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18 December 2012 Asia Pacific/Australia

Equity Research Investment Strategy (Strategy)

Australian Equity Strategy STRATEGY

Underweight banks in anticipation of job cuts, payment shocks and declining house prices The Consensus . After all,

banks have sailed through very turbulent times post-financial crisis. They have maintained their strong credit rating and high dividend yields, and reduced their dependence on offshore funding. Further, policy makers seem to have done a remarkably good job of keeping the domestic economy insulated from deteriorating global macro conditions.

However, we believe that banks are only bond proxies to a point. We are shifting to an underweight position on banks. Valuations are not attractive, and there are downside risks to earnings and dividends as de-leveraging risks intensify. We are particularly concerned about payment shocks on interest-only loans (which make up roughly a third of the mortgage book), as well as the effects of rising unemployment.

Risks are concentrated on over-geared housing investors. Leveraged investors are struggling to make money because net rental yields of 3.2% are well below mortgage rates of 6.4%. At most, investors can only afford to be 50% geared. However, the data suggest that borrowers are 60%+ geared, with a lot of this gearing on interest-only terms. Essentially, investors are subsidising losses on their property portfolios out of wages, in the hope of future capital gains. But their ability to keep doing this will be stretched if house prices do not rise, and if payment shocks hit.

We are quite pessimistic about the prospect of house price inflation. Housing is 20% 40% overvalued by historical standards. Also, housing demand is extremely low, because potential buyers are very concerned about unaffordability and rising unemployment. If demand remains low relative to supply, house prices could fall substantially. Average home equity could fall disproportionately, making the re-financing of loans more difficult.

The over-gearing situation does not have to end disastrously. If the RBA cuts rates deeply (e.g. to 1.5%), it could stabilise debt dynamics and house prices, buying households time to work out their over-indebtedness. However, the RBA does not seem to be contemplating deep rate cuts despite the slowdown in train. Also, the lack of pass-through of RBA cuts is becoming a problem.

Please note that this is an Australian equity strategy view, and is not necessarily shared by the Credit Suisse Australian banks team.

Research Analysts Credit Suisse Australian Strategy

Atul Lele

612 8205 4284 [email protected]

Damien Boey 612 8205 4615

[email protected]

18 December 2012

Australian Equity Strategy 2

Sector Focus: Banks Introduction The Consensus view is that Australian banks are bond proxies, and should outperform in a falling yield environment. After all, they have sailed through very turbulent times post-financial crisis. They have maintained their strong credit rating and high dividend yields, and reduced their dependence on offshore funding. Further, Australian policy makers seem to have done a remarkably good job of keeping the domestic economy insulated from deteriorating global macro conditions.

However, banks are only bond proxies to a point. We believe that they have now become

:

Dividend sustainability is questionable considering how high payout ratios are, as well as the downside risks to Australian growth, and the prospect of rising bad debts.

Leading indicators point to the unemployment rate rising substantially.

Households are under more financial strain than the official data suggest. It is not just a slowing mining capex cycle that we need to contend with we must also deal with household de-leveraging.

Moreover, we think that the RBA is now too far behind the curve to prevent a major slowdown in 2013.

We are switching to an underweight position on banks (from neutral).

Valuations are not attractive In our view, banks are looking slightly expensive for a benign credit growth outlook. They look more expensive when we factor in the risk of sharp slowdown and rising bad debts.

Bank PEs relative to the market are slightly above long-term average. But the Consensus is not factoring in a material rise in bad debts. Should bad debts rise, earnings could fall substantially, and banks would look quite expensive.

Bank dividend yields are high relative to the market, and relative to bonds. However, we note that payout ratios are pushing up towards 80% for the major banks the highest they have been since the early 1990s crisis. Should bad debt charges double (from a fairly low base), payout ratios would rise up towards 100% but these levels would be considered by most commentators as unsustainable. Therefore, we need to factor in the possibility of dividend cuts should the economy slow sharply.

Figure 1: Figure 2:

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1987 1990 1993 1996 1999 2002 2005 2008 2011 2014

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Source: Bloomberg, Datastream, IBES, Credit Suisse Source: Bloomberg, Datastream, IBES, Credit Suisse

The Consensus view is that Australian banks are a quality yield play

However, we think that banks have become too expensive, and too exposed to deteriorating macro conditions

Banks are slightly expensive for a benign macro environment. They look more expensive when we factor in a rise in bad debts

ratios are unsustainably high considering the risk of rising bad debts

18 December 2012


Re-assessing the quality of the mortgage book Since the financial crisis, analysts have been quick to point out a distinct change in household borrowing and spending behaviour. The argument is that households have chosen to spend and borrow less and inject more equity into their homes. Analysts usually cite the sharp rise in the saving rate to 10% (from close to 0% in 2006), and recently strong deposit growth as evidence that households have become more conservative in their behaviour. Much of the cashflow generated from higher saving is supposed to have flowed into mortgage repayment. Echoing these arguments, the major banks now report that:

Mortgagees are on average four to nine months ahead on their repayments. They seem to have spare cash, and even room to re-draw upon on their mortgages.

Average loan-to-value ratios for mortgagees are around 60%. Households have a sizeable equity buffer against the risk of house prices declining, and banks have reasonably good loan-loss recovery prospects in the event of foreclosure sale.

