GJ Prasad

Author Archives: GJ Prasad

24th March 2019

Bank Capital Investing in the “EGG ME” Era | Free Content

You may not like it but EGG ME is here to stay

First it was the PBOC, then came the ECB and now the Fed.  Investors are now starting to pencil in the likely new era of “EGG ME” or Extraordinary Globally Guaranteed Monetary Easing in perpetuity.  And in this “EGG ME” background it is becoming difficult to get bullish on bank equity in any part of the developed world.

I would argue that in certain parts of the world, bank equity valuations are stretched (Canadians, Aussie and even some large cap US banks) and do not reflect economic realities.  In addition, non-bank players are disrupting the traditional lenders and eating away the already shrinking revenue pie.  In Europe, the problem is even more acute given that the banks have multiple fundamental problems including shrinking margins, high cost base and very poor growth prospects.

Investors getting used to GIMME

Fool me on growth, fool me on inflation but GIMME (Guaranteed Indefinite Maximum Monetary Easing) QE forever seems to the only way to keep risk assets from completely falling over.    Given that decent global growth levels are getting increasingly difficult to achieve and inflation not reaching targets in any sustained manner, central bank after central bank are outplaying one another on who is going to be more dovish.  And the minute there is a semblance of monetary policy normalisation, investors are throwing a big tantrum and running for the hills.

This backdrop means that monetary accommodation likely to stay for extended periods of time or even indefinitely and that is certainly seems to be the case in Europe.  In addition to the above issues facing the sector, investors are focussing on:

  • complexity of legal structure and intra-group lending
  • cross border exposure especially in high risk EM countries
  • level of potential impairment from holding periphery government bonds
  • operational / reputational risks especially relating to KYC/ML
  • reliance on cheap central bank funding

If you didn’t notice, European Bank Index (SX7E) was down almost 7.5% last week reflecting investors angst and despair about earnings momentum.  We can add to it the Brexit related uncertainty and the very poor PMI numbers in Germany and France.


What to do in bank capital investing?

From an equity investor perspective, at first sight, valuations across the sector seem cheap given the low Price/TNAV (trading at a large discount to tangible net asset value), attractive dividend yield and fairly priced on a price to forward looking earnings estimates.  But all of the three valuation metrics could still be questioned – is TNAV accurate?  Are dividend payouts sustainable?  Are the forward estimates realistic?

Valuations may be cheap and attractive but markets see to be focused on the “unknowns’ and risk/issues outlined above and they are unlikely to be resolved anytime soon. Clearly qualitative factors comfortably taking precedence over quantitative models.

With bank equity looking potentially expensive and likely to underperform, investors may be forced to look into high yielding assets such as AT1s and bank sub debt.  Whilst the carry on AT1s may be attractive (given where risk free assets are trading) there are other issues to consider including risk premium, equity/rates volatility and most importantly secondary market liquidity.

The structural weakness of the European banks come to the fore when they are sliced and diced in a worst case scenario – very poor earnings profile, inadequate reserve coverage for impairments and core capital shortfall due to leverage.  In such scenarios (though a low probability event), at least for some banks, capital burn is significant and whilst equity investors will take most of the hit, the AT1 instruments may yet come into play in terms of potential write-downs or conversion into equity.

This I think would be due to the issuer reaching PONV (point of non viability) and regulator stepping in well before actual triggers come into play.  This PONV is the biggest unknown qualitative factor (and one that is decided by the regulator) in AT1 valuation.  Thus, single name selection becomes even more important in AT1 investing.


Devil is in the details – keep on buying does not work

One thing is for sure – this asset class needs specialist / expert handling – someone who understands the macro picture in addition to having a deep knowledge of the issuer and the sector and can handle the volatility that comes from the underlying cross asset structural features.

Having said that there are a number of issues that look attractive to own for long- term investors.    Next comes the question of liquidity, as to who would be the marginal buyer of these AT1s in size and what is the clearing level for that.  I believe that AT1s yielding 7% (and above) on a yield to call basis and 6% on a yield to perpetuity basis should find some decent interest.   A number of AT1s issued by large cap high quality European banks screen well on this metric including the likes of Lloyds, HSBC, UBS, ING, Nordea.

