It’s worse than that...he’s dead Jim

Mint – Blain’s Morning Porridge  November 26 2012

I suppose this is what you might call proper rain. Not a fine mist of gently invigorating dampish sky, but great big lumpy clods of solid soggy miserableness digging divots into my skull. Trains cancelled, delayed, wetter and smellier than a wet dog's wet bits, and loads of grumpy commuters. Fantastic.. welcome to another exciting week in the Euromarkets.

Let’s get the downright bleeding obvious stuff out way first. Nothing yet on solving the US debt cliff. Catalunya on the path to potential independence – although a long way to go.  Greek bailout discussions reach chapter 783, but we’ll likely to see some form of buyback/new money solution today. And now the Argentina Holdout US court ruling conumdrum.

The European stuff is all predictable and pretty much factored into markets – so some upside potential post Greece decision. The Argentine default farago is more complex and contradictory - at the moment it favours sovereign debt under foreign law without a collective action clause, but that premise might not hold up if Argentina can prove a Star-Trek defence... "the good of the many over the rights of the few". Watch that space if you’re holding Euro Sov risk in anything but Euros.

Banks

In the news this morning is yet more pressure on banks. The FT carries three front page tales of banking woe: Barclays investors calling for the investment bank to be closed, rumours of yet more regulation following the UBS fraud trial, and Euro Kommissar Barnier demanding "political will" to institute European banking union. Lots of noise about the importance of separating bad investment bankers from good commercial bankers.

And while this all goes on, and the Regulatory Banking Complex holds sway over ever decision banks make - who would want to invest in banks?

These last days of the investment banking era are fascinating. We're seeing a mass extinction event as the meteor of the banking crisis slays the investment banking model. Panic, shock, horror.... where will market liquidity come from if not the banks? Where will entrepenuers find cash and investment ideas? How will new issue markets develop? Don’t panic.. It’s evolutionary:  the investment banking dinosaurs are replaced by leaner warm blooded financing entities – agency brokers, corporate boutiques, and such. On the basis nothing is ever new.. almost feels a bit pre-big bang! (1986 for the kids reading this….)

But, while the change occurs, bank paper looks distinctly uncertain and therefore painful. I’m a fixed-income geek, but I’m wondering if I spend more time on bank stocks? My idyll was triggered by someone telling me last the breakup of Credit Suisse might be a “valuation catalyst”…

What?

Is a valuation catalyst? (Or are our Swiss friends attempting to ring fence as much of the bank from American legalised rape and pillage?)

And after Kommissar Bernier’s warning, I’m also trying to understand what the big bank risks are that could result in another series of collapses? Since 2007 – when the regulator really got their claws into it - haven’t the banks been made much safer by over-regulation? Er no. Have they not significantly de-levered yet? Er no.. in 2008 banks held $262 bln of bonds yielding 4.4%. Today they hold $500 bln at 1.9%. What’s to like about that?

Too many hold far too much really really toxic stuff like sovereign debt on the basis a Euro breakup won’t ever never happen, and many still have loads of “distressed” stuff on their banking books held at mythical 100% marks on the basis if they sold anything they would have to mark whole book to real prices!

In terms of bank paper, I’ve said a number of times bank senior and secured (ie covered bonds) will be safe even for the worst names – at least medium term because of the “Too Embarrassing to Fail” credo. Sub and hybrid is a selective call based on writedowns, calls and dividend risks. BB is the new AA – price accordingly! This summer’s rally in bank credit - Itraxx Sub tightening from 600 to 300 over the past year – is pretty much played out to the new rating reality.

As for CoCos – although I know some serious hedge funds think 7% plus yields represent value, I’m thinking too many retail buyers got involved and the risks of any bank breaching capital levels at 7% resulting in a CoCo writedown are just too deep. If it happens expect retail investors to call foul if bonds get written off before equity!

In stocks, most banks still pay close to the square root of zero in terms of dividends. Pre 2007 banks were 20% plus of global indices… now the just over 10%! Find me banks trading much over book value in Europe?

Bottom line is: Banks are less transparent than ever due to accounting complexity and reporting obstification, being targets for avaricious leglislators, dying under regulatory overkill and returns are few and far. Basel 3 and leverage ratios? For good reasons bank stocks still look cheap. Nothing stays the same for long. Selectively growth prospects make some banks very interesting – especially in the US where it’s already happening.

On the other hand.. Get past the noise surrounding banks.

Don’t be put off by European banking union –which seems to slinking into an uncertain future despite M Barnier warning it might “destabilise” markets. I don’t understand why it’s so important Europe mutualises banking risk through banking union. Global banking is umbilically connected but national issues remain national issues: the Irish banking bubble, Spain property or German institutional banks inclination to buy anything with a whiff of toxicity were national problems! Systemic risk can be addressed as well by national regulators as ones based in Frankfurt! Regulators will no doubt disagree with me.

But real factors - like the imminent defenestration of Credit Suisse et al for CDO mis-selling or Barclays for the heinous crime of being British and Barclays (guilty as charged!) are analogous to windfall taxes on the banking sector. I’m surprised more banks haven’t been similarly skimmed. Or UK non-execs saying banks surrendered too easily to retail complaints like PPI in UK which has killed banking returns for years.

The core of what makes a good bank is CAMEL+L: Capital, Assets, Management, Earning, Liquidity plus Leverage. The definitions are all changing. Capital uncertainty means only equity counts. The fear of further pain has escalated the capital quantum good banks are expected to hold. Asset quality is critical, but subject to games of accountingseek! Management is a big concern – best and brightest no longer want to work at banks, top bosses have been ruthlessly purged by the regulatory Nonklematura, while the financial engineers and quants that drove decades of banking innovation (mostly for the better) have been sunk under legions of HR, compliance, oversight, reporting… whatever. An army with 10 times as many service troops as front line infantry is unwieldy and inefficient. 

Liquidity is what killed banks during the crisis – and could kill them again if/when Europe implodes. Access to liquidity markets has greatly improved for all but the very worst names – but the market remains horribly vulnerable. Leverage worries me lots. It’s now the critical measure – especially in terms of how banks de-lever and achieve attractive returns on assets without risking themselves to the ceiling! And now that regulators are setting leverage ratios its clearly going to be arbitraged. If leverage results in losses eating-up all a bank’s capital, especially if banks have been forced to buy supposedly “risk-free” Sovereign Debt! (Don’t laugh…. It’s happening) then spot last man laughing.

There is good news in banking– look at how US banks have successfully recapitalised themselves (albeit through some hefty issuance of prefs). Give European banks a similar opening and they could also recapitalise!

Back to my original thesis – bank stocks? I’d be intrigued for any client views on the topic… I’m thinking some banks look undervalued. At the same time the regulatory future worries me – leverage ratios and the need to delever will cause banks to optimise/arbitrage asset mix, and experience demonstrates that way leads to madness. Although bank credit has performed very strongly, I’m beginning to suspect that could prove very wobbly if/when crisis strikes… got to wonder if it’s time to take credit profits?

Views?

Massively out of time!

BB

 

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