Many households have more than one income earner servicing the loan. Households have some buffer against unemployment risk, because if one income earner loses their job, the other should be able to continue servicing the loan.

These statistics are typically used to highlight the quality of the Australian mortgage book. However, we question whether the loan book is really as strong as it is made out to be:

Whenever we hear about households pre-paying their mortgages, we must be mindful of the definition of minimum payments. The longer the repayment period, the smaller regular payments become. The average contractual maturity of a traditional mortgage is 25 years but on a 25-year loan life, it is not difficult to be ahead on repayments, assuming that households have borrowed within their means. Indeed, on standard variable rate mortgages, with no pre-payment penalties, the natural tendency is for households to pay off more principal when interest rates fall, as they tend to leave their total debt servicing payments unchanged (i.e. they take the saving on lower interest payments and automatically use it to pay off principal). Considering anecdotes that the average effective maturity of traditional loans is much less than 25 years, the more interesting question is why mortgagees are only four to nine months ahead on a their repayment schedule. Interest-only loans further complicate matters, because they lower the minimum payment threshold in the short term but raise it in the longer-term. We believe that payment shocks on these loans could be quite problematic in the foreseeable future. Considering these complications, what matters, in our view, is not whether households are ahead on their mortgage payments, but rather, whether they have gotten further ahead over time. Also, we note that every dollar that a household does not repay on their mortgage accumulates. For a given level of interest rates, a lower repayment rate today would only mean a higher loan balance to be repaid tomorrow, and higher interest payments. Subject to penalties, some degree of prepayment may considered rational for households, and therefore unsurprising.

The average mortgagee may have a home equity buffer of around 40% but the average can be misleading. Even a 10% 20% decline in house prices could start wiping out the equity of more recent borrowers, that have benefited less from house price inflation (or have even lost as a result of house prices falling).

It is possible that two income earners are now required to service debt (principal and interest). Put differently, if one income earner were to become unemployed, the other may not be able to continue servicing the mortgage. If this is the case, then Australian households have become more exposed to unemployment risk not less.

In the following sections, we add a bit more colour to these arguments.

The Consensus view is that Australian households are generating cash and paying down their mortgages post financial crisis

However, we are sceptical about this claim

Are households really ahead on their mortgages, or have the goal posts been moved?

Is the two-income earner test really a safety net?

The average household has a 40% equity buffer but what about the marginal household?

18 December 2012


Principal matters Many commentators define debt servicing as interest cover. However, we know (all too well) from the financial crisis experience that the ability to pay back interest is not all that matters in assessing housing affordability and financial stress principal repayment matters as well.

In the national accounts, principal repayment is not accounted for in calculating the household saving rate. Household saving is calculated without deducting principal

ween saving in the form of cash, and saving in the form of an asset. But for our purposes, the distinction matters a lot, because principal payments are not strictly discretionary and indeed, are now a key determinant of household free cashflow.

There are three ways that we can measure principal payments in Australia:

Back out actual repayments from system credit growth and housing finance approvals: Housing finance approvals, net of re-financings are a proxy for net new lending. But credit growth should be equal to new lending minus net principal repayments. Therefore, the dollar difference between net housing finance approvals, and credit growth should be equal to actual aggregate net principal repayments. We can divide this number by the number of mortgagees to estimate the actual principal payment per mortgagee. However, this measure does not distinguish between principal payments financed out of income, and those financed out of the proceeds of asset sales. Moreover, it does not distinguish between scheduled (minimum) principal payments and excess repayments. Therefore, the tendency is for this measure of principal repayment to overstate the regular repayment burden. Nonetheless, it does tell us about what households are actually doing and specifically whether the repayment rate is increasing or decreasing through time. Also, the data is granular enough to split out repayments on owner-occupier and investor housing loans.

Simulation of minimum principal payments using a credit foncier model applied to housing finance approvals: The credit foncier model assumes that households re-pay the loan amount in a linear fashion. Regular payments are constant through time, and sufficient to repay the loan principal and interest over the duration of the loan. Initially, the principal repayment component of the loan is small, while the interest repayment component is quite big. But as the loan reaches maturity, principal repayments become bigger than interest repayments.

We can apply a 25-year credit foncier model to eapprovals, and aggregate the payments across loan vintages to calculate the aggregate minimum principal repayment burden. We can divide this number by the number of mortgagees to estimate minimum principal payments per mortgagee (assuming a 25-year loan life). However, this measure makes a strong assumption that loan repayment is linear, such that the profile of aggregate repayments through time are really just a function of where households sit in the loan-life cycle. This assumption may not be strictly correct. Households could repay their loans more slowly than the minimum, as in the case of interest-only loans. Or they could repay their loans more quickly than is required. Another possibility is that they could draw out the term of the loan through re-financing. Notwithstanding these limitations, the principal payment outcomes implied by the credit foncier model are still useful as a reference point for our analysis.

In assessing the state of household cash flow, we often fail to take principal repayment into account

There are three different ways of estimating principal payments in Australia

18 December 2012


Responses to the ABS household expenditure survey. Every five to six years, the ABS releases results from its household expenditure survey. In the survey, owner-occupier mortgagees are asked to provide details about their weekly income and expenditure, as well as mortgage repayments. The mortgage repayment data can be heavily skewed by sampling biases but nonetheless, remains useful in understanding the profile of actual regular principal payments (financed out of income, rather than the proceeds of asset sales).

