bomb ticking for off balance banks

A TICKING bomb for the banking sector is its off-balance sheet activities, which at last count stood at $12.9 trillion.

Australian banks have a big exposure to derivative markets. Their total shareholder value of $110 billion is dwarfed by the size of the banks' collective exposure to derivative markets of $12.9 trillion.

Put simply, the total derivative positions of the banks are 117 times as big as the banks' shareholder value. If even 1 per cent of these derivatives contracts default because third parties at the other end get into trouble, the whole shareholder wealth would be wiped out and our banks could be broke.

Given total bank assets are $2.1 trillion, it begs the question why Australia's banks have exposure to $12.9 trillion of derivatives positions. All banks hedge to reduce risk, but this is a big amount of hedging.

For example, Westpac has a face value of $1.4 trillion in derivatives at September 30, 2007, compared with an equity base of $16 billion, which is a multiple of almost 100 times.

The banks will argue they have outstanding risk management procedures and derivative arrangements have offsets so that only a net amount is at risk. Indeed, the Reserve Bank estimates that at September 30, 2007, the total credit risk and exposure of the banks to off-balance-sheet activity is $140 billion.

A more cynical observer would say the acquiescence of bank regulators to banks running off-balance-sheet liabilities greater than their capital just adds another layer of gearing.

But the reality is most are too big to be allowed to fail and wipe out their shareholders' funds. Banks worldwide are in a favoured position. While most are listed entities, they can always count on the shareholders being underwritten by the taxpayer in a crunch. The most recent examples of this were Northern Bank in Britain, which reportedly had about €25 billion ($54 billion) pumped in by the Bank of England, and Societie General attracted immediate support from the French Government. In the US, the Federal Reserve has been helping out its commercial and investment banks.

There is no denying that the banks have slick risk-management systems and, as long as there are no defaults, everything will keep on humming.

But the potential magnitude of the problem becomes even greater as the banks dominate the debt and equity of the country through their dominance of funds management.

As one investor said: "Do the bank balance sheets show a true picture? Well that's not what they are for. They are basically a disclaimer exercise."

But turning from the off-balance sheet world, to the on-balance sheet world, including the stock market, Australian banks have taken a walloping, none more than NAB, which is now trading at the same level it was nine years ago when the bank was concerned it was a sitting duck to foreign predators.

Apart from hedge funds targeting the banks, investors are becoming increasingly uneasy at the exposures the banks will have to corporate failures.

The reality is that as the sub-prime mortgage crisis continues to unwind, more corporate defaults will take place. While, on average, Australian corporations are in better shape, in terms of profitability and gearing, there is a group of financially engineered companies with low profitability that have piled up a mass of junk bond debt that will soon come to refinancing at much higher spreads. And as monoline insurers look wobbly, this will add to the difficulty in getting a refinancing package.

Already companies such as Centro, MFS and RAMS Home Loans have suffered the plight or tough credit markets. Others are sure to follow.

NAB has the largest market share in commercial lending and the second-highest transaction banking market share, which makes it a strong candidate for having the riskiest loan book with regard to Australian commercial lending.

However, an analysis by Wilson HTM of listed companies that have lost more than 20 per cent and more than 50 per cent of their market capitalisation in the past year, NAB may have the lowest exposure of all the banks to poorly performing companies when ranked by debt outstanding.

In the case of the Commonwealth Bank, its profit results epitomised some of the challenges facing the banking sector in Australia: rising expenses, rising cost of debt and murky bad and doubtful debt exposure.

Commonwealth Bank's latest results revealed bad and doubtful debt charges rose 40 per cent from the first half and a 71 per cent increase from the previous corresponding period.

Reported gross impaired assets were up 66 per cent from $338 million at December 31, 2006 to $562 million at December 31, 2007.

New and increased impaired assets were $566million at the end of December 31, 167 per cent of gross impaired assets at December 31, 2006.

Given the statements by the Reserve Bank suggesting at least two further rate rises in Australia, this will put a great deal of pressure on the many highly geared consumers and lead to an increase in loan defaults. As a consequence, many analysts are increasing their bad and doubtful debt charges in the retail banking sector both this year and next year.

UBS put together a watch-list of potential problem loans, including Centro, Countrywide Financial, MFS, Allco and Allco Principals Trust, to which they have lent a collective $5.7 billion. It suggests that Centro has a $500 million unsecured loan and $700 million secured loan with ANZ, a $160 million unsecured loan and $1 billion secured loan with the Commonwealth Bank and a $350 million unsecured loan and $750 million secured loan with NAB.

The other big risk is Countrywide, which has a $150million loan with ANZ, $300 million loan with Commonwealth Bank, $300 million loan with NAB and $100 million loan with Westpac.

There is little doubt banks have undertaken extended value-destroying lending, based on declining underwriting standards. But as the cost of debt increases and the shake-out in credit markets triggers concern about losses in syndicates or companies involving the banks, including ANZ's exposure to Lance Rosenberg's embattled broking house Tricom, it is premature to discuss systemic issues.

But for banks, with expanding funding cost pressures, and Commonwealth Bank's results showing a blowout in expenses, most banks will start initiating cost-saving programs. As Wilson HTM analyst Brett Le Mesurier says: "Expense growth is a problem with salaries increasing by 12 per cent over the year, which was the major factor in the high rate of expense growth during the period. This latter feature occurred notwithstanding the refund of $64 million from the Australian Government from over payments of GST."

For the next couple of years, there is little doubt that the banks will face some challenging times, particularly if some of their off-market activities start to look wobbly. Let's hope they have a good handle on it.