European Banking Crisis?

[ni-co]

[i repost this post about European banks from the "RBS: sell anything" thread to encourage further discussion on this topic in its own thread. I think it's important and being overlooked by most investors at the moment.]

 

Ni-co, I want to discuss. Something feels weird but Why a banking crisis?

 

Big picture, I think, is negative rates causing banks with thin Tier 1 capital layer to lose money, thereby triggering further regulatory capital requirements.

 

At the same time, from 2014 onwards, they almost all have begun financing their T1 capital requirements with CoCo bond issues. Those bonds are a fucking nightmare. They are accepted as T1 capital because when there is too little T1 capital ("trigger event") the bonds are either written off completely or automatically converted into common shares (this depends on the features of the single issue; most are converted).

 

The thing is, the ones that will be converted give bond holders a huge incentive to short the respective stock. This is a known problem called "the death spiral" (see reverse convertibles in the 1990s). But even the CoCos that are not converted are in danger of being written-off completely when it becomes more clear that the trigger event will actually happen.

 

This is all happening right now. Yields on CoCos just exploded. Consequently, for the next few years there is no chance in hell that banks will be able to sell additional CoCos to prop-up their Tier 1 capital. The only option remaining is therefore the issuance of new equity. Well, good luck with that!

 

It wouldn't be that bad were it not for the fact that capital markets are closing for those banks exactly at the moment when they need them the most (which was completely foreseeable at the point when the CoCos where "invented", s. this FT article from 2009 (!) where one guy therefore calls them "equity time bombs").

 

Add to this that market participants know that tangible book values of the European banks are phony. The balance sheets are loaded with bad assets that have never been written off during the "last" financial crisis. Nearly all the Europen banks need to be recapitalized and you can kick the can down the road only for so long. Then, have a look at DBs derivative book (mostly obscure OTC derivatives) which is the largest or second largest in the world with a nominal amount close to world GDP. They say it's mostly "netted-off" but this is only true as long as no counterparty's failing.

 

Take all this together and you may see why I don't want to own any of the European banks.

 

I'm worried that, in the event of a systemic crisis, European banks are too big to be rescued by their own countries since their books are several times GDP in a lot of cases. This is completely different from the US financial crisis and I think it's the reason why they haven't been recapitalized so far. It is very comparable to Japan from the 1990s onwards, though.

[JBTC]

ni-co, great post.

 

A couple of questions:

 

1) So is this potential crisis being triggered mostly by negative interest rates, or are there other factors that have caused the kick-the-can-down-the-road approach by the Europeans to no longer work?

 

2) Assuming ECB knows what you know, is there anything they can do to forestall the crisis? Is there a way for us to tell if ECB sees what you see? I suppose they do talk to the banks they regulate.

 

Thanks for your insights.

 

 

[PatientCheetah]

Thank you for the great insight! Precondition, trigger/catalyst, confirming market price based response, booya!

[HJ]

Thanks for starting this thread.  I didn't understand that aspect of the problem for European banks. 

 

A separate problem that is arguably more fundamental is alluded to in the Citi report, the interruption of "petrodollar" recycling. 

http://www.cnbc.com/2016/02/05/citi-world-economy-trapped-in-death-spiral.html

 

In round number, if you say US was consuming 9MM barrel per day of oil, producing 5MM barrel / day before shale revolution, when oil was at $100 per barrel, there is recycling of 100*4MM*365 = $146 billion of annual petrodollar that US sends to the oil producing nations and somehow gets recycled through the banking system into the world economy and capital markets.  If one reflects on how the most important USD money rate is determined in London (LIBOR), one quickly come to realize that the European banks served as the main conduit in recycling those flow.  Now that $146 billion a year has been interrupted at least for a while. 

 

The last time this has happened in the 80's, we had the Latin American crisis which gave us Brady bonds, followed by break up of Soviet Union, then the Tequila crisis, and ultimately the Asian crisis.  This was in the context of Europe brining on North Sea production, and didn't suffer much.  Probably hard to argue all of these global events are directly and exclusively caused by oil price movements, but there's at least some level of correlation.  And this time, the European banks are significantly more exposed to the emerging markets than the US counterparts.

