Category Archives for "Bank Capital"
So, AT1 bonds have generically rallied 3 points or so but some bonds are up 4-5 points in a very short period and given the cash prices (low to mid 80s) it translates to a 5% return. All this in the first 3 weeks of this year and almost half the returns (10%) I had penciled in this for the entire year.
Why did CoCos pop? In a nutshell the performance was driven by re-assessment of rates…..
We had three large US banks (Citi, JPM, Wells Fargo) report Q4 2018 earnings and there were similar attributes in terms of earnings, outlook and similar comments on the state of the US economy. All three reported sound increases in year-on-year earnings though they fell short in terms of market expectations/forecasts. All three banks reported ROE close to double digits and reaching their COE. Also, asset quality and capital metrics look robust and well placed to handle any unexpected sharp economic slowdown.
But, having said that, what is clear is that FICC business is becoming more and more difficult to make decent returns and this despite the massive volatility in rates and currency markets in Q4 2017. JPM’s 21% drop and Citi 16% drop in FICC does not bode well for other investment banks that are reliant on FICC revenues.
Last week was a good one for risk assets especially in bank capital (and within that AT1) driven by dovish Fed speak, trade war resolution optimism and no new “unknowns” to rattle investors. Add to that the lack of supply in high yielding paper in bank capital land and the result was a sharp rally.
But seasoned investors would have also noticed that none of the underlying issues impacting European banks have gone away (slow growth, margin pressure, liquidity pressure, high cost base) and hence caution is probably the next best strategy here.
So what now? Is this the beginning of a new risk on phase or just another false dawn…
It is not even a full working week into 2019 and we are seeing large volatility across asset classes – yet some of the themes that are likely to persist throughout the year are already getting confirmed:
This potentially means that the main central banks in the developed countries – Fed, ECB, BOE and BOJ resort to the old playbook of slowing/reversing rate hikes; become more dovish in forward guidance and decrease the speed of balance sheet reduction. And the Chinese central bank may go one step further and add further monetary stimulus to tide over a credit contraction.
Whilst this may help risk markets to bump along, the implication for the European banks is more downbeat as it would impact profitability. Lower loan growth (due to credit impulse slowing down) and margin compression (both due to competition and lack of profitable lending opportunities) may see banks struggling to improve top-line revenue growth. Add to this the high cost base and a potential increase in loan losses, one can see earnings trajectory to reverse or at best stay flat. In this environment, most banks likely to struggle to generate ROE close to COE.
Earnings recession is likely to lead to lower shareholder distributions in the form of dividends and/or buybacks. And this lack of earnings visibility is what has caused equity valuations of the major banks to drop 30% or more in the last 3 to 6 months. And in many cases, they trade at P/TNAV of 0.6 times or lower.
Some of the European banks have leverage issues and may yet need to either restructure their operations or reduce their risk assets. Plus, home bias should see some of them retrench and reduce global footprint and /or get out of non-profitable operations or businesses.
Although the above backdrop is not hugely optimistic, in a perverse way, credit investors may be the biggest beneficiaries, especially given the reluctance of European governments to let banks fail.
Looking at the situation differently:
Barring a full blown deep economic recession and/or unexpected tail risks due to political risks, most of the national champion banks in Europe have more than adequate capital to continue as going concern entities and don’t need re-capitalisation. The other area of market concern in terms of liquidity may get addressed through the renewal of the TLTRO program for another 3 years and hence eliminating the need for primary markets to be open for debt rollover.
Suddenly, this low growth, low inflation, asset de-risking set up is creating a situation where bank credit is starting to become attractive given current spread level. Current yields on many of the LT2s and Holdco Senior paper issued by national champion banks in Core European countries are more than compensating for the tail risks out there. And AT1s issued by the large cap banks getting close to fair value and attractive to buy and hold.
The contrarian view is that AT1s issued by banks that meet the following criteria are very attractive and likely to see significant price appreciation on a 6-9 month view:
Ask yourself this question – would you want to own AT1s issued by systematically important banks (yielding 7% or more) or HY bonds issued by firms in highly cyclical industries and with low visibility/transparency? I believe the answer is the former.
