Australian banks to battle headwinds from the cooling housing market

Moderating housing loan growth could drag banks' profitability.

Analysts at BMI Research expect Australian banks and their share prices to continue to face headwinds from the cooling housing market over the coming months due to their heavy exposure through mortgage lending.

"The country's elevated property market will likely soften due to its poor affordability, existing macro-prudential measures, as well as weak wage growth, and we expect housing lending growth to also moderate, which will act as a drag on the profitability of banks. Efforts to improve the capital positioning of banks are also likely to weigh on their share prices as dividend cuts are likely in light of weakening profitability," the analysts said.

Here's more from BMI Research:

Australian banking equities (S&P/ASX Banks Index) have underperformed the country's broader stock index (S&P/ASX 200 index) since the start of 2017, and in our view, this underperformance is likely to remain in place over the coming months. Australian banks, particularly the big four, are heavily exposed to the slowing housing market (with mortgages accounting for approximately 60% of overall gross loans and advances), which will likely act as a drag on profitability as credit growth softens.

According to the Australian Prudential Regulatory Authority (APRA), the return of equity for the Australian banking sector came in at 13.0% in June, which was below the peak of 18.0% in June 2015.

We continue to believe that Australia's housing market, particularly Sydney and Melbourne, remains highly unaffordable, following years of rapid price increases. Poor affordability, coupled with regulator's existing macro-prudential measures and weak wage growth, are likely to weigh on the property market. Indeed, we are starting to see signs that the elevated real estate market is cooling.

According to Corelogic, Sydney house prices grew by 0.2% q-o-q in September, which marked the slowest pace of increase since values 2.2% over the March quarter of 2016. Additionally, the largest provider of property analytics also reported that Melbourne's housing market was also showing slower growth conditions.

Some of the policies that have been put in place by the Australian Prudential Regulatory Authority (APRA) in an effort to ensure financial stability include taking supervisory action against banks that grow their property-lending investment portfolio by more than 10.0% per annum (2014), requiring banks to implement tougher rules to assess the mortgage servicing ability of borrowers (2015), and the restriction of the flow of new interest-only residential mortgage lending (March 2017).

We expect these measures to continue to put downside pressure on investor housing credit (which came in at 7.3% y-o-y in August), alongside the moderation in the housing market. We are forecasting headline credit growth to come in at 4.8%, before a further slowdown to 4.0% in 2018, from the average of 5.2% y-o-y for the first three quarters of 2017.

In an environment in which Australian banks are vulnerable to a significant correction in the housing market, the Reserve Bank of Australia (RBA) reiterated in its September 2017 Financial Stability Review (FSR) that the APRA announced additional capital requirements in July, such that banks are 'unquestionably strong'.

While the RBA stated in its FSR that the total non-performing housing loans (including impaired and past due) as a share of total housing loans for banks were low in the first half of 2017 at around 0.8%, we highlight that a sharp drop in house prices could trigger a substantial rise in mortgage defaults, therefore making higher capital requirements a logical move by the regulators.

The RBA stated that Australian banks are well placed to meet the higher capital requirements through retained earnings and dividend reinvestment plans. However, our expectations for profitability to come under pressure due to slowing credit growth and record low mortgage lending rates suggests that retained earnings is likely to be weak.

This suggests that in order to improve their capital positioning, banks would have to reduce their dividends, which is a negative signal to investors, and therefore will likely weigh on their share prices. Indeed, according to data from Bloomberg, the dividend payout of the S&P/ASX Banks Index remains on a downtrend, falling to 82.6% in September versus the peak of 102.3% recorded in September 2016, and in our view, this trend is likely to remain intact.