Why the Australian Share index is so reliant on just 5 companies and the risks that this brings

Welcome to Finance and Fury

Today we are discussing the concentration risk

Last week – how the modern banking system acts like dominos failing– Due to their liabilities and obligations to one another

this week – look at the other side of the balance sheet – Which is the Equity Holders – Shareholders – who owns the shares of banks Also – the concentration risk that just a handful of companies have in the overall size/weight of the Aus Share Market. Plus – Look at two events that every bank just did as this is a real-world example

 

Concentration in the index – Complex with lots of elements – break down major ones

Remember – Big 4 banks – including Macquarie = 5 of the top 8 companies on ASX by market cap

Australian bank shares – ownership and connectivity – beyond the derivative concentration representing 23% of ASX300 - IMF report in 2012: big four controlled 88% of residential mortgages and 80% of deposits. biggest six American banks held 30% of total deposits not just banking: the big four own 53% of life insurance premiums, 57.3% of retail investment funds through bank-owned platforms – Insurance and investment sides to banks also purchase shares on the ASX – of which they make up a large chunk This can just further increase the concentration risk of markets – if an investment manager owns 5% of a share and sells, that moves the prices down – a lot – average daily volume is about 0.15% - both buys and sells - Beyond banks owning their own shares directly – Subsidiaries – Investments, Banks – through super funds, investment managers, insurance companies – either buy them through own subsidiary or another bank – Super funds (investment managers) – Industry/index funds – hold shares on the ASX - Example – Aus Super – Balanced fund has $100bn in it – 22% allocation – range of 10-45% ASX market cap – $1.6-$2trn depending on the market cycle – $2trn now, but $1.8trn middle ground What can easily lead to a downturn in the share market? What if you have $2.8tn across all super funds – plus $100bn inflow p.a. – and super investment managers decide to dump the ASX? –strategic ‘rebalancing’ or ‘profit-taking’ If the target is 25% to AS – a drop in exposure by 10% down from 35% - selling shares/index – ASX $2trn – a sale of a super fund in Aus shares by 10%, sale of 14% of shares held on the ASX – that is a lot of power to move a market – top 20 super funds have around $1.3trn of the super investments also a lot of power in the property market - cover more in another episode Names on the list – Broken up between Public Sector, Industry or Retail (banks) – Pretty equally split in % of top 20 Of the retail funds – about $420bn in 8 – Bank Subs or non-bank financial services MLC Super (NAB), CFS Super (CBA), Retirement Wrap (BT), OnePath super – ANZ AMP super – 2 funds, IOOF super, and Mercer (owned by USA insurance company – Marsh & McLennan) Bank Major holdings – Blackrock entities – 3 of the top 10 for every bank but NAB – ‘Advisors, Management, UK’ Macquarie has about 7% of its shares But this is who the owners are – banks use custodial holding companies – HSBC, JPM, CitiGroup – 40-55% between 3

 

Beyond just being investors in one another and Concentration through connectivity and custodial power –

Banks are Counterparty to each other – either a lender/borrower to one another – derivatives last week example of one side