We use all three measures to better understand how principal payments are evolving through time. The different indicators may not give us an entirely consistent picture of repayment behaviour but we think they can be reconciled to tell a broadly consistent story. Even in the differences, there is still valuable information to be gleaned.

Comparing credit aggregates to credit foncier

Across all loans, we can see that the measure of loan repayment derived from credit aggregates and housing finance approvals, is consistently higher than the estimate derived from our credit foncier model. This tells us that the average effective maturity of loans is much shorter than the contractual maturity of 25 years. Indeed, on our estimation, the effective maturity is closer to 10 15 years.

The apparent prepayment may reflect households making regular excess repayments on their mortgages. But it may also reflect households are repaying (or retiring) loans out of the proceeds of asset sales.

Figure 3: Housing Finance Approvals & Credit Growth Figure 4: Household Principal Payments

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Source: Bloomberg, Datastream, RBA, Credit Suisse Source: Bloomberg, Datastream, RBA, Credit Suisse

What matters is not so much the spread between the two measures but how that spread has evolved. A rising spread could be a reflection of more principal payment out of asset sales, or a faster rate of regular repayment. But a narrowing spread could indicate that housing turnover has slowed, or that households are being forced to pay back more principal, as a result of the loan life cycle.

Since the financial crisis, the spread between actual, and theoretical principal payments has narrowed. In our view, this is partly a result of slower housing turnover but it probably also reflects a slower rate of regular payment by households, as well as a rise in minimum principal repayments.

Comparing owner occupiers with investors

If we do the same analysis just on owner-occupier loans, we get a slightly different picture. Actual repayments (derived from credit aggregates and housing finance approvals) fell after the financial crisis, but more recently have risen. Indeed, they have risen more quickly than minimum principal repayments (simulated from a credit foncier model). This may be evidence that owner occupiers are more aggressively repaying their loans, as the banks have tried to highlight recently.

Contrary to popular belief, it appears that the aggregate repayment rate has slowed post financial crisis

Owner-occupiers have lifted their repayment rate recently

18 December 2012


Figure 5: Owner-occupier Mortgagee Principal Payments Figure 6: Owner-occupier & Investor Principal Payments

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Total Owner-occupier Investor


The real issue is with investment housing loans. The actual repayment rate has shrunk noticeably in recent years, masking the pick-up in owner-occupier repayments in the aggregate data. In part, this is a reflection of slower turnover in the market with fewer sales of investment property, there have been fewer loan repayments out of the proceeds of those sales. But we also believe that the rising popularity of interest-only loans has contributed a lot to this outcome. Most interest-only loans offer an initial 10- to 15-year period of principal-free debt servicing, with a dramatic ramp-up in payments beyond this horizon as principal payments are activated. According to RBA and APRA data, between 30% 60% of new investor loans (i.e. flows) over the past decade have been interest-only loans. Interest-only loan flows have been so significant, that in terms of the stock of credit outstanding, more than a third of investor housing credit is now o - terms (although where they generally sit in the loan life cycle is uncertain). The increased use of interest-only loans over the past decade has probably depressed the actual principal repayment rate, and will continue to do so until principal-free periods lapse.

Comparing credit foncier repayments with ABS survey data

We suspect that interest-only loans are not only distorting the profile of investor housing loan repayments they may also depressing repayments on owner-occupier housing.

Figure 7: Owner-occupier Mortgagee Principal Payments Figure 8: Re-financing Activity

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Source: ABS, Bloomberg, Datastream, RBA, Credit Suisse Source: ABS, Bloomberg, Datastream, RBA, Credit Suisse

We can see this in the spread between ABS survey responses and the output of our credit foncier model. For the available history that we have, the ABS survey responses seem to be consistently lower than the minimum payments estimated from our credit foncier model. This could be due to:

Re-financing efforts. Re-financing makes mortgages new again and effectively lengthens the maturity of the original loan. Households with newer mortgages tend to repay principal at a slower rate than households with older mortgages, simply because of where they sit in the loan life cycle. Re-financing can occur without a housing transaction but quite often households re-finance their loans when they change

But investors have slowed their repayment rate, masking the pick-up in the repayment rate of owner-occupiers

Interest-only loans and slowing property turnover have depressed the repayment rate for housing investors

18 December 2012


homes. The renewal of the mortgage has the effect of drawing out the term of the original loan and lowering the repayment rate. But on the other hand, over our sample period, housing has become more expensive to turnover. As households have migrated to bigger, or more expensive homes, they have taken out bigger loans, requiring bigger principal repayments. It is an empirical question as to whether the effect of the lower repayment rate is bigger or smaller than the effect of increasing the loan balance. But suffice to say, it is possible that re-financing has depressed principal repayments in the ABS survey relative to our credit foncier model.

