The worst is yet to come

By Staff Writer

Within hours of Tito Mboweni’s announcement of an interest rate hike last week, SA’s four largest banks shed R11,2bn (3,4%) of their total value (R349,6bn) on the JSE.

As financial services are the main driver of GDP growth, this was a particularly severe blow to a linchpin of the economy. But the rate increase was the straw that broke the camel’s back.

Behind closed doors, analysts are furiously revising their growth targets for each bank. The early thinking is that this hike, and another in June, could knock 5% off their growth in profits — a revision running into billions.

As one senior bank executive forecast: “If there’s another hike in June, then we’ll probably see the earnings of a retail operation fall by between 3% and 5%.”

In the grim days following Mboweni’s decision, analysts cut their 2009 earnings forecast for Absa by 1,2%, and brokerage Keefe Bruyette & Woods radically slashed its expected Nedbank share price by a quarter, from R160 to R120.

Brokerage UBS cut its estimate of Absa’s share price 10% to R122, Standard Bank’s by 5,7% to R122, FirstRand’s by 9,3% to R19,50 and Nedbank’s by 4,1% to R144.

Nedbank financial director Mike Brown summed up the gloomy sentiment: “We always thought 2008 was going to be tough, but now it’s going to be a whole lot tougher.”

Of course, everyone knows that to some extent, banks can profit from interest rate hikes — when the Reserve Bank hikes rates, so do the commercial banks. The banks then make more profit on the money they lend.

But Standard Bank’s finance director Simon Ridley explains that the most recent rate hikes have stripped away the benefits for banks.

“The rate hikes last year opened our net interest margins, but we give away the bulk of that benefit in higher bad debts. Now, we’ve definitely crossed the line where we lose more in bad debts than we gain in interest margins,” he says.

The problem is that when bad debts rise, the impact is exponential. So, though Standard Bank has comfortably managed to keep its bad debt ratio (bad debts as a percentage of all the money it has lent) below 1%, this level might now be breached.

Says Ridley: “Before this hike, we were thinking that our bad debt ratio would remain in the mid 0,90%. Now it’s looking north of 1%.”

Consider how the hikes affect Nedbank — the least exposed to consumer bad debts, as the bulk of its profits come from big corporates: until now, it was expecting its earnings to grow by around 16% (inflation, plus GDP growth plus another 5%). But Brown says: “Though we initially said that 16% would be the top end of our expectations, this rate increase makes this look even less likely.”

Nedbank also had a target range for bad debts of between 0,55% and 0,85% of its total advances. Says Brown: “With this hike, it is now likely that our bad debt ratios will be pushed above 0,85%.”

So, is the latest rate increase a tipping point for the rest of the banks?

Certainly, says Michael Jordaan, the CEO of First National Bank. “In 2006, our models priced in a possible 250 basis point rate hike, but since then we’ve had a 450 basis point hike. This means we’ve put business on our book that could withstand a 2,5% increase in rates, not necessarily the 4,5% increase we’ve had,” he says.

This picture looks scary, but Jordaan shrugs it off: “As I tell a lot of people, you’re not a true banker until you’ve lived through this kind of market squeeze.”

Crucially, Jordaan believes the true X-factor in the equation is property prices.

“If property prices hold up, the banks will be fine. But if these prices drop, you’ll see some heavy impairments come through for the banks, and it won’t be pretty.”

In the real economy, consumers are feeling the heat. The FM’s research shows thaton average 4140 cars are being repossessed each month — an increase of around 20% from last year.

Marcel de Klerk, who heads Absa’s vehicle and asset finance business, says his bank is repossessing about 1250 vehicles a month. “In 2005, we were probably repossessing only about 600/month. People in the middle market earning R15000/month or less are taking severe strain,” he says. Of course, repossessing cars doesn’t really help anyone. The bank sells the car at an auction. “With the overstocked market, we’re getting back about 16% less in auctions than we were getting last year. So everyone’s losing.”

WesBank CEO Brian Riley says consumers were able to ride the first couple of interest rate hikes, but this is no longer the case. “For each additional 50 basis point rate hike we are getting now, the effect is immediate, as more consumers slip into arrears.”

It’s equally tough for mortgages. In real terms, a person’s bond repayments have climbed 32% in just more than a year.

Says Absa’s home loan boss Gavin Opperman: “This has far outstripped the wage increases from most companies.”

There has also been a rise in the number of properties being repossessed by the banks, and sold in execution. But this is still relatively small, mainly because people are loath to lose their houses.

Standard Bank, for example, repossessed only two houses a month last year. But director Owne Sorour warns: “The lag effect of the higher interest rates is starting to take its toll, and we did see an increase in repossessions over the past five months.”

So how can the banks mitigate the pain? For the consumer, they could be more accommodating when bad debts arise.

Absa’s Opperman says the banks are aware of this. “Look, we’re not out there to take people out of their homes. It concerns me how many customers are falling into default, but then they have to come and speak to us,” he says.

To protect themselves, the banks can only continue cutting costs — a difficult task with cost-to-income levels at record lows — and ride out the storm. Standard Bank’s Ridley says: “Besides trimming costs at the margin, our best response is to focus on collections, and make sure we’re keeping on top of that.”

Though every pundit with a microphone is telling people to buy bank shares, the bad debt story is rightly giving investors pause. “The real issue is how much of the current pain is already priced into the share prices of these banks,” says Andrew Vintcent, portfolio manager at RMB Asset Management. “But we’ve looked at it, and believe the share prices already reflect a large part of this impact,” he says.

Vintcent points out that bank shares are now trading at a huge discount to the rest of the JSE. So in whole numbers, the JSE is trading on a p:e ratio of 15,6. By contrast the banks are trading on a ratio of 7,8 — showing the banks are vastly cheaper. Says Vintcent: “The last time the banks were rated this low compared with the rest of the market was in 1974.” Though he concedes that the domestic economy is still taking a lot of strain, he says bank shares are still a relatively sound defence against a consumer slowdown compared with retail shares such as Woolworths or industrial stocks like Imperial.

But another analyst, who didn’t want to be named, disagrees. “These stocks look cheap, but that’s provided there are no more rate hikes, and provided the property market holds up. And banks in Turkey, for example, are far cheaper. So I think these stocks will remain cheap for a while still.”

But for the brave, it’s just as difficult to see which bank would be the best option, given the rising interest rates. Standard Bank is easily the most expensive (on a p:e ratio of 8,7), but on the other hand it has the largest exposure to more benign markets like Argentina and Nigeria. Equally, Absa is the largest retail bank — and so most exposed to consumer bad debts — but then, its profits from its corporate and investment bank are still small, and are expected to grow in leaps and bounds.

Within that, Vintcent says, Standard Bank’s diversification, FirstRand (the cheapest of the banks), and Absa are RMB’s preferred picks. But the point remains — with bad debts set to grow exponentially as the squeeze hits customers, banks haven’t yet seen the worst. - Rob Rose


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