And I repeat my view from my 2019 outlook:
2019 is going to be a very interesting year for bank capital and, clearly, there is significant scope for generating substantial returns based on single name selection and dynamic portfolio risk management.
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It may look so bad, yet there is scope for 10%+ returns through careful single name selection.
Growth slowdown and dis-inflation will lead to ECB staying put on rates and potentially re-introducing QE. Another round of TLTRO funds is likely to be made available to banks as capital markets remain shut. Credit contraction likely to persist as banks further de-risk. Populism means tail risks remain high. And finally banking union and an EU wide bank deposit insurance program unlikely to happen anytime soon and that means more fragmentation. Non-bank financial institutions likely to further disrupt lending business models.
Further margin compression to be expected with funding costs going up. Slowdown in capital market activities leading to further revenue pressure. Cost pressure leading to more restructuring and capacity shrinkage. Compliance, legal and settlement costs across the industry to remain elevated.
All of above means expect further profitability issues for the industry and ROE to come under pressure. Most banks unlikely to meet COE and expect mid to high single-digit ROEs for most banks. Capital distributions in the form of dividends and share buybacks to slow down.
Expect a small deterioration in asset quality this year and future NPL formation depends on how low growth gets in 2019. Further, banks exposed to leveraged loan markets, EM cross-border lending and consumer financing should see a large tick up in credit costs this year.
Capital and funding outlook:
Current regulatory capital ratios are fine across the large cap banks but leverage is still an issue. Pressing need is to meet TLAC and MREL requirements and to that expect significant issuance of Non-Preferred senior and Holdco senior paper. Most of AT! Issuance already done but refinancing for 2020 calls may come by if markets open up. Expect non-call in AT1 and LT2 as banks preserve capital.
…but there is scope for plenty of dispersion and hence single name selection becomes key.
Names that screen well on above criteria: Lloyds, HSBC, UBS, ING, Nordea, Svenska, DnB NOR, Credit Agricole
Names that score fine but will be a continuous focus to market participants – Barclays, SANTAN, BNP, ISPSIM, RBS, STANLN, CS
Names that have issues on one or more topics mentioned above and hence need more scrutiny – DB, UCGIM, SG, DANKSE, BBVA, BPIM, CMZB
AT1 – likely to further underperform but will find clearing levels around 8% yield to perp. It is all about relative value within AT1 with defensive names holding up better than higher beta names.
LT2 – potentially the best part of capital structure to own (depending on name) due to limited issuance and overall yields relative to AT! Or NPS. Better to own operating bank LT2 given potential for spread compression.
NPS / Holdco – likely to underperform from current levels due to ongoing issuance requirements and risk premium required for potential bail-in risks. Holdco Senior is structurally better to own ahead of NPS as it benefits from diversified cash flows from operating subsidiaries
Once the right issuer has been identified, then AT!s issued by that bank would be attractive to own if:
2019 is going to be a very interesting year for bank capital and clearly there is significant scope for generating substantial returns based on single name selection and dynamic portfolio risk management.
As usual, the devil is in the detail and through careful single name and single-issue selection there is scope for 10%+ returns in bank capital space.
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.
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.
For all the attention on DB & its inability to generate decent ROE and the consequent equity underperformance this year, BNP is another large cap national champion bank that seems to have lost its way with its equity which is down almost 35% YTD. Looking through the reported Q3 figures, although not that obvious at first glance, equity investors seem to have focussed on some disturbing underlying trends.
To start with, the bank, like its peers, is struggling to generate decent revenue growth in its corporate and investment bank, especially in its FICC business. On top of that, the bank’s cost-to-income ratio is in the 70% area. Loan losses have come down but that is due to benign economic conditions in Europe. Yes, it reports an acceptable 9% to 10% ROE for now but earnings are now exposed to multiple headwinds.