 

A weak financial system faced with the impact of redirection of meaningful capital flow and inability to raise capital.  Not a recipe for smooth sailing for financial markets.

[ni-co]

This is also an interesting aspect I haven't thought about. To be clear: I'm not sure that this negative rates, CoCos are the cause – it's only my working hypothesis.

[orthopa]

This is also an interesting aspect I haven't thought about. To be clear: I'm not sure that this negative rates, CoCos are the cause – it's only my working hypothesis.

 

Dumb question, what exactly do you mean by CoCo's?

[ni-co]

This is also an interesting aspect I haven't thought about. To be clear: I'm not sure that this negative rates, CoCos are the cause – it's only my working hypothesis.

 

Dumb question, what exactly do you mean by CoCo's?

 

Contingent Convertible Bonds. Here's a primer on them:

http://www.bis.org/publ/qtrpdf/r_qt1309f.pdf

[ni-co]

Gundlach is "frightened".

 

http://www.bloomberg.com/news/articles/2016-02-05/gundlach-says-frightening-seeing-financial-stocks-below-crisis

 

Does anybody have some or insight what he thought were the causes? (If he has any idea at all)

[writser]

CoCo's receive way too much attention. Typical zerohedge meltdown-is-coming material. Just for reference, the worldwide outstanding market in CoCo's is probably way smaller than the market cap of Wells Fargo. Everybody knows that these things can convert in equity at inopportune moments and even if all of them convert into equity: nobody gives a **** - at that point there are bigger problems to solve.

[John Hjorth]

... Everybody knows that these things can convert in equity at inopportune moments and even if all of them convert into equity: nobody gives a **** ....

 

This board is about making money by value investing, and cooperation by discussion to get better at it [making money by value investing]. Personally and right now, I consider it a better trade off to move on without reading your personal [at least to me: biased] comments like the above.

 

It's about not knowing all positions of fellow active and contributing board members, and respect. Recent posts in ZINCK-topic comes to mind about concluding, with mutual respect - We are all humans here on board.

 

Likely I will miss out on some good comments and considerations from you. I will live with that, to avoid what I don't like in your posts recently.

 

Recently I read a post on this board from a member on this board "taking pleasure" in things going wrong for Ackman. I don't understand that line of posting on this board, nor do I have the will to try [ref. what I wrote above what this board is about].

 

Specifically I asked ni-co to start this topic, because ni-co is short SAN [from what I have read so far from ni-co - reasons, that I can't turn down right now [likely not at all], and that makes an impression], and I'm long SAN [a lot].

 

This is what this board is about : Getting better by discussion and related reasoning. Actually, I hold ni-co's starting post very high, he might be helping me as a short, while I'm long right now.

 

Disclosure : 5 largest positions right now, calculated based on Friday close : Cash : 36,4%, BRK : 12,1%, SAN : 7.9%, Novo Nordisk A/S [NOVO. CPH] [uS ADR : NVO] :  6.0%, MKL : 5.0%.

 

Time to get to work on this. I will wait for the disclosure of the full financial statements for SAN 2015 at the end of February 2016, and I will tear it apart to atoms [exactly a bean counter job], and I will report back here on board.

 

 

 

[ni-co]

CoCo's receive way too much attention. Typical zerohedge meltdown-is-coming material. Just for reference, the worldwide outstanding market in CoCo's is probably way smaller than the market cap of Wells Fargo. Everybody knows that these things can convert in equity at inopportune moments and even if all of them convert into equity: nobody gives a **** - at that point there are bigger problems to solve.

 

Oh really? I don't think they get a lot of attention. My impression is that most people don't have a clue why DB's equity is on a 20 year low and spreads are blowing out (which I wouldn't regard as "not giving a ****"). What's your theory on this? If at all, people are talking about how bond holders might lose the principal of their CoCos but I haven't seen a sensible discussion about the interplay between those bonds and the common share capital – neither here nor in the WSJ, the FT, the Economist or Zerohedge for that matter. But this is my whole point (I couldn't care less about some bond holders losing their money).

