The Meltdown of the Financial Sector, Justified or a Bear Trap?
Financial markets were rolling over and the financial sector in particular seemed to be the target of stress. Besides equity prices, bonds and hybrids of financial institutions have been repriced aggressively since the beginning of the year and have accelerated lately. The actions observed at the markets, particular in the financial sector on a global scale, look for many investors on the surface level like a recall of 2008, although the environment and balance sheet health of US/European banks is remarkably different.
Due to the uneasiness of the markets we spent considerable time in understanding the market dynamics and the various reasons that are travelling through the investment community and hit the financial news headlines. Multiple sources from investment professionals that cover the financial sector were used for putting all the different pieces together, which in the end cleared things up and enabled us to make informed decisions. Listed below are the most common themes that were mentioned.
Common Explanations by Market Observers
- Move of the BoJ to implement negative deposit rate took market by surprise
- The perception that the FED has lost the fight after Yellen’s statement of diminished likelihood of quarterly subsequent rate hikes in the future
- Crumbling global growth rates will trigger higher default rates and thus will hurt banks' profitability; in addition, negative deposit rates in Europe and low yield for longer will take its share of the European banks' EPS growth
- The banking sector appears less healthy and weak
- NPL and bank bail-in issue in Italy
- At1/CoCos are not save as the coupon payments are in question
- Deutsche. Bank debacle has sent shock waves through the European Banking Sector; it is believed that the banking sector is weak and could cause another financial crisis
- Implementation of the BRRD (Bank Recover and Resolution Directive) directive that establishes the forced bail-in in Europe
For this forum we summarize the findings and put them into the context of the banking sector as it was the entry point why we got interested in (or almost forced to) investigating what is going on and whether the dramatic repricing of banks' capital structure bears any rational fundamentals.
The Health of the Banking System
Globally, the repricing of banks happened with just looking at the bank equities which started to crumble in December of last year and have been slaughtered since. Based on the index level for the US KBW Index, EuroStoxx Bank Index and Japan Toppix Bank Index, they have lost between 20-30%. On the individual front outliers like Deutsche Bank were punished by idiosyncratic events and suffered losses of more than 30% in their stock prices.
The current situation of slammed global bank stock prices appears more dramatic than after the Lehman default, which can be interpreted that the market believes a full-blown financial crisis is on the horizon. Last time we witnessed these valuation levels for a number of financials the S&P was trading below 700.
Is the situation really that dramatic of what the markets are signaling investors? We followed up on this question and reviewed the health of the banking system from the various angles.
The following observations for European banks were made:
- Valuation - With current valuations we are at the bottom of 2009 and 2011 but the banks look completely different: equity base tripled, leverage ratio came in from 25x to 13x; under US GAAP US and European banks look the same with core-capital calculated under BASEL III at around 11%, which in comparison is at least 2-3x more core capital than back in 2008.
- Profitability - Although bank earnings retraced in Q4 compared with previous quarters, it is expected that banks will grow EPS in the coming years. SocGen, as an example for a big bank in Europe, is producing 8% ROI, trades at 50% discount to tangible book, has 15% FCF, pays 50% out (7.5% yield), book growth at 7% and has the capital to withstand the AQR stress test with minus 5% European growth rate while Europe is actual growing at 1-2% (would need a 7% drop within the next 3 years!). They could withstand it and have no need to raise capital. The same applies pretty much for the majority of the sector.
- Bank’s Balance Sheet - The overall credit segment of the European financial sector is approx. EUR 1.3tr of which EUR 800bn are in senior, EUR 350bn in Tier 2, EUR 130bn are in hybrids (EUR 93bn in CoCos) and additional EUR 60bn in older Tier 1. As pointed out under Valuation, banks have an average core-capital Tier 1 ratio of 11%, which means 400bps more than the requested 7% under Basel III and prepare themselves for further increase to comply with additional requirements in the years to come, such as for the Basel III leverage ratio or the Global SIFI (for systemic relevant banks), making them even stronger in the long run. The average hybrid in the sector represents 4% of the total core capital; translated for banks like BNP, Santander it means they have EUR 10-20bn of capital buffer before those securities get converted into equity or do not earn any coupon.
