Banking on healthy housing
Raising his stake … would Warren Buffett buy into the CBA? Photo: Bloomberg
Every year since 2005, Warren Buffett has increased his stake in US bank Wells Fargo. And you can understand why. Wells is a hugely diversified financial institution with the country's largest branch network. Throughout the global financial crisis, it remained profitable and earnings per share have now exceeded their pre-GFC peak.
Over the past year, its share price has increased 33 per cent and yet it still trades on a modest-looking price-earnings (P/E) ratio of 11.5.
Commonwealth Bank's recent history is not so different. It currently trades on a P/E ratio of 12.8 and increased its market share during the GFC.
And while Wells Fargo sports an overall valuation about twice that of CBA, it also reported roughly twice the profit in its latest full financial year. That's as it should be. Commonwealth is half as profitable as Wells and half the price.
There's one more major factor that Buffett's brain would be sparking over. Unlike their US counterparts, Australian banks are well regulated and well capitalised.
Severe losses in mortgage lending, the largest slice of Commonwealth's loan book, are less likely because mortgage lending is ''full recourse'' to the borrower, unlike parts of the US.
Loans are also back-stopped by mortgage insurance. Compared with the US, the effects of a property crash in Australia are therefore likely to be minimised.
Dollar-for-dollar of revenue, in its latest full-year result, CBA was almost twice as profitable as Wells.
Impairments (the polite banking term for bad debts) are the big difference. More than 25 per cent of Wells's pre-tax profit was swallowed up in impairments, compared with 9.9 per cent for CBA.
So Wells is working through the detritus of the US housing collapse. But the recent trend in impairments is clear: since peaking at $US22.7 billion in 2009, the subsequent annual figures have been $US15.8 billion and $US7.9 billion (a little more than 1 per cent of its total loan portfolio).
Australian banks are at the start rather than the end of the cycle.
ANZ and NAB have recently indicated that bad debts are likely to rise over the coming year. We expect a similar trend at CBA. With impairments as a percentage of its loan portfolio at 0.21 per cent, there is still the possibility of substantial increases in this figure.
Bad debts act like a cost spring. For Wells, having suffered through the GFC, a previously extended spring has been contracting. For CBA, the spring is coiled and likely to expand over coming years. The question is by how much. Without a housing disaster, an increase in bad debts is quite manageable. With one, Australian mortgage defaults are likely to rise sharply.
Mortgage insurers would be all but useless in this scenario: their balance sheets would vaporise and the banks would be left footing the bulk of the bill.
But a housing crash is unlikely. The risk has receded in recent years as local banks have changed their capital structures and reduced low-doc lending.
On asset-based measures such as price/book value and price/net tangible assets, Commonwealth is almost twice as expensive as Wells Fargo, reflecting its higher margins.
Both institutions have managed to grow their earnings per share over the past five years, but Wells has reduced its dividend, conserving capital to deal with those bad debts.
For Australian investors who have forgotten what a recession looks like, this is a good reminder of the pressure tough times can place on bank balance sheets. And that, in the end, is the point of this comparison. Australian banks - a cosy, immensely profitable cartel - do very well right up until the point they don't.
Wells survived the GFC intact but is still paying the price. CBA, which on some metrics looks similar to it, hasn't yet faced a crisis and may not have to. If it did, shareholders might see their fate in that of their Wells Fargo brethren.
This isn't to predict a crisis, merely to accept the possibility of one.
Commonwealth will probably continue to deliver fat, fully franked dividends - amounting to a current yield of 5.8 per cent - even in the face of moderately rising bad debts.
But if you're one of the many Australian investors whose portfolio is weighted more heavily than Intelligent Investor's recommended 10 per cent maximum to bank stocks, then at least you are now facing the risks with your eyes open.
This article contains general investment advice only (under AFSL 282288).
Nathan Bell is the research director at Intelligent Investor, intelligentinvestor.com.au.