Interest-only loans. In our view, it is unlikely that the unusually low level of principal repayments in the ABS survey can be explained entirely by re-financing. This is because on our estimation, too much maturity extension would be required from too few mortgagees. We note that the re-financing rate is fairly low between 5% 10% of loans per annum, and the limited re-financing activity that does occur would have to lengthen the average maturity across all owner-occupier loans significantly to 35 years (from a contractual maturity of 25 years) just to bring credit foncier payments down to the level suggested by the ABS survey. And even if the average household is on the minimum repayment schedule, there must be households who are behind schedule, or not paying principal at all, because we know that there are households who are ahead on their mortgages.

In our view, average repayments have probably also been depressed by the increased popularity of interest-only loans even among owner-occupiers. Indeed, according to RBA and APRA data, interest-only loans have made up between 10% 30% of owner-occupier flows over the past decade.

Re-financing and interest-only loans have played a material, and indeed, necessary role in helping households to manage their finances. To illustrate this, consider the findings of the 2009 10 household expenditure survey. According to the survey, owner-occupier households:

Had 1.8 income earners on average, earning $2,238 per week, supporting one dependent child.

Paid $407.18 of income tax per week, and $79.34 per week in superannuation and life insurance contributions.

Spent $1,271.86 per week on goods and services.

Repaid $136.03 per week of mortgage principal, and $321.92 in interest.

In aggregate, these households saved $21.67 per week. However, it would not take much of an increase in weekly principal payments to drive households on average into a negative cash flow situation. Even an increase in payments to our credit foncier minimum of $240 per week would cause households to experience cash flow problems. In other words, but for unusually low principal payments from re-financings and interest-only mortgages, households may not have been able to break even in 2009 10. But equally, the resetting of payments to a higher level once principal-free periods lapse could cause a significant negative shock to household cashflow, causing them to either pare back spending, or default on their mortgage. We note that household finances look precarious in this scenario even with more than one income earner servicing the mortgage.

Now statisticians at the ABS caution analysts about using the household expenditure survey data to calculate saving. So the possibility of household saving turning negative (but for unusually low principal payments) could be easily dismissed as noise. Put differently, it is a necessary, but not sufficient condition to show that household saving could have been negative. What we really need to show is that the household cashflow situation has deteriorated through time, increasing the likelihood of financial stress.

Re-financing and interest-only loans have depressed the repayment rate for owner-occupier housing

Owner-occupiers are quite sensitive to changes in mortgage terms (e.g. payment shocks)

18 December 2012


Household discretionary cashflow is very low To construct a timely measure of owner-occupier discretionary cashflow, we:

Assume that in 2009 10, the average owner-occupier household had two income earners earning the average weekly ordinary time wage. We map out the profile of household labour income through time using the wage cost index.

Use the 2009 10 household expenditure survey to benchmark weekly consumption. Specifically, we focus on non-discretionary expenditure items such as food, utilities transport and healthcare. We back-cast and extrapolate nominal non-discretionary spending from 2009 10 using CPI data (as the volumes purchased of these items should not change much through time).

Calculate an estimate of weekly principal payments using a combination of the different measures used in our earlier analysis.

Also calculate an estimate of weekly interest payments backed out of credit aggregates and published standard variable mortgage rates. For what it is worth, these estimates are very close to the estimates published by the ABS in the household expenditure surveys.

Deduct from labour income, taxes (at an average 20% rate), superannuation (at an average 9% rate), non-discretionary spending, interest and principal payments to arrive at a measure of discretionary cashflow.

Figure 9: Owner-occupier Mortgagee Free Cashflow Figure 10: Owner-occupier Free Cashflow & Saving Rate

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Source: ABS, Bloomberg, Datastream, RBA, Credit Suisse Source: ABS, Bloomberg, Datastream, RBA, Credit Suisse

In contrast to what the national household saving rate would suggest, our measure of discretionary cashflow for owner-occupier mortgagees is actually still low by historical standards. It fell very sharply just prior to the financial crisis as wages failed to keep pace with rising debt servicing costs and basic living costs. Since this time, cashflow has only recovered moderately, despite generally low interest rates, again because wages have failed to keep pace with the basic cost of living, and principal payments have remained onerous. In our view, this indicates that the cashflow situation for mortgagees is still tight. Worst still, a number of households appear to be ill-equipped to handle payment shocks as interest-only loans reset.

It does not pay to be a leveraged housing investor In calculating household discretionary cashflow, we have not taken into account non-labour income. HILDA survey data suggests that owner-occupiers have relatively low cash balances and deposits (e.g. of around $8,000 per household in 2010), and relatively small stock holdings (or around $10,000 per household in 2010). So we are comfortable excluding capital gains, dividends and interest income, as these items are not material (especially now that returns are falling).

The cashflow situation for owner-occupiers has only improved modestly since the financial crisis

18 December 2012


A potential problem in our analysis occurs from the exclusion of rental income on investment housing. According to the HILDA survey, around 26% of owner-occupier mortgagees also have an investment property with a median value of $420,000 in 2010. The rental income on these properties could be quite substantial.

However, we believe that net of debt servicing and maintenance costs, households are not really earning that much from their investment properties. Indeed, the data suggest that on average, they may even be losing because of excessive gearing, high borrowing rates and extremely low net rental yields. The fact that net income on investment property is so low suggests that many households are relying on capital appreciation to make their investments worthwhile. But in a flat-falling house price environment (please see section below for further details), this is problematic. Worse still, many investment properties are encumbered by interest-only loans, meaning that they are susceptible to payment shocks in the coming years.