 

CoCo nominal vs. Wells Fargo market cap doesn't matter in my opinion. I think what matters is CoCo nominal vs amount of equity capital of the issuing bank and you may know that this is substantial for most of the European banks. Apart from that, size isn't really the biggest problem but that capital markets are closed for now for those banks and they are really in need of equity capital.

[Rasputin]

[i repost this post about European banks from the "RBS: sell anything" thread to encourage further discussion on this topic in its own thread. I think it's important and being overlooked by most investors at the moment.]

 

Ni-co, I want to discuss. Something feels weird but Why a banking crisis?

 

Big picture, I think, is negative rates causing banks with thin Tier 1 capital layer to lose money, thereby triggering further regulatory capital requirements.

 

At the same time, from 2014 onwards, they almost all have begun financing their T1 capital requirements with CoCo bond issues. Those bonds are a fucking nightmare. They are accepted as T1 capital because when there is too little T1 capital ("trigger event") the bonds are either written off completely or automatically converted into common shares (this depends on the features of the single issue; most are converted).

 

The thing is, the ones that will be converted give bond holders a huge incentive to short the respective stock. This is a known problem called "the death spiral" (see reverse convertibles in the 1990s). But even the CoCos that are not converted are in danger of being written-off completely when it becomes more clear that the trigger event will actually happen.

 

This is all happening right now. Yields on CoCos just exploded. Consequently, for the next few years there is no chance in hell that banks will be able to sell additional CoCos to prop-up their Tier 1 capital. The only option remaining is therefore the issuance of new equity. Well, good luck with that!

 

It wouldn't be that bad were it not for the fact that capital markets are closing for those banks exactly at the moment when they need them the most (which was completely foreseeable at the point when the CoCos where "invented", s. this FT article from 2009 (!) where one guy therefore calls them "equity time bombs").

 

Add to this that market participants know that tangible book values of the European banks are phony. The balance sheets are loaded with bad assets that have never been written off during the "last" financial crisis. Nearly all the Europen banks need to be recapitalized and you can kick the can down the road only for so long. Then, have a look at DBs derivative book (mostly obscure OTC derivatives) which is the largest or second largest in the world with a nominal amount close to world GDP. They say it's mostly "netted-off" but this is only true as long as no counterparty's failing.

 

Take all this together and you may see why I don't want to own any of the European banks.

 

I'm worried that, in the event of a systemic crisis, European banks are too big to be rescued by their own countries since their books are several times GDP in a lot of cases. This is completely different from the US financial crisis and I think it's the reason why they haven't been recapitalized so far. It is very comparable to Japan from the 1990s onwards, though.

 

Hi ni-co,

 

why do negative rates cause banks with thin tier 1 capital to lose money?  do you expect this to continue or can those banks adjust their cost base? 

 

Since the world has our play book on how to handle systemic banking crisis, they can just follow it, even prevent it from happening (they can prevent a lehman brother failure).  Their sovereign debts are in such high demand that they can easily recap their banks, wipe out shareholders, wipe out junior bond holders, temporarily guarantee everything, new bond issuance, etc.  They can also temporarily ban short selling on financial stocks (we did this). 

[Gamecock-YT]

Then, have a look at DBs derivative book (mostly obscure OTC derivatives) which is the largest or second largest in the world with a nominal amount close to world GDP. They say it's mostly "netted-off" but this is only true as long as no counterparty's failing.

 

This is the more interesting part for me. Granted commodities, have spiked the last few days, but you get an unwind via a bankruptcy of Glencore/Nobel Group the exposure is going to bring someone down with them.

[ni-co]

why do negative rates cause banks with thin tier 1 capital to lose money?  do you expect this to continue or can those banks adjust their cost base? 

 

Because experience shows that they can pass on negative rates to depositors only in a very limited way. Their NIM is waning. Take a look at Japanese zombie banks.