Thus, the implementation of Basel III forced banks to work on their capital base with accumulating capital through profit conversion as well as issuing equity, subordinated and senior debt.
- Effect on EPS of the Negative Deposit Rate - Last year the average negative deposit rate was 20bps, which only applies on excess reserves that banks park with the central bank; in the case of Europe and Japan it is expected to have a very marginal impact on banks profitability between 4-5% of total EPS on a 3-5-year time horizon (also only applies to new deposits!). Although it is a drag on profits, Swedish banks can be reviewed as a poster child for how banks can operate profitably even in an environment of a negative 50bps deposit rate (in fact Swedish banks exhibit highest profitability in Europe but also have to face tailwinds from the macro perspective). How banks in central and peripheral Europe can navigate that issue varies, as i.e. BNP and ING are well diversified and can compensate the losses very well while Italian and Spanish banks experience a stronger negative impact but were/are still able to grow and to increase capital organically. A negative rate of 2% was mentioned as a real issue for banks.
- Defaults in Stressed Sectors - The potential defaults of oil/metal & mining related bonds have a rather insignificant impact on European and Japanese banks and are more an issue for US local and regional banks; European and Japanese banks were retrenching from the US as they got fined in participating in the US$ market; thus, exposures to the US have been reduced and are very limited to the Energy and Metal complex. BNP’s numbers are a good proxy for other big European banks: with a total of EUR 26bn, 60% to major oil companies, 75% is in IG, average maturity is less than 2 years and they believe the “doubtful” exposure is less than 1% (approx. EUR 260mn) for a company that posts annual profits between EUR 4-6bn! Without any recovery (usually 60%), if the doubtful exposure defaults it has just an impact of 5-10% on EPS in one year. Furthermore, although other sectors (all that belonging to the brick & mortar business) face tough times with growing competition from the online businesses, no big wave of defaults are expected, unless a heavy recession awaits or substantial rate hikes are happening, which both are seen as tail events
- Legacy NPL Issues – Most countries were dealing with the repercussions from 2008 for a number of years with Ireland and UK at the forefront and largely solved them. The issue is currently more pressing in Italy as the government took its time to deal with it. The systemic banks are not affected at all and mostly regional, smaller banks have the issues on their books. It is expected that more banks will face potential solvency issues in Italy but the potential targets have been identified and should not come as much of a surprise. However, these events can always have repercussions across the European banking sector, the effects should rather be short lifted and more technical in nature. Expected M&As can clean up the landscape, which would help to solve issues faster.
- Recipe for Banking Crises - Banking crises occur when acceleration in lending combined with loosening underwriting standards and sudden macro-economy retrenches are happening. For 7 years the banks have been on a diet in US, Europe and Japan. Banks in Europe have a loan-to-deposit ratio of 1:1! And the deposits are growing 2-3% p.a. with little loan growth as it started to pick up slowly in 2015.
- Summary of Arguments - The perception of the market is that banks are weak and cannot withstand any recession. Last week, during her hearing before lawmakers, Janet Yellen pointed out that substantial payoffs have been achieved in the form of a much more resilient and stronger, better-capitalized and more liquid banking system. Besides that comment, the following arguments shall dismiss this perception: First, banks now delivered for a number of years (no credit expansion, no expansion of the balance sheet etc.); second, they are profitable on the global scale and also for the most part in Europe with some idiosyncratic exceptions which are even in aggregate not systemic; third, the banks are solid from the capital and liquidity point of view; fourth, the banks were able to grow capital organically besides raising capital (converted profit into capital); fifth, banks are transparent about their buffers until the subordinated debt gets converted into equity and/or coupons are not paid; sixth, a liquidity issue is almost impossible to occur for a bank with the various liquidity facilities provided by the ECB (even Greek banks did not run out of liquidity as they got funded by the ECB); seventh, with the communication on buffers it is clear that these numbers were discussed with the ECB and that the ECB signed off of them, which all leads to the fact that the ECB knows about the strength/weaknesses of the banks and is deeply involved in the background.
- Market Momentum Turns - Insider buying like from Jamie Demon last week (sixth calendar week) could be observed which should provide confidence that the repricing is overblown.
