Interest-only switching going gangbusters

Via Morgan Stanley:

While Australian banks’ margin recovery is in the sweet spot in late 2017, today’s new data from WBC shows IOL switching could be playing out earlier than the market expects. This presents downside risk to margins in 2018.

Interest only switching is rising: WBC has more IOL(~50% of Australian mortgages) than other banks (~40%),and in today’s 3Q17 update it reported that ~A$20bn of IOLhas switched to paying P&I in FY17 to date. The annualised switching rate has risen from ~8 to 9% in 1Q/2Q to ~13% in 3Q17 and then to ~23% in July (first month of 4Q17). The key driver is rising customer initiated switching in response to three successive rounds of IOLrepricing, with the largest repricing of +34bp taking place in June/July.

Margins in a sweet spot for 2017, but downside risks for 2018: As we wrote in last week’s COTW, margins are in a sweetspot in late 2017, but competition and IOL switching create risks for 2018. While CBA refused to disclose the amount of switching in 2017, today’s data from WBC suggests that IOL switching could be playing out earlier than the market is expecting. All else equal,a quarter of IOL customers switching to P&I is a ~1.5% headwind to major bank earnings and ~2bp to margins. This headwind is higher at WBC (~2% of earnings; ~3bp margins) and slightly lower at ANZ (~1% of earnings; ~1.5bp margins).

Risks to volumes remain: We target major bank housing loan growth to slow to ~4% FY18E from ~6 to 7% FY16/17 given the impact of marco-pru measures and higher mortgage costs. Tightening lending standards are a further source of downside risk to FY18E. IOL switching is only a modest headwind to loan growth in FY18E, but it will compound over time as fewer customers roll their loans for extended interest only periods.

The abnks might then be forced to muscle out margins further, that is, hike rates again.

Having said that, if mortgage growth does slow to 4% then house prices are going to be stalled and falling. The slowest mortgage growth rate we’ve ever experienced was in 4.4% in early 2013:

So the banks may have trouble hiking rates.

Credit Suisse is more sanguine:

Major bank fundamental outlook: Following bank reporting season, our fundamental outlook for the major banks is as follows:

■ Average EPS growth of 3%;

■ Revenue growth of 3-4% (lending balance growth of 4%, net interest margins compression of 1-2bp throughout the forecast period);

■ Cost-to-income ratio declining from 44.4% FY16 to 42.4% FY19E; cost growth 3%;

■ Underlying profit growth of 4-5%;

■ Bad debt charges benign (0.21% FY16, 0.18% FY17E, 0.21% FY18E, 0.21% FY19E);

■ Equity Tier 1 ratios strengthening from 9.85% FY16 to 10.52% FY19E; and

■ ROA strengthening from 0.83% FY16 to 0.87% FY19E; ROE modestly softening from 13.8% FY16 to 13.6% FY19E. Estimate changes: As illustrated in the following table, we variously upgraded and downgraded our earnings estimates in the wake of each reporting season result / trading update:

It remains too early to write off MP 2.0.

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