Monday, 18 February 2008

ANZ Profit Warning... I Mean Trading Update

Last week in Time to Buy the Big 4? I noted that despite the strong sell off in the major banks there would be further opportunities down the road to pick them up at cheaper prices. Just 3 trading days later and they are all cheaper, ANZ significantly so.

ANZ gave a trading update as they do twice a year between reporting results. Business is traveling well with the company expected to beat the 11.5% growth in profit before provisions posted in FY07. 'Before provisions' is the key phrase here, since ANZ also announced that they are raising some significant provisions for specific credit quality issues.

Firstly they are raising a provision of US$200m . As ANZ tells it:

between 2005 and February 2007, ANZ entered into derivative transactions which involved selling credit protection on a portfolio of corporate names, and simultaneously buying matching protection from highly rated US financial
institutions to remove market risk. This was perceived to involve little credit risk and generated modest trading income.

The significant increase in derivative market credit spreads and volatilities has resulted in a positive mark to market position with the sellers of the credit protection. However one counterparty, which is a US monoline insurer, has been downgraded to a CCC credit rating. The uncertainty around the ability of that firm to meet its obligations under the hedging agreement has resulted in an accounting requirement to raise an Individual Provision of US$200 million based on the current mark to market exposure to that monoline.

What they are describing here is a Credit Default Swap (CDS). If you don't know what a CDS is read here. So the risk here is that the counter-party, the monoline insurer ACA Capital goes under and cannot hold up their side of the swap agreement. Which would then mean:

The effective economic impact if the monoline insurer fails is that ANZ takes on direct exposure to a high quality portfolio of corporate names. In fact, this portfolio has a higher proportion of investment grade corporates than ANZ’s existing Institutional portfolio. For an actual loss to emerge, around 20% of names within the portfolio would need to default. This would only occur in an extreme environment in which a significant number of companies defaulted globally, which is not anticipated under any current economic scenario.

Whilst the provision will vary with movements in the mark to market, we expect that a significant proportion of the Individual Provision will be written back in future periods.

So there is a good chance that a proportion of these provisions will be written back down the road. Also in the release, other significant provisions were taken for:

• Impact of credit rating changes on a commercial property client - a significant credit rating downgrade for one large commercial property client has resulted in a charge to the Collective Provision of around $90 million although at this stage it has not been necessary to make an Individual Provision. A review indicates the factors driving this client’s credit rating downgrade were specific to that client, with the remainder of the commercial property portfolio in good shape.

• Failure of a resources client has resulted in an additional Individual Provision of $51 million.

Centro (CNP) is most likely the commercial property client, whilst Lafayette Mining was the failed resources client. According to an article in the SMH, UBS estimates that ANZ had a $500 million unsecured exposure to Centro, a $700 million secured exposure and a $150 million exposure to US-based lender Countrywide.

If Countrywide, which in all likelihood would have gone bankrupt without Bank of America stepping in, is what ANZ means by a 'high quality portfolio of corporate names' then there could be more trouble down the line. It would be interesting to know if ANZ has any exposure to the other monoline insurers or other major US banks of brokers.

Doing some back of the envelope calculations, ANZ's provisions could rise from $567m in FY07 to approximately $930m for FY08. That's assuming that credit quality, excluding the exposures above remains about the same. Not a safe assumption by any means.

Thus ANZ's provisions could run close to a billion dollars in FY08 and potentially wipe out profit growth for the year. Current consensus earnings forecasts according to Aspect Huntley are for eps growth of around 10% for FY08.

Clearly there will be a round of revisions tomorrow from analysts as there was after CBA's result last week. If analysts can manage to put 2 and 2 together they will probably start downgrading the rest of the major banks as well.

Incidentally, of the 16 brokers covering ANZ, 5 have STRONG BUYS on the stock, 4 have BUYS and 7 have a HOLD. Not a single SELL rating among them. I haven't checked analysts ratings on this stock in some time so I don't know if anyone actually had a sell on these stocks before they started falling 3 months ago and then changed to a buy, but knowing analysts, I doubt it.

This kind of news from ANZ will become more prevalent over the next 12 months as we enter the worst part of the credit cycle. As stated before, rising credit provisions coupled with higher wholesale funding costs will crimp bank earnings in the medium term. Now the question becomes how much of that has been priced into the stocks given their significant decline since the end of October?

Nobody can answer that, but I still believe time is on the side of the patient as there will be more shoes to drop as far as credit quality is concerned.