Estimates of gross rental yields on property vary between 3.7% 4.25%. Based on RBA and ABS data, the rental yield is 3.7%, whereas based on RP Rismark data, it is closer to 4.25%. Net of other costs of home ownership (e.g. depreciation, strata, council fees and maintenance costs), the net rental yield could be 0.5% 1% lower than the gross. Let us suppose that the average net rental yield on property is around 3.2%.

This rate of return is well below the standard variable mortgage rate currently around 6.4%. So for a leveraged investor to breakeven on their property purchase, the most they could afford to gear is 50% (3.2% divided by 6.4%). However currently, households with a mortgage have gearing levels that are considerably higher than 50%:

According to the HILDA survey, investment properties are roughly 60% geared.

According to RBA data, households on average are 62% geared. In aggregate, households hold roughly $4.2 trillion worth of real estate assets, and owe $1.3 trillion worth of mortgage debt. Across all households, home equity appears to amount to $2.9 trillion and the gearing ratio appears to be 31%. But these statistics fail to take into account the concentration of mortgage debt. Historically, a third of households have a mortgage, a third own their home outright, and a third rent. It is reasonable to assume that of the one-third of properties rented out, some are owned by leveraged investors. Effectively 50% of households are encumbered by a mortgage. Therefore of the $4.2 trillion of real estate assets held by households, only $2.1 trillion of assets are owned by mortgagees. And netting off $1.3 trillion of mortgage debt, it appears that leveraged households only have $800 billion of home equity. Put differently, the effective gearing level is around 62%.

Figure 11: Rental Yields & Mortgage Rates Figure 12: Actual & Break-even Household Gearing

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Overall, it appears that gearing is 20% too high. Investors have a natural tendency to de-leverage because net of interest costs and other expenses, they are actually losing money on their properties and this is before taking into account principal payments and likely payment shocks from resets on interest-only loans. Effectively, households are using their

Investor housing is not generating positive carry

Investors are over-geared considering that net rental yields are well below mortgage rates

Investors can only subsidise losses on housing for so long.

18 December 2012


wages to subsidise their housing investment in the hope that capital gains will be significant enough to eventually generate a return. However, in an environment where house prices stagnate or even fall over an extended period of time, this behaviour becomes unsustainable. The risk is that at some point, investors will stop subsidising their properties when they hit cashflow constraints. Potentially, as payment shocks hit, they will have to sell their properties in order to de-leverage.

The RBA seems unsympathetic to mortgagees This situation does not have to end disastrously. It is possible for the RBA to alleviate some of the stress on mortgagees by aggressively cutting interest rates. To eliminate the 20% overgearing, the RBA must bring down the mortgage rate by 20% to 5.3% from 6.4% currently. 110bps of cuts to the standard variable mortgage rate are required. However, we know that in this easing cycle, banks are on average only passing on 75% of every rate cut. Therefore, in order to bring down the mortgage rate by 110bps, the RBA would need to cut the cash rate by almost 150bps.

Figure 13: RBA Cash & Mortgage Rates Figure 14: RBA Cash Rate & 2-year Treasury Yield

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However, this would bring the cash rate down to 1.5% well below what the RBA, and bond market investors are currently thinking, and certainly well below previous

The RBA generally does not believe that the Australian economy is facing hard landing risks. Indeed, officials have repeatedly stated that the housing market is likely to recover in response to easing delivered so far picking up the slack from the ailing mining and mining capex sectors. But we do not think that the housing market is recovering, because easing to date has been relatively ineffective. Moreover, things could get worse as unemployment rises. Therefore, for the time being, the RBA seems to be behind the curve, and is not dealing with the de-leveraging pressure that many households face.

House prices are falling Another way out of the overgearing problem is for borrowers to re-finance their loans, draw out their mortgage, and lower their principal repayment rate. If they are on interest-only loans, borrowers could attempt to extend the principal free period. Hopefully households would end up refinancing at considerably lower interest rates, such that the slower rate of principal repayment would not cause their outstanding loan balances and interest payments to materially rise. However, borrowers may find it difficult to re-finance if global credit market conditions are tight. Also, they may struggle to get re-financing if house prices are falling and if their equity base is diminishing. The Consensus view is that Australia has a housing shortage supporting house prices. Population growth and replacement demand suggest that the theoretical rate of household formation is around 175,000 homes per annum. But housing starts are running at only 150,000 per annum. In theory, there is a shortage of housing at the margin.

Stress will rise if house prices do not increase, and payment shocks hit

The RBA could help to alleviate the stress on households by cutting rates deeply

However, the RBA does not seem to be contemplating deep rate cuts, and banks are impeding the transmission mechanism

Falling house prices could exacerbate re-financing risks

18 December 2012


Figure 15: Population Growth & Building Approvals Figure 16: CBA/HIA Housing Affordability Index

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Source: ABS, Bloomberg, Datastream, Credit Suisse Source: Bloomberg, Datastream, Credit Suisse

However, notwithstanding the theoretically high rate of household formation, home sales are currently sitting close to 20-year lows. It appears that demographics are not a sufficiently strong driver of housing demand rather unaffordability, de-leveraging pressures and concerns about job security are weighing on potential homebuyers.