 

 

Since the world has our play book on how to handle systemic banking crisis, they can just follow it, even prevent it from happening (they can prevent a lehman brother failure).  Their sovereign debts are in such high demand that they can easily recap their banks, wipe out shareholders, wipe out junior bond holders, temporarily guarantee everything, new bond issuance, etc.  They can also temporarily ban short selling on financial stocks (we did this).

 

Exactly, wiping out shareholders is what I'm expecting. That's also why I own LEAP puts (I don't like going short stocks outright). Keep in mind that most of banks' assets are European sovereign debt – they can't follow the US playbook. I think they may follow the Japnese one more or less or they might nationalize the large banks completely.

 

Then, have a look at DBs derivative book (mostly obscure OTC derivatives) which is the largest or second largest in the world with a nominal amount close to world GDP. They say it's mostly "netted-off" but this is only true as long as no counterparty's failing.

 

This is the more interesting part for me. Granted commodities, have spiked the last few days, but you get an unwind via a bankruptcy of Glencore/Nobel Group the exposure is going to bring someone down with them.

 

I'm not so sure that bankruptcies in the commodity industry alone would cause a systemic banking failure but, as it is with petro-dollars, it certainly doesn't help. It's an additional headwind in my opinion.

[original mungerville]

CoCo's receive way too much attention. Typical zerohedge meltdown-is-coming material. Just for reference, the worldwide outstanding market in CoCo's is probably way smaller than the market cap of Wells Fargo. Everybody knows that these things can convert in equity at inopportune moments and even if all of them convert into equity: nobody gives a **** - at that point there are bigger problems to solve.

 

Oh really? I don't think they get a lot of attention. My impression is that most people don't have a clue why DB's equity is on a 20 year low and spreads are blowing out (which I wouldn't regard as "not giving a ****"). What's your theory on this? If at all, people are talking about how bond holders might lose the principal of their CoCos but I haven't seen a sensible discussion about the interplay between those bonds and the common share capital – neither here nor in the WSJ, the FT, the Economist or Zerohedge for that matter. But this is my whole point (I couldn't care less about some bond holders losing their money).

 

CoCo nominal vs. Wells Fargo market cap doesn't matter in my opinion. I think what matters is CoCo nominal vs amount of equity capital of the issuing bank and you may know that this is substantial for most of the European banks. Apart from that, size isn't really the biggest problem but that capital markets are closed for now for those banks and they are really in need of equity capital.

 

I don't think they are getting that much attention either. Raoul Pal has been raising awareness re European banking problems although he can not say what exactly the issue is - he thinks its maybe a bunch of things. We could list initial issues being

 

1. recycling of petrodollars turning into selling by sovereign wealth funds to fund their government deficits,

2. structural $US short position of Emerging markets and other factors continuing to drive to the dollar up and Fed currently diverging from Japanese and European monetary policies,

3. large sovereign debt levels in Europe,

4. negative interest rates negatively impacting margins,

5. big opaque derivatives book,

6. emerging market default potential and large European exposures to those markets (eg, Spanish banks lending to South American countries),

7. commodities collapse and f/x volatility impacting derivatives positions (ie some sort of net exposure must have swelled somewhere over the past couple quarters),

8. trading bank regulations/capital requirements impacting trading margins,

9. cultural issues at bank not really changed where traders continue to seek profit for their own short-term gain rather than for long-term gain of the bank,

10. importantly market may perceive thin equity capital on a mark-to-market basis (ie book overstates equity capital),

11. Add cocos' equity dilution potential to this mix,

12. Potential for a Chinese banking crisis as well (see Soros and Kyle Bass),

13. Related is a sharp devaluation in Yuan (Bass, Soros, Druckenmiller, Mark Hart, etc).

 

Anything else we can add to this list?

[SharperDingaan]

CoCo Bonds are not Tier 1 Capital. At best they are Alternative Tier 1 and haircut accordingly; most are low trigger and qualify as Tier 2. www.bis.org/publ/qtrpdf/r_qt1309f.pdf CoCo’s activate at the regulators discretion – not the contractual triggers; and the regulators do not have to explain.

