Monthly Archives: December 2018
Monthly Archives: December 2018
A decade back in the land of mega-credit there were three big kings – GE as one of the biggest issuers, which used debt markets as a tool to grow its global reach by offering vendor financing, GS as one of the biggest originators and distributors in the debt capital markets and DB as one of the biggest market makers in the OTC credit products.
And all three entities seem to have lost their way. GE with its leveraged balance sheet has found it difficult to generate decent returns in its core businesses, GS has found that traditional investment banking needs low-cost funding and DB has a huge cost base problem and a bloated and capital-intensive fixed income business. Equity investors in all three entities have endured significant pain with sharp falls in their respective stock prices.
GE’s problems seem to be its huge debt pile and involvement in low/non-profitable businesses. Once a global leader in many industries, it has failed to properly read the big transformational changes in some of its businesses. GE’s stock has been hit hard as equity investors don’t seem to like what they see. On the other hand, credit investors have just started to fret about a potential ratings downgrade to junk, which may mean that traditional investment-grade funds may have to sell their holdings. Given the amount of debt issued by GE it seems that the potential transition from IG to junk may cause significant pain to current investors.
GS wants to diversify away from the traditional investment banking business and wants to add a retail banking franchise. Given the ongoing shrinkage of the industry sales and trading revenues due to regulatory changes, disintermediation by newer players, automation etc, the firm has found it difficult to deliver strong earnings.
And now the firm is dealing with legacy litigation and compliance issues, which may yet see more reputational damage and impact revenue growth. As of now it still seems that these issues are more relevant for equity investors but if headlines continue to be negative, credit investors will be impacted given that the paper is issued out of the Holdco entity. And there is not much sub debt to absorb large-scale unexpected losses.
That brings me to DB and the issues are well known. It has a huge cost base problem and is still heavily reliant in the Fixed Income business, which is capital intensive. Further, the scale and scope of its investment banking business has meant that it has been involved in a variety of issues and each requiring significant management attention and – more importantly – exposed the bank to operational risks and large costs. The wealth management business is the bank’s most profitable area and management have failed to divert the capital resources from the investment bank to this unit.
With a cost-to-income ratio of almost 90% and a RoE of about 2%, the scale of the bank’s earnings problem is clear. Given where the stock trades (close to 0.3 times P/TNAV) and level of share price drop, much of the downside risks seem to have been priced in. Credit investors seem to take comfort from the potential intervention of the authorities given its systemic importance.
If any of above three entities were to run into significant difficulty in the next 6-12 months, the impact on the overall credit markets would be dramatic and hence one of the big tail risks to be monitored and risk managed. This, on top of deteriorating liquidity in secondary markets and a general aversion to risk, which will only further amplify spread widening.
Just as an afterthought, there is plenty of talk of a potential DB/Commerzbank merger to create a German national champion bank. Whilst this may yet happen, in my view, the merger is unlikely to solve the underlying issues. In my personal opinion, a more radical idea may be for GS and DB to consider combining their FICC businesses and address the revenue pie shrinkage issue and overall cost problem. That seems very unlikely though given other considerations.
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What is the single most driver of AT1 valuation – equity metrics, duration, spread premia for inherent credit risks, risk premium for the varied options sold to issuer – coupon deferral, non-call, and potential trigger risks for conversion/writedown? Whilst the right answer is a combination of all of the above factors (and hence very difficult for ordinary folks to decipher) the real and more important answer seems to be liquidity risks (i.e. finding a clearing level) in terms of finding new buyers. This is especially true when markets focussed on a particular macro tail risk event (say Italian politics or EM contagion) and/or headline risk on the issuer and above-mentioned valuation metrics are thrown out of the window.
Plus sometimes, the correlation between equity and AT1 breakdowns as different investor bases look at them differently, making it impossible to properly hedge out AT1 price drop risks by shorting equity (in some cases adds to the pain trade as AT1 drops due to lack of buyers and equity jumps on short covering). And trading RV between issuers in AT1 has its own issues as in many cases they are not easily comparable and different issuers have varied valuation factors and RV exposes gross notional risks.
The point being that AT1 was issued to investors in good times as a nice carry trade giving decent yields (relative to risk free assets) but investors failed to appreciate the multi-layered risks in the instrument and more so on liquidity risks in terms of being able to get out (especially in size) when the tide turns.
