18th December 2018

Three (erstwhile) Kings in credit land | Bank Capital

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 – leverage is always a problem

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 – Old issues not going away

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.


DB – can it really transform in current form

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.


Conclusion

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.

GJ Prasad

A senior European bank research specialist with significant breadth/in-depth sector knowledge, GJ has researched bank capital instruments extensively - having covered the asset class for more than 15 years as an analyst and 7 years as a risk taker in buy-side roles. His specialisation includes carrying out detailed financial modelling work on the European banks focusing on asset quality, earnings and capital adequacy metrics. His deep-dive work focuses on single name selection and extensive risk analysis on capital securities, especially on structural features, issuer credit profile and equity/AT1 valuation.