And when it gets there, I believe specialist bank capital funds, distressed debt investors and private equity firms will want to own this but as a price taker.  The asset class needs a certain type of deep pocket investor with locked in capital and one who is prepared to do the necessary deep dive work both at an issuer level and at an issue level.  And be able to slice and dice the balance sheet to estimate asset recovery values and its impact on capital structure.


Bank LT2, NPS and TLAC paper look attractive – significant cushion given buffers

Sub debt is always going to trade on the back of equity performance and investor perception and hence unlikely to materially tighten in spread terms but may outperform equity/AT1.   In particular, the sub debt issues from the large banks in Italy and Spain are attractive to own.

Also, it appears to me that Non-preferred senior bonds issued by the larger banks and TLAC paper issued by global banks are starting to become attractive as defensive plays to fund shorts in other parts of the capital structure and/or across names.


Conclusion

To summarise, bank capital investing is becoming much more interesting from a relative value perspective and to some extent this strategy takes out the directional risk element.  Careful single name selection and then determining which part of the capital structure to invest becoming more and more crucial.

17th March 2019

Will the German Mega Zombie Bank (GMZB) take off? | Bank Capital Insights

So, it is official – Two zombies may join up to form a mega bank Earlier this Sunday, both DB and Commerzbank officially confirmed that they are in exploratory talks about a potential merger.  It looks like the German government is happy to see the two banks combine and create a German national champion bank.  […]
Subscribers can log in to continue reading. Otherwise, purchase The Monthly Access Pass, One Year Subscription or One Year + Trade Ideas to become a subscriber.
8th March 2019

ECB’s Third Let’s Try Risk On (TLTRO 3) | Free Content

Post-ECB Meeting

I had set out my Bank Capital Outlook at the beginning of the year (2nd January 2019) wherein I saw significant scope for generating substantial returns (10%+) based on single name selection and evaluation of macro factors.  And as of now, this strategy has returned 6% YTD.

Now, following yesterday’s ECB meeting wherein additional accommodation was announced, subtle changes to the investing strategy are required.

ECB keep on accommodating again and again

ECB’s TLTRO 3 will undoubtedly help the EZ banking system with more liquidity and funding options and will help the weaker banks to roll over existing debt – and also help credit creation in the process. Overall, the probability of default should decrease further as banks fund through the ECB.


Equities look slightly vulnerable

Without economic growth, most of the existing NPL stock is unlikely to go away and, in fact, may lead to further NPL creation.  In any case, earnings are likely to be impacted due to margin compression and given the high cost base, little room for additional loan loss provisions.  And if banks were to take additional litigation/settlement and restructuring costs, earnings are likely to come under pressure.

Return on Equity is already low for many of the banks, and may yet go lower.  Given the 10%+ COE for most EZ banks, the case for investing in EZ bank equities is just not there.  To me, there is plenty of downside in EZ bank equities.

Whilst the ECB may have solved the liquidity issue, it has not taken away the potential Solvency issue (in case of a deep recession and/or other tail risks) and consequent recapitalisation for some banks and this new TLTRO does not address that.  I believe that there is still plenty of downside in EZ bank equities.


AT1 is attractive but needs careful selection

Most of the AT1 issued by large cap EZ banks do look attractive. However, one needs to take into account the potential extension risk and especially those AT1s with low reset spreads.

Is AT1 attractive to own?

Once the right issuer has been identified, then AT1s issued by that bank would be attractive to own if:

  • AT1 yield is double the bank’s dividend yield
  • No more issuance to meet regulatory capital thresholds
  • Significant headroom on both coupon paying ability test and conversion trigger test
  • Bank’s equity is trading at or above 0.6 P/TNAV

And if rates keep rallying, the chances of non-call actually increase as banks may be incentivised to keep the existing AT1s instead of tapping the markets for replacement.

So, I think the longer call AT1s may be better to own ahead of short-dated calls.  Also, it is better to own the national champion peripheral bank AT1s given the additional yield and hedge them with single name equity puts.


NPS the sweet spot

My personal view is that the Non-Preferred Senior / Holdco Senior issued by the large EZ banks look very attractive on a risk-adjusted basis (taking into account probability of default and loss given default).  The spread differential between NPS and LT2 of the same issuer seems to be excessive. The only issue seems to be the potential large supply of NPS debt, but I think that it has been overplayed.