There is only about EUR 150 billion of issuance to contend with and who knows what will be clearing level on many of these issues if we have a big risk-off event and there is a buyer’s strike. And with limited ability for the market makers to absorb this risk (due to post-financial crisis regulations to carry inventory), my concern is that the overall AT1 market is set for further downside risks (and very limited upside risks) with no where to hide.
Indeed, they will get very attractive when YTP reach 8% and above relative to owning equity. But we are not yet there.
Headline risk continues to overwhelm DB stock and, over the last few weeks, it has been hit by a plethora of negative news including its involvement in the Danske Bank’s money laundering case, ongoing tax raids by German authorities, cum-dividend issues on ADRs etc. The impact of these relentless negative headlines has had a significant impact on the bank’s stock, which is now trading at less than 0.30 times P/TNAV.
This raises the question – Can the bank afford to absorb large sized settlement and litigation costs that may yet arise from the above issues? Given the very high cost base (cost to income ratio is 90%), the bank generates very poor operating income to absorb unexpected losses and if revenues were to decline further due to a lack of client activity and ongoing risk aversion, it exposes the bank to negative earnings and hence a potential hit to equity. The unknown factor in terms of future litigation costs is a key driver of investor pessimism. In addition, if the bank were to undertake a very large business restructuring this would involve significant one-off costs, which again adds to the pressure on profitability and ultimately capital build.
DB reports good regulatory capital ratios, well above minimum thresholds – but a 4% leverage ratio for a bank with EUR 1,305 billion of leverage exposure is just not good enough, especially if underlying earnings momentum is weak or even negative. For example, in a highly hypothetical situation, if the bank had to take, say, an additional EUR 10 billion of provisions/costs for the matters discussed above, it would create an almost EUR 8 billion capital hit (assuming current revenues hold) and that would translate to the Tier1 capital dropping to EUR 44.5 billion and leverage ratio falling to 3.4%. Add to this the EUR 23 billion of Level 3 assets and one gets the picture. And that is why equity investors are nervous.
Yes, the bank has good liquidity buffers and can withstand potential short-term counterparty/deposit flight. But the wall of debt that is maturing over the next few years (almost EUR 20 billion every year until 2022) means that the bank is reliant on wholesale markets being open and available.
Press reports over the weekend indicate that the German Government may be considering a merger of Deutsche Bank with Commerzbank to create a large German national champion bank. At first glance, this looks an interesting option to combine two underperforming banks with similar attributes in terms of low profitability and limited future visibility but with significant scope for cost reductions and a larger capital pool to absorb losses.
But merely creating a much larger entity does not solve the underlying core issues faced by both banks, more so for DB; The reason being that the bank is too large and too complex to be managed as a standalone entity and any additional merger will only complicate matters and cause further uncertainty.
DB’s issues stem from multiple factors – oversized/overstaffed businesses in FICC land and a strategic failure in the past to redirect capital to the more profitable wealth management and corporate banking businesses. FICC is a highly cyclical business and one that is undergoing profound structural change. Technology and automation are the key drivers of profitability in that business and DB has been very slow to react and adapt to the new landscape. What DB needs is a radical restructuring in the FICC business and it needs to get rid of many units that are currently generating very poor returns – and downsize its balance sheet exposures significantly.
Equity investors have taken notice of the issues and hence give the poor valuation on its stock. It seems that credit investors especially AT1 and LT2 investors are stuck in no man’s land and unsure of what to do next (yes, the yields are attractive but there are significant tail risks).
In my personal opinion, the bank’s AT1s are still not fully reflecting the substantial downside risks especially in the unlikely event of PONV (point of no viability) being reached or if there is a significant counterparty run. Coupons may not be at risk for now but it is still an overhang given the low profitability and current levels of ADI.
CBK as in Central Bank Kindness and not Commerzbank.
Given the systemic nature of the bank in the global financial system, it is likely that some form of government or central bank support (at least in liquidity) would come through but that will be at a price wherein sub-debt holders will be fully bailed in.
To that extent it seems to me that only the preferred senior part of the capital structure is safe for now (though one may yet get spread widening). I fear that credit investors have still not fully factored the potential downside risks.