Often, market commentators point out that housing affordability indices are not that far off their historical average. For example, the CBA/HIA measure of housing affordability, based on interest cover is very close to its post-1985 average. Therefore, the argument goes that further (minor) rate cuts should succeed in boosting affordability and housing demand. However, we believe that interest cover-based measures of housing affordability are misleading, because principal matters a lot as well:

Housing affordability calculated on a house price-to-wage basis is still exceptionally high by historical standards. On this measure, housing is roughly 40% overvalued.

Debt service cover is still very low by long-term historical standards roughly 20% below average. We calculate debt servicing obligations as interest payments on a new housing loan, plus principal repayment calculated using a 25-year credit foncier model. Even if rates are cut, it is very hard to lift this measure of affordability, because rate cuts do not reduce principal payments.

Figure 17: House Price-to-wage Ratio Figure 18: Debt Service Cover

1.2

1.4

1.6

1.8

2.0

2.2

1909 1919 1929 1939 1949 1959 1969 1979 1989 1999 2009 2019

Log (House Price-to-wage Ratio) Average +/- 1 S.D.

1

2

3

4

1960 1970 1980 1990 2000 2010 2020

Debt Service Cover Average +/- 1 S.D.

Source: Bloomberg, Datastream, Stapledon, Credit Suisse Source: Bloomberg, Datastream, Stapledon, Credit Suisse

In addition, first home-buying incentives have changed across the country, negatively impacting housing affordability. In major states, first homebuyers are no longer entitled to

,000 grant. Instead, the grant has been replaced by more generous incentives (up to $30,000) that are restricted to new home purchases. When we take into account the fact that new homes make up less than 10% of the market, weighted for eligibility, first homebuying incentives have been more than halved.

Housing demand is unusually low considering rate cuts delivered so far, and strong population growth

18 December 2012


We believe that low housing affordability is deterring potential homebuyers from making purchases. Therefore, it is unsurprising that the participation of new entrants in the housing market is very low. Compounding this problem, it would not make sense for existing investors take on more gearing and more property exposure, because they are already finding it hard to make money. Therefore, there is a distinct lack of momentum in the market to keep the bubble going.

Indeed, we suspect that momentum is sufficiently weak to drive house prices down. Historically, the ratio of home sales (a proxy for housing demand) to building approvals (a proxy for housing supply) has been a reasonably good leading indicator of house price movements. Currently, the demand-supply balance is very low roughly 30% below its long-term average. This suggests that at the margin, the housing market is oversupplied. The oversupply is consistent with house prices falling 10% 15% over the next year.

Figure 19: Home Sales & Building Approvals Figure 20: House Prices & Housing Demand/Supply

0

8

16

24

0

25

50

75

2000 2002 2004 2006 2008 2010 2012 2014

Home Sales (LHS) Building Approvals (RHS)

2

3

4

5

-16%

0%

16%

32%

2000 2002 2004 2006 2008 2010 2012 2014

YoY% Change in Real House Price (LHS)Home Sales-to-Building Approvals (RHS, Led 9 Months)

Source: ABS, Bloomberg, Datastream, Residex, Credit Suisse Source: ABS, Bloomberg, Datastream, Residex, Credit Suisse

Figure 21: Victorian Home Sales & Building Approvals Figure 22: Victorian House Prices & Demand/Supply

0

20

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1985 1990 1995 2000 2005 2010 2015

Victorian Metro Sales (LHS) Victorian Building Approvals (RHS)

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4.0

-21%

-14%

-7%

0%

7%

14%

21%

1986 1990 1994 1998 2002 2006 2010 2014

YoY% Change in Victorian Real House Price (LHS)Victorian Home Sales-to-Building Approvals (RHS, Led 1 Year)

Source: ABS, Bloomberg, Datastream, REIV, Credit Suisse Source: ABS, Bloomberg, Datastream, REIV, Credit Suisse

Figure 23: National Inventory of Homes for Sale Figure 24: Melbourne Inventory of Homes for Sale

Source: SQM Source: SQM

Unaffordability and unemployment risk are weighing on demand

Contrary to popular belief, the housing market is marginally oversupplied

18 December 2012


The oversupply seems to be most heavily concentrated in Melbourne. Indeed, SQM research data suggest that the inventory of homes for sale in Melbourne is currently well above where it was in the financial crisis.

We also believe that oversupply will become problematic in mining cities such as Brisbane and Perth. So far, the evidence is that these markets are holding up well but we believe that this reflects relatively shallow job cuts in the mining sector to date. Should the pace of job cuts gather more momentum, we could see the housing dynamics in these regions take a turn for the worst.

Figure 25: WA & Qld House Prices & Commodity Prices Figure 26: Perth Inventory of Homes for Sale

-50%

0%

50%

100%

1990 1995 2000 2005 2010 2015

YoY% Change in Mining Capitals' House Price IndexYoY% Change in Non-rural Commodity Price Index (Led 1 Year)

Source: ABS, Bloomberg, Datastream, Credit Suisse Source: SQM

If house prices really do fall by 10% 15% over the next year, this has a disproportionately large impact on home equity. The average home-owner with a mortgage has a gearing ratio of 62%. Therefore, every 1% decline in house prices causes roughly a 2.6% decline in the home equity of mortgagees. A 10% 15% decline in house prices would cause a 26% 40% decline in home equity. As substantial a decline as this is, it would not completely eliminate home equity for the average borrower. But even though the average borrower may not be wiped out more recent homeowners, with considerably less home equity might be. This would make it harder for them to re-finance, especially if they are on interest only loans. Therefore, the risks of default are higher when payment shocks hit.

