more expensive as banks reduced their interbank lending volumes and kept this lending at short duration. In July 2009 Commonwealth Bank of Australia (CBA) raised $1 billion, via unguaranteed 5 year floating rate notes, at a margin of 145 basis points over the 90 day bank bill swap rate (BBSW). Debt capital markets’ confidence has improved since then, as evidenced by CBA raising $1.5 billion, at an 85 basis points margin over the 90 day BBSW in September 20103. This is much lower than the average 100 and 115 basis point premiums (over 90 day BBSW) the Big 4 banks are currently paying on 1 and 3 year term deposits respectively4. Of concern to fixed term investors, is the possibility that the banks may look to further reduce term deposit rates if they can raise funds less expensively with equal reliability elsewhere.
During the GFC Australian banks focused on raising deposits as a stable source of funding. By increasing domestic deposit funding Australian banks insulated themselves from volatile global money markets. Post GFC the average Australian 1 year and 3 year bank term deposit rates peaked at 6.0%pa and 7.0%pa respectively in December 20095. Between September 2009 and August 2010 the aggregated term deposit base grew a whopping 20.6% to $416 billion6. Whist the average 1 year term deposit rate remains 6.00%pa, the average 3 year term deposit rate has gradually fallen to 6.15%pa by October 20107.
Chart 2 – Term deposit rates correlation to banks aggregated term deposit base Data Source: Reserve Bank of Australia
Any increase in costs such as the rise in term deposit rates has a negative impact on bank profit margins. As chart 3 shows, the differential between the average 3 year term deposit rate and 3 year fixed residential mortgage rate has fallen from around 4.00%pa in July 2008 to 0.65%pa in August 2010. Since then that margin has increased to over 1.20%8. Is this a sign that the banks are looking to reverse their margin squeeze?
Today the average 3 year fixed term lending rate is around 7.35%pa whilst the average term deposit rate for the same period has fallen to 6.15%. Again this is evidence of loan margins increasing and term deposit rates reducing as banks move to maintain or increase their typical 2% plus net interest margins.
Chart 3 – Profit margin 3 year fixed interest loan Data Source: Reserve Bank of Australia
At the same time there is evidence that the banks are also offering high interest rates on at-call funds held in online savings accounts, typically for set short promotional periods. Interestingly after the November 3, 2010 RBA Official Cash Rate 0.25%pa rise, some banks increased their promotional rates, whilst holding term deposit rates on terms 12 months and longer. It may be that the motivation behind this is to roll-over longer term investors to shorter term deposits. If so, it is probable that once these promotional periods end, the banks may further reduce the deposit interest rates. Whilst some investors will move their money elsewhere, inertia amongst customers should result in a slow attrition and a greater profit margin for the banks.
The Australian Government Bank Deposit Guarantee reduced the risk of bank deposit investments. This guarantee is scheduled to be reviewed in October 2011, however there are many who believe that it should be removed sooner as the increased risk the banks faced in 2008 is largely gone. An effect of this guarantee was the reduced competitiveness of mortgage trusts and other fixed income investments not guaranteed by the Australian government. This resulted in the banks currently facing very limited competition both in terms of fixed income investments and in the commercial mortgage lending sector. However there are glimpses that this period may be coming to an end.
It is likely that non bank mortgage investments will be more attractive to investors at the expiry of the deposit guarantee in 2011, if not before, as banks reduce term deposit rates to improve lending margins. By way of example we can already see how the returns from mortgage trusts are becoming attractive once again when we contrast the results of Balmain Wholesale Mortgage Trust against average 3 year bank term deposit rates (Chart 4).
The Balmain Wholesale Mortgage Trust 3 year yield surpassed average bank term deposit rates in August 2010 reaching 6.80%pa. In November 2010 the yield reached 6.84%.
Today both mortgage trusts and banks are able to write higher margin commercial mortgages than those written pre GFC. Loan-to-value ratios have reduced and interest servicing capacity has increased on new loans being written. These reduced risk and higher reward direct mortgage investments are likely to again become an attractive option to income seeking investors. Commercial mortgage trust investments perform best when investors commit to a term that is equivalent to the term of the underlying securities. As expiry of the deposit guarantee draws closer and bank term deposit rates reduce, non bank income investments should become more competitive.
Chart 4 – Balmain MWMT Vs 1 & 3 Year term deposit rates Data Source: Reserve Bank of Australia, Balmain Funds
The banks’ desire to drive shareholder profits and limit capital funding costs is seeing them reduce interest rates on longer term deposits. At the same time they have increased mortgage interest rates beyond the increase of the RBA official cash rate. Investors that require high income returns might start to consider non-bank alternatives for income investments, and also accept that high income yielding investments will not necessarily be liquid. In this situation, liquidity needs to occur from a financial planning/portfolio perspective rather than only considering investments that offer immediate or shorter term liquidity. Importantly investors should recognise that inertia comes at a cost (to them) and might start considering alternate income investments (either directly or via their financial adviser), sooner rather than later.
Written by Jonathan Stacey, Analyst of Balmain NB Corporation Limited on behalf of Balmain Fund Administration Limited. All metrics have been derived from data obtained from: Balmain Funds, Reserve Bank of Australia, Australian Bureau of Statistics, Australian Prudential Regulation Authority, Australian Financial Markets Association, Bloomberg and Annual Reports for the following banks: Australia and New Zealand Banking Group, Commonwealth Bank of Australia, National Australia Bank, and Westpac Banking Corporation.
Disclaimer This document is provided by BALMAIN FUND ADMINISTRATION LIMITED ACN: 134526604, Australian Financial Services License: 333213 (“BALMAIN FUNDS”), contains general information only and does not constitute financial product advice. In preparing this document, BALMAIN FUNDS has not taken account of your objectives, financial situation or needs. Because of this, you should, before acting on this document, consider the appropriateness of the information, having regard to your objectives, financial situation and needs. In preparing this document BALMAIN FUNDS has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which has otherwise been reviewed in preparation of the document. The information contained in this document is current as at the date of this document and is subject to change without notice. Past performance is not an indicator of future performance. Neither BALMAIN FUNDS, nor any of its directors, authorised representatives, employees, or agents, makes any representation or warranty as to the reliability, accuracy, or completeness, of this document. Nor do they accept any liability or responsibility arising in any way for errors in, or omissions from, this document. BALMAIN FUNDS strongly recommends that you seek independent accounting, financial, taxation, and legal advice, tailored to your specific objectives, financial situation or needs, prior to making any investment decision.
This publication contains certain statements which may constitute “forward-looking statements”. Such statements are subject to inherent risks and uncertainties which could cause actual values, performance or achievements to differ materially from those expressed, implied or projected in any forward looking statements.
BALMAIN FUNDS disclaims any intent or obligation to update publicly any forward-looking statements, whether as a result of new information, future events or results or otherwise. Investors are cautioned that forward-looking statements are not guarantees of future performance and investors and borrowers are cautioned not to put undue reliance on forward-looking statements due to the inherent uncertainty therein.
If one of the Balmain Group’s products is acquired, entities within the Balmain Group may receive fees and other benefits.
The writer, Jonathan Stacey, does not hold any long or short, equity, derivative or debt positions of any of the companies, funds or trusts referred to in this document and does not derive any remuneration directly or indirectly as a result of the opinions expressed in this document.
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