The idiosyncratic Event of Deutsche Bank
Deutsche Bank (”DB”) was in the headlines and although it did not spark the global angst of any major banking issues, it at least fueled the rumors which in last consequence accelerated the selling and caused the roll-over of the European banking sector during the sixth calendar week; DB itself experienced the selling pressure painfully with aggressive repricing of the outstanding securities across their capital structure.
From the birds-eye perspective the headlines on DB were worrisome, but once the issues were reviewed in detail it was clear that a misperception was seeded and the concerns were overblown. The following shall highlight a few arguments where the market was wrong:
- Rightly, it can be argued that the bank is weak in terms of profitability, but not from the point of view of capital structure.
Many are looking at the leverage ratio and interpret one of the highest numbers within the industry as structurally weak without taking into account that the investment banking consumes much of the leverage and that the bank is actually undergoing a painful restructuring process which in the mid-term will lead to a lower leverage ratio anyway.
- Like other peers DB has a capital ratio of higher than 11% and carries unencumbered cash of approx. EUR 250bn. It is striking to read in newspapers that the bank may have a capital or even a liquidity issue. Those statements are more than beyond reality and cannot be taken seriously.
- It seemed that panic was created out of miscommunication. (Financial) Newspapers got it completely wrong as they wrote DB has EUR 1bn of cash to pay the coupon of their CoCos, which is nonsense. The issue is much more structural as the CoCos were structured out of the German entity which followed the German GAAP (on the group level they have the same buffer as the other big banks); in the German entity they have a buffer of EUR 1bn and they need to pay EUR 350mn this year and next year it is covered by further EUR 4.5bn of provisions. On the group level they can get hit by more than EUR 10bn of capital depletion and still be able to pay the coupons.
- On the liquidity side, DB set the right tone and announced the buyback of senior debt; not only that they anchor the bonds and hint that those are mispriced, DB can put cash to work and will book a profit on this extraordinary effective liability management exercise. It is conceivable that the bank will use up to 20% of the cash to retire more senior papers.
- Investors smelled smoke when they looked at the CDS spreads and inverse CDS curve, usually a sign of trouble. In this case it is a logical reaction by the market as (1) the cash and the synthetic market got repriced in tandem, (2) investors were trying to hedge their subordinated debt through CDS and (3) counterparties have to buy more CDS exposure with the spread widening. Thus, the high demand of the short end of the curve reflected by the inverse CDS curve is less due to the fact that people were betting on DB’s default than rather a technical hedging mechanism.
All in all the reasons for the sell-off in financials seem from the headline perspective somewhat rational, but once you dive into the real situation of the banks' landscape and understand the fundamentals it is hard to justify why the global banking sector came under such pressure while no systemic risk of over rolling of the sector is on the horizon. It seems more that idiosyncratic events as pointed out with Deutsche Bank or another case with Novo Banco in Portugal and the incidences in Italy combined with global recession fears sparked the selling and fed themselves into a negative feedback loop.
Although people believe that there is stress in the banking sector (presumably the current equity and bond markets are telling this) looking at other various parameters there is not much of a sign for upcoming stress: (1) The interbank rate, represented by the LIBOR, did not react, meaning the trust between banks remains at a high level (OIS moved in absolute terms marginally) and (2) deposit outflows could not been recognized with the exception of third-tier banks in Italy. Also given the fact of contained effects from energy and metal and mining defaults and still tepid global growth, the banks seem to be built on solid grounds and the sell-off is self-induced, not representing the actual banks’ balance sheet strengths.
It can be assumed that the ECB is observing the current markets closely and is very much focused on the banking sector as it drives 70% of the real economy through lending and is the focal sector that needs to function; therefore banks cannot be ignored due to the monetary transmission mechanism. The US is different, as the Private Market is much more developed than in Europe, therefore managers expect strong policy response from the ECB in March.
The credit managers we talked to see the markets with even a better risk/reward than 2009 and due to their confidence level put more capital to work (also personally) across the capital structure as all different asset classes are disconnected from their fundamentals. They believe the market is set up for a decent snap-back as no more sellers are on the frontline and once buying is starting again the price action can be significant as it was on the way down.
If you are interested in a deeper dive into this topic, please request your copy of our long version; it replicates a compilation of a more detailed examination of the above-mentioned eight arguments of what drove the markets and how the current valuations are reviewed by the investors we talked to.