Figure 27: Home Equity of Mortgagees Figure 28: House Prices & Home Equity

0

1,000

2,000

3,000

4,000

5,000

1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013

Home Equity of Mortgagees Real Assets Mortgages

-40%

-20%

0%

20%

40%

60%

1977 1982 1987 1992 1997 2002 2007 2012 2017

YoY% Change in Average Home Equity per MortgageeYoY% Change in House Prices

Source: ABS Bloomberg, Datastream, RBA, Credit Suisse Source: ABS Bloomberg, Datastream, RBA, Credit Suisse

Unemployment is rising The risk of substantially higher unemployment exacerbates all of the de-leveraging risks we have just mentioned. In our view, the worst of the job cuts is yet to come.

Over the past few months, the labour market seems to have been quite resilient to negative sentiment, and external shocks. It seems that consumer and construction sectors have managed to pick up some of the slack from deteriorating mining and financial services sectors.

House prices could fall 10% 15% over the next year, implying a 26% 40% decline in home equity

Labour market weakness could exacerbate de-leveraging risks

18 December 2012


However, all leading indicators point to weakness in the labour market over the next year:

Job advertisements are declining, pointing to a reduction in aggregate hours worked in the next few months.

Reported spare capacity is rising, consistent with a substantial rise in the unemployment rate.

Figure 29: Aggregate Hours Worked & Job Ads Figure 30: Unemployment Rate & Capacity Utilization

-75%-50%-25%0%25%50%75%

-9%-6%-3%0%3%6%9%

1985 1990 1995 2000 2005 2010 2015

YoY% % Change in Aggregate Hours Worked (LHS)YoY% Change in ANZ Job Ads (RHS, Led 3 Months)

72%

76%

80%

84%

88%0%

3%

6%

9%

12%

1989 1992 1995 1998 2001 2004 2007 2010 2013 2016

Unemployment Rate (LHS)NAB Capacity Utilization (RHS, Led 6 Months, Inverted)

Source: Bloomberg, Datastream, Credit Suisse Source: Bloomberg, Datastream, Credit Suisse

We are suspicious about the hiring activity that has gone on in certain sectors. For example:

The spurt in retail and wholesale employment probably reflects the short-lived recovery in retail sales earlier in the year (which was partly driven by stimulus). Going forward, we would not expect consumer sectors to be aggressive hirers, because spending growth has since slowed, and employment is a lagging indicator of spending. Indeed, if house prices really do fall 10% 15% over the next year, we would also expect to see retail sales growth fall, and consumer-driven sectors shed jobs.

Construction sector jobs rose in 4Q. That said, the bulk of the increase in construction jobs came in Victoria, which just so happens to have the weakest housing market conditions. We do not think that the construction sector will continue to add to employment. Indeed, if building approvals fall away, we would expect construction to be a drag on employment.

Figure 31: Employment by Sector Figure 32: Employment & Retail Sales

-100

0

100

200

300

400

2005 2006 2007 2008 2009 2010 2011 2012 2013

Mining & Construction Retail, Wholesale, Finance & Property

Cumulative jobs created since 2005

-6%

0%

6%

12%

-3%

0%

3%

6%

1997 1999 2001 2003 2005 2007 2009 2011 2013 2015

YoY% Change in Employment (LHS)YoY% Change in Retail Sales (RHS, Led 3Q)

Source: ABS, Bloomberg, Datastream, Credit Suisse Source: ABS, Bloomberg, Datastream, Credit Suisse

All leading indicators point to rising unemployment

We are sceptical about the recent resilience of the labour market data

18 December 2012


Figure 33: Retail Sales & House Prices Figure 34: Non-residential Construction & NAB Survey

-16%

-8%

0%

8%

16%

24%

-6%

-3%

0%

3%

6%

9%

1998 2000 2002 2004 2006 2008 2010 2012 2014

YoY% Change in Real Retail Sales (LHS)YoY% Change in Real House Prices (RHS)

-20

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-30%

0%

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1990 1995 2000 2005 2010 2015

YoY% Change in Private Non-residential Building (LHS)NAB Survey Capex Outlook (RHS, Led 3Q)

Source: ABS, Bloomberg, Datastream, Credit Suisse Source: ABS, Bloomberg, Datastream, Credit Suisse

Also, we are yet to see major job cuts in commodity-driven sectors. In particular, we would expect to see cuts in the mining capex space. This is because capex and employment are highly correlated, and current levels of mining capex are not sustainable. Indeed, on our estimation, miners now have a sizeable 20% funding gap to plug given that profits have fallen dramatically, and capex has ramped up significantly. In our view, it is unlikely that profits will rise dramatically because of sharply higher commodity prices. It is also unlikely that miners will raise more capital to fund capex spending. Therefore, it is most likely that miners will cut their capex, which would result in substantial job losses.

