The seasonal rally that usually pushes bank stocks right to the front of the market is at risk of getting derailed by the Banking Royal Commission, which kicked off this week.
The Royal Commission is putting the spotlight on "liar loans" and investors have yet to fully understand and appreciate the risk of these loans on the bottom lines of our country's biggest mortgage lenders.
This uncomfortable spotlight on the big banks comes at a time in the year that is typically great for the sector with investors clambering to buy into bank stocks to ride the dividend train.
This is why the big banks have historically performed well right through to April with the sector normally leading the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) higher.
But the dividend train hasn't come up against a Royal Commission before and could get derailed this time as the focus on "liar loans", where borrowers exaggerated their income and were given loans they could not afford, will force investors to reassess the liabilities of the $1.7 trillion residential mortgage market.
While the ABC reports that these loans make up two-thirds of bank lending, it is one of the least investigated areas of the financial industry and a survey by UBS found that a third of 1,000 new mortgagees have lied about their income.
If that doesn't quite concern you, a federal court ruling against Australia and New Zealand Banking Group (ASX: ANZ) at the end of last month could prove to be the canary in the proverbial coal mine.
The court ruled that ANZ had breached responsible lending laws when it failed to properly verify the income of car loan borrowers. It appeared that the bank replied too heavily on payslips, which are easily doctored.
The circa $5 million penalty to compensate 320 customers is a rounding error for the bank but UBS is warning that this could set a dangerous precedent when it comes to home loan borrowers.
It is usual practice for banks to ask for three payslips when processing home loans. I suspect they don't do much or any counterchecks, so if the latest federal court ruling were to be applied, banks could be liable for a very big compensation bill.
It is also worthwhile noting that household income data collected by the Australian Bureau of Statistics (ABS) is lower than the income reported by our mortgage lenders.
Further scrutiny on liar loans will be a drag on the share prices of the big four, which includes Commonwealth Bank of Australia (ASX: CBA), Westpac Banking Corp (ASX:WBC), National Australia Bank Ltd. (ASX: NAB) and ANZ Bank.
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