Asset quality and risk management used to be strong points – but with a reasonably large stock of NPLs and presence in Italy, Turkey and other Emerging Markets as well as exposure in personal financial services, future credit-related costs may yet go up. And additional provisioning may yet be needed at a time of decreased revenues and a stagnant cost base.
Overall funding metrics seem fine with a loan-to-deposit ratio around 94% and a highly diversified funding base. But that cannot mask the bank’s reliance on wholesale funding (?) given its large balance sheet size. As a large and frequent issuer of debt securities, the bank has very good access to capital markets and is able to issue debt at satisfactory spread levels.
Capital is where I find that the bank has really not kept pace with global peers. Yes, CET1 ratio is a decent 11.7% and leverage ratio at 4% (and it was at 4.6% at end of 2017) but in the event of a large tail risk event, these ratios drop sharply. In the recently concluded EBA stress test, the bank’s CET1 ratio dropped to 8.64% in a hypothetical adverse scenario. The bank seems to have levered up its balance sheet in recent periods, especially in the investment bank.
Given the leverage situation and potential for headline risks stemming from a presence in Italy and Mediterranean countries, in my personal view, the bank’s AT1 securities and LT2 debt seem to trade tight. I think that this is a function of the bank’s French domicile and perceived strong risk management strengths.
Relative to equity, I wonder if AT1 holders have more confidence in the bank’s overall business strategy, past track record and current fundamentals despite the recent underlying trends and issues.
Only time will tell if this comfort factor of credit investors is justified.
It has clearly been a tough 2018 for many asset classes and, within that, AT1 has not been spared. The asset class saw its first annual loss with most of the widely followed benchmark indices down 3% to 5%. The asset class has been hit by risk aversion, tail risk events and investor apathy.
However, it seems to me that within the credit world, AT1 has been hit hard more due to liquidity and momentum factors. It is becoming increasingly technical in terms of who holds it and driven by headline risk. Everything else in terms of valuation doesn’t seem to matter. My observations on a handful of AT1s reflect that it trades in a very tight space and ignores any concept of fundamental valuation. More so on a relative valuation basis either to equity and/or LT2 or Non-Preferred Senior.
Looking at the performance of AT1s issued by the European banks over the last 6 months, it is clear that much of the larger “underperformance” in certain names has been driven by idiosyncratic stories/themes – ISPIM and UCGIM impacted by Italian politics, BBVA by Turkey exposure, Danske Bank due to on-going operational risk related issues and 2018 vintage issues due to re-pricing of call risk.
A full-blown CDO type balance sheet analysis on some of the banks in my universe indicate significant relative value opportunities in both directions (long equity vs short AT1 in some cases and long AT1 and short AT1 in others) but finding the right notional amounts to use and the underlying liquidity to actually put it to work is even more challenging. Fundamentals are important, for sure, but it seems that market technicals seem to matter equally.
In nearly all of the above names, the underperformance of equity to AT1 has been even more dramatic. Two observations – RV across issuers and/or capital structure has been the only effective way to manage the portfolio risks and the importance of deep-dive analysis in selecting single name exposure within the AT1 asset class.
Now comes the more difficult part – which single name exposures to own? Without going to specific names or issues at this stage, we could yet set up criteria to come up with a shortlist of names to own:
There are a number of large cap European banks that would meet most of the above criteria (if not all the criteria). I don’t want to give away those names as yet as I am sure you will find the exercise much more interesting.
Bye Bye – I believe we may yet see more price weakness as more investors figure out that this asset class is not for them. And if equities keep going lower, purely from a sentiment perspective, AT1s will get dragged lower. So maybe it is bye bye time for some tourist investors.
Buy – 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 8% (and above) on a yield to call basis and 7% to 8% on a yield to perpetuity basis should find some decent interest.
And when it gets there, I believe specialist bank capital funds, distressed debt shops 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. Finally, of course, have the ability to stomach the volatility as the markets price in one tail risk event to another. And don’t forget a specialist who understands the instrument, the issuer and the macro tail risks.