But big 4 banks are highly interconnected - each other’s largest counterparties – nobody else is big enough the connection is far from direct ownership of shares – but banks borrowing from each other, rather than owning large parts of each other – Balance sheet has assets and liabilities – Under lending laws – lenders get paid back before investors If a bank borrows another money, and one bank goes out of business – banks get any money first – shareholders probably get $0 – when you look at the size of the loans to overall ‘equity’ Thankfully for them – the global markets and companies are just as easily reached as domestic ones – financial services can fall under free trade Not so good for us – as when a banking crisis happens in USA – we get hit just as bad Requiring each other – as there is so much money needed only one of the other big four can normally help Banks fund costs through short term debt securities – why hold cash – when you can use it to lend at 3.5% and borrow at 1.5% interest – like funding your lifestyle on CC and investing the rest of the money – then trying to repay the debt using your investment earnings – doesn’t work unless you can consistently get over 22% p.a. returns on an investment to outpace the accumulation of debt – but if you got 22% investing, and card was 2% - who wouldn’t do that? When there is a crash in the banking system – hard to fund expenses as nobody wants to lend to you – GFC – Called liquidity crisis – but in reality, was an insolvency crisis – two different things – as banks don’t even have the assets to fund any ‘bank runs’ Further hastens the decline in share values due to cashflow losses – rule of business: cant meet expenses = bankrupt If you look at a banks balance sheet – almost worthless – Shares themselves in Banks are insolvent in values – DB had total assets of 1.541 trillion dollars and total liabilities of 1.469 trillion dollars – difference of $72bn is in shareholder equity CBA – Total assets $975bn – liabilities at $907bn – What is lest is shareholder equity – 7% of assets WBC - Total assets $880bn – liabilities at $815bn – $64.5bn left or 7.3% of assets Most banks run on this margin - Hsbc – massive value of assets - $2.56 trillion total assets - Remember – Loans to you are assets to banks – if you borrow = liability Banks values come from the ability to make money – Price is What we will pay for shares Bank shares – Total equity or market cap – or what shares are worth on market prices CBA - $146.5bn – 7.4% - Shareholder Equity (book value) - $67bn – Banks assets minus liabilities WBC - $99bn – 5%, ANZ - $80bn – 4%, NAB - $75bn – 4%, MQG - $42.7bn – 2% But if they lose a small margin in assets = no equity left – Regulators aware – hence the recent issues of debt and equity

 

These are becoming heavily controlled – legislated – APRA forcing banks to increase their reserve capital – money against loans This is done through issuing ‘Subordinated notes’ - this is part of the Bail-in regulations that are being put into place Issue debt – they call it bonds – but notes with provisions of write off if APRA determines it is necessary Reason for doing this? Banks liquidity - Issue equity – raise money from creating new shares and converting them Balance sheet 101 – if someone buys your debt (i.e. you borrow money) – if your assets don’t go up to match it = negative This is where the balance sheet of a bank best maximises its profits when it gets as close to 0% net assets reflect But if they issue debt, they need equity to balance the books – this is where shares are issued to counteract major Banks are doing both – creating new shares and selling them in chunks – to other banks/financial companies – issuing billions of $ in shares to the other – SIBs or SIFIs (terms in the big to fail eps – where to invest and where not to) Issuing shares where the trading can be legislated – ban sales – easier to do than the unpopular approach of shutting the market down - But newly created Common Equity Tier 1 capital to offset the increased liabilities – which are used as capital reserves – but dilutes the number of shares – unless profits grow by more, dividends suffer

 

Where value comes from? – Future cash flows and profits – Based on debts and leverage – Profit from both ends –

 

Investment firms buy bank shares – Or new corporate debt in banks if they are fixed interest managers –

Odd thing – Banks were told by APRA to raise $500m (approx.) in reserves – But they seem to be quadrupling Debt in USD – by CBA, NAB -, $1.5bn - WBC - $2.25bn USD, ANZ – strangely has in AUD floating – well issues new FPO shares and the buyers were themselves and JP Morgan NAB – Just Citigroup Global Markets alone - 38m shares - $26.28 = $1bn to offset the notes

 

Probably going to be costly – Interest payments on this – dilution of profits for dividends to existing shareholders

The solution to holding more on the balance sheet as ‘capital reserves’ = fund it with debt that can be traded away in the future - Does this make sense?

Remember – you are giving them $1,000 upfront – so if the notes go to $200, or are converted at that value, or not honoured – which is allowed if 5 days pass without the conversions occurring upon APRA notifying a bank - The complex connections don’t end there – a lot of these conversion laws are regulated in US laws – USD face values

 

At this stage, looks to be a similar lead up to pre-GFC – Instead of MBS – debt products with mortgages as backing assets - Now with bail-ins you take investor money for debt, which can then be written off if APRA determines a bank may become non-viable While you may not directly own these notes – A lot of the retail and industry Investment managers are the largest holders of banks – and also banknotes – through super or some index funds, you are indirectly invested in these Ongoing protection racket – protection that is provided isn’t for the individual investors - if it works once, may as well give it another go

Lead into next episode – what are super funds doing with your money?

Holdings - https://www.marketscreener.com/COMMONWEALTH-BANK-OF-AUST-6492243/company/

 

Thanks for listening to today's episode. If you want to get in contact you can do so here.