CDS land..

And in CDS land, I think Senior Fin Index is wide relative to Main and I see Senior Fin trading through Main over the course of the year.  And within Single names, Senior CDS of peripheral EZ banks look wide relative to Core EZ banks and expect further compression.


Conclusion

2019 will continue to be a very interesting year for bank capital with loads of opportunities and significant volatility. But there is significant scope for generating substantial returns based on single name selection and dynamic portfolio risk management.

7th March 2019

When the DOVE turned even more DOVISH | Bank Capital Insights

Carry on “TLTRO”… In a slightly unexpected move, the ECB pushed out the timing of its first hike until the beginning of 2020 at the earliest and offered banks a new round of TLTRO loans to help revive the euro zone economy.  In the process, the ECB further lowered the growth and inflation forecasts for […]
Subscribers can log in to continue reading. Otherwise, purchase The Monthly Access Pass, One Year Subscription or One Year + Trade Ideas to become a subscriber.
4th March 2019

European Banks: Never a Dull Moment | Bank Capital Insights

They come in threes… First, it was Danske. Then came Swedbank, followed by Nordea. Suddenly, the money laundering scandal issue is starting to look systemic in the Scandinavian banking system. All three banks are very well capitalised and hence in a good position to absorb any large settlement/remedial costs. But the impact on earnings is […]
Subscribers can log in to continue reading. Otherwise, purchase The Monthly Access Pass, One Year Subscription or One Year + Trade Ideas to become a subscriber.
28th February 2019

No Stopping the Easy Carry Business (ECB) | Bank Capital Insights

Carry on TLTRO – The show must go on It seems that market participants are placing more and more confidence that the ECB will announce a new fixed TLTRO program next month. That will mean credit supply to the EZ economies will continue unabated and counter any economic slowdown, with the biggest beneficiaries of the […]
Subscribers can log in to continue reading. Otherwise, purchase The Monthly Access Pass, One Year Subscription or One Year + Trade Ideas to become a subscriber.
26th February 2019

Negative Yields Do Wonders | Bank Capital Insights

KBC issues EUR Perp NC5 at yield of 4.75% KBC (the Belgian bank assurer) apparently are issuing a EUR 500 million Perp NC 5 AT1 with a yield of 4.75%.  This despite Santander’s decision not to call their 6.25 EUR AT1 a couple of weeks ago and general economic uncertainty. KBC has a good credit […]
Subscribers can log in to continue reading. Otherwise, purchase The Monthly Access Pass, One Year Subscription or One Year + Trade Ideas to become a subscriber.
21st February 2019

Danske Bank AT1: Mispriced for extension risk? | Trade Ideas

Danske Bank – The money laundering saga continues  Danske Bank continues to be in the headlines with the ongoing money laundering scandal at its Estonian unit.   The bank’s shares have tumbled more than 50%+ in the last 12 months on uncertainty surrounding overall litigation and remedial costs. The bank’s 2018 annual results do indicate the strength of […]
Subscribers can log in to continue reading. Otherwise, purchase One Year + Trade Ideas to become a subscriber.
19th February 2019

HSBC – Solid as a rock | Bank Capital Insights

Equity investors may be disappointed HSBC reported Q4 and FY 18 earnings report on Tuesday morning that missed consensus estimates.   Most of the weakness stemmed from a slowdown in the global banking and markets division. The bank’s stock was down about 4% post the earnings announcement reflecting the earnings miss and slightly negative outlook for 2019.   The […]
Subscribers can log in to continue reading. Otherwise, purchase The Monthly Access Pass, One Year Subscription or One Year + Trade Ideas to become a subscriber.
17th February 2019

Let it Rip | Bank Capital Insights

Risk-on week for EU banks Last week was a good one for European banks with risk rallying across the board – from equities to sub debt to single name CDS to credit indices.  We had a number of banks reporting earnings and investors liked what they heard – especially from the banks that have almost […]
Subscribers can log in to continue reading. Otherwise, purchase The Monthly Access Pass, One Year Subscription or One Year + Trade Ideas to become a subscriber.
1 2 3 5