Cicutto's Job Is To Sit Tight
Sydney Morning Herald
Wednesday October 10, 2001
Until it sells its problematic HomeSide arm, NAB has to keep corporate magic tricks to a minimum.
The most positive aspect of yesterday's National Australia Bank briefing on its HomeSide mortgage service business was that nothing of any significance was revealed.
While some of the market participants involved in the briefing may have been disappointed that NAB's Frank Cicutto didn't announce the sale of HomeSide, no news was definitely good news.
After two massive writedowns of the carrying value of HomeSide this year $865 million in July and then the shock $3 billion writedown last month investors have become very nervous about the potential for more losses in a business operating in a volatile US environment.
Cicutto and NAB chief financial officer Richard McKinnon provided reassurance yesterday.
HomeSide is now operating profitably and continuing to write net new business it is expected to have earned $150 million at an operational level for the year just ended its hedging has stood up to US interest-rate movements and no more provisions against its value are expected.
While HomeSide hasn't been sold, the process of selling is under way. NAB says it has nine potential buyers. This looks like a great opportunity for someone to grab the business at its low point.
HomeSide has suffered from two distinct but loosely related problems.
The July writedown was due to unprecedented volatility in the relationship between mortgage spreads and US Treasury securities.
Mortgage service providers make money by keeping about 30 basis points of borrowers' interest payments as they flow to investors in mortgage pools. Their value is driven by the present value of the future income streams those mortgages generate.
As US interest rates tumbled earlier this year after a series of cuts in official US rates, home owners refinanced their loans at unprecedented rates, shrinking the value of those future income streams.
HomeSide and its peers protect themselves against prepayments by hedging their mortgage servicing rights.
There is no perfect hedge, but historically 30-year US Treasuries have provided a 90 per cent correlation with mortgage rates. This year, however, the link blew out, leaving HomeSide uncovered.
NAB appears to have that problem under control. Its restructured hedges have worked lately and McKinnon said the bank had another 100 basis points in protection, although he also warned there was still a risk of unanticipated prepayment levels.
The second and more damaging issue HomeSide faced was the discovery last month of a built-in error in the model that calculates the value of its mortgage servicing rights.
The error meant the model understated HomeSide's sensitivity to rate movements, overstated the value of its servicing rights and left the group underhedged. The flaws have been fixed.
Thus, while NAB cannot guarantee that some new issue won't arise in the US that damages HomeSide's value, it appears to be on top of the identified problems and HomeSide appears to have been stabilised.
However, continuing scepticism about NAB's exposure to the intensely competitive and volatile US mortgage market means there will be a discount for risk in its share price unless HomeSide is sold and NAB's exposure to that market is truncated.
NAB is also anxious to rid itself of the problem business, although it knows it needs to salvage as much value as possible from it.
It is likely to be seen as a distressed seller, so getting a good price the written-down book value of HomeSide is about $2.2 billion isn't guaranteed.
Apart from ridding itself of the uncertainty that is weighing on its share price, a sale would improve its capital ratios and restore its strategic flexibility.
Cicutto conceded the obvious yesterday in admitting that until HomeSide was sold, NAB wouldn't be looking at any strategic activity or buying back any shares. NAB can't issue scrip until the uncertainty over HomeSide has been resolved, and after the writedowns it no longer has the big excess of capital to return to shareholders.
As it happens, Cicutto probably wouldn't be planning any major expansion through acquisition anyway. Even before the most recent problems emerged at HomeSide, he had cooled on the prospect of a major UK acquisition, mainly because of the high cost of any target.
His caution was well-founded. The earnings of the UK mortgage banks have started to turn down quite steeply, but their share prices haven't moved in tandem because of the prospect of rationalisation of the second-tier banks.
The HomeSide-induced decline in NAB's price and the depressed Australian dollar make any acquisition even less attractive.
The combination of questions about HomeSide, which will remain until it is sold, and the cost of any UK acquisition leaves Cicutto no option but to focus on organic growth until circumstances change.
© 2001 Sydney Morning Herald
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