Figure 35: Mining Capex, Profits & FDI Figure 36: Mining/Construction GDP & Hours Worked

100

1,000

10,000

100,000

1987 1990 1993 1996 1999 2002 2005 2008 2011 2014

Mining Capex Mining After-tax Profits + FDI

-20%

-10%

0%

10%

20%

1987 1990 1993 1996 1999 2002 2005 2008 2011 2014

YoY% Change in Mining & Construction Hours WorkedYoY% Change in Mining & Construction Real GDP

Source: Bloomberg, Datastream, Credit Suisse Source: Bloomberg, Datastream, Credit Suisse

Taking into account all of these considerations, we suspect that we could see 100,000150,000 job losses over the next year, and the unemployment rate could easily rise to 7% from 5.2% currently. Indeed, the unemployment rate would rise substantially even without major job losses, because of strong population and labour force growth.

Rising unemployment is likely to continue weighing on housing demand. Moreover, it is likely to add more pressure to over-leveraged households, as many of these households are dependent on multiple income earners to service their loans. In a worst case scenario, rising foreclosures could also add to the supply of housing at the margin, further depressing house prices.

The worst of the job cuts may still be ahead of us

18 December 2012


Investment conclusions We are underweight banks because:

Valuations are not attractive.

Earnings and dividends have downside in an environment where unemployment is rising, house prices are falling, and de-leveraging pressures are intensifying. We suspect that bad debts could rise considerably, rendering current dividend yields unsustainable.

The RBA does not seem to be acting sufficiently quickly to deal with de-leveraging

on rate cuts.

We are particularly concerned about the ability of households to continue servicing their debts in lieu of payment shocks on interest-only loans. Contrary to what the national accounts might suggest, the cashflow situation for mortgagees is quite tight, and the vulnerability to payment shocks or unemployment risk is quite high.

Risks are quite concentrated in the investor housing space. Top-down analysis suggests that investors in the housing market are struggling to generate net income because rental yields are so far below borrowing rates, and gearing levels are higher than what they should be. Therefore, it seems as though investors are subsidising losses on their property portfolios out of labour income, in the hope of future capital gains. However, we are quite pessimistic about the prospect of house price inflation particularly from such an overvalued starting point. On the contrary, the most recent data suggest that housing

potential buyers are very concerned about unaffordability and rising unemployment. If housing demand remains low, house prices could fall substantially. The risk of house prices declining is significant because it means that the equity of borrowers could fall disproportionately, making it more difficult for investors to re-finance loans as payment shocks hit.

We are underweight banks because of unattractive valuation, and deteriorating macro conditions

18 December 2012


Disclosure Appendix

Important Global Disclosures Atul Lele, CFA and Damien Boey, each certify, with respect to the companies or securities that the individual analyzes, that (1) the views expressed in this report accurately reflect his or her personal views about all of the subject companies and securities and (2) no part of his or her compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report. The analyst(s) responsible for preparing this research report received Compensation that is based upon various factors including Credit Suisse's total revenues, a portion of which are generated by Credit Suisse's investment banking activities

Outperform (O) : Neutral (N) : Underperform (U) : *Relevant benchmark by r erse which consists of all companies covered by the analyst within the relevant sector, with Outperforms representing the most attr active, Neutrals the less attractive, and Underperforms the least attractive investment opportunities. As of 2nd October 2012, U.S. and Canadian as well as European rareturn relative to the analyst's coverage universe which consists of all companies covered by the analyst within the relevant sector, with Outperforms representing the most attractive, Neutrals the less attractive, and Underperforms the least attractive investment opportunities. For Latin Ame rican and non-Japan Asia stocks, ratings

alia, New Zealand are, and prior to 2nd absolute total return potential to its current share price and (2) the relative attractiveness of a

-month rolling yield is incorporated in the absolute total return calculation and a 15% and a 7.5% threshold replace the 10-15% level in the Outperform and Underperform stock rating definitions, respectively. The 15% and 7.5% thresholds replace the +10-15% and -10-15% levels in the Neutral stock rating definition, respectively. Prior to 10th December 2012, Japanese ratings were

Restricted (R) : In certain circumstances, Credit Suisse policy and/or applicable law and regulations preclude certain types of communications, including an investment recommendation, during the course of Credit Suisse's engagement in an investment banking transaction and in certain other circumstances.

Volatility Indicator [V] : A stock is defined as volatile if the stock price has moved up or down by 20% or more in a month in at least 8 of the past 24 months or the analyst expects significant volatility going forward.

Overweight : d/or valuation is favorable over the next 12 months. Market Weight : Underweight : aluation is cautious over the next 12 months. er multiple sectors.

Credit Suisse's distribution of stock ratings (and banking clients) is:

Global Ratings Distribution

Rating Versus universe (%) Of which banking clients (%) Outperform/Buy* 42% (54% banking clients) Neutral/Hold* 39% (48% banking clients) Underperform/Sell* 15% (43% banking clients) Restricted 4% *For purposes of the NYSE and NASD ratings distribution disclosure requirements, our stock ratings of Outperform, Neutral, and Underperform most closely correspond to Buy, Hold, and Sell, respectively;; however, the meanings are not the same, as our stock ratings are dete rmined on a relative basis. (Please refer to definitions above.) An investor's decision to buy or sell a security should be based on investment objectives, current holdin gs, and other individual factors.

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