 

Point of non-viability (PONV) triggers allow regulators to trump any lack of timeliness or unreliability of book-value triggers. However, unless the conditions under which regulators will exercise their power to activate the loss absorption mechanism are made clear, such power could create uncertainty about the timing of the activation.  (P. 45)

 

Negative interest rates reduce the size of bank deposits, & thereby the amount the bank can lend. Reduce deposits by 10M, & at 20x leverage – you will be forced to either make 200M less in loans, call in 200M of existing loans, or do some combination of both. Nobody pays a banker to keep their money for them (negative interest rate). Companies deliberately put their accounts into overdrafts & invest their cash in liquid short term paper & government treasuries; selling as needed to pay bills as they come due. Individuals do something very similar.

 

Call in enough loans at a loss & the bank goes under; the process accelerates as soon as current losses exceed current net income – further reducing equity. Do the Coco bond conversion before the process goes viral, & maybe – the bank survives? There is a reason so many prominent banks are trading below the crises lows, & nobody is talking about it.

 

We also hold a long position in SAN and have done so for many years. We hold significantly less than we did, & bought at higher prices with a strong $C; net of $C devaluation, we are more or less breakeven. For us it is primarily a diversifying investment into the Spanish speaking world, worth more to us as a largely non correlated - non NA, and non- Euro, asset.

 

SD

 

[SharperDingaan]

“emerging market default potential and large European exposures to those markets (eg, Spanish banks lending to South American countries)”

 

South American countries routinely default; it is nothing unusual for a Spanish bank - & they have long learned how to deal with it. The same cannot be said for Euro-banks, where there is materially less confidence.

 

SD 

 

[ni-co]

CoCo Bonds are not Tier 1 Capital. At best they are Alternative Tier 1 and haircut accordingly; most are low trigger and qualify as Tier 2. www.bis.org/publ/qtrpdf/r_qt1309f.pdf CoCo’s activate at the regulators discretion – not the contractual triggers; and the regulators do not have to explain.

 

Keep in mind that the BIS report is from 2013. This is mostly a very recent (2014 and 2015) phenomenon. Take a look at this:

• For DB: here or here
  
• For CS: here
  
• For SAN: here or here
   
  

 

All the recent large issuances have been done to prop-up T1 capital.

[ni-co]

We could list initial issues being

 

1. recycling of petrodollars turning into selling by sovereign wealth funds to fund their government deficits,

2. structural $US short position of Emerging markets and other factors continuing to drive to the dollar up and Fed currently diverging from Japanese and European monetary policies,

3. large sovereign debt levels in Europe,

4. negative interest rates negatively impacting margins,

5. big opaque derivatives book,

6. emerging market default potential and large European exposures to those markets (eg, Spanish banks lending to South American countries),

7. commodities collapse and f/x volatility impacting derivatives positions (ie some sort of net exposure must have swelled somewhere over the past couple quarters),

8. trading bank regulations/capital requirements impacting trading margins,

9. cultural issues at bank not really changed where traders continue to seek profit for their own short-term gain rather than for long-term gain of the bank,

10. importantly market may perceive thin equity capital on a mark-to-market basis (ie book overstates equity capital),

11. Add cocos' equity dilution potential to this mix,

12. Potential for a Chinese banking crisis as well (see Soros and Kyle Bass),

13. Related is a sharp devaluation in Yuan (Bass, Soros, Druckenmiller, Mark Hart, etc).

 

Anything else we can add to this list?

 

Agree completely with your list (though I wouldn't rate the issues necessarily in that order – but I assume that you didn't either). There also is our evergreen: The potential disintegration of the Eurozone and/or the euro.

[SharperDingaan]

In most cases the bank will have burned through the bulk of its Tier 3 & Tier 2 capital before the AT1 CoCo capital is activated. If the underlying cause is systemic, there will also be multiple DSIBs in similar positions; and the central bank will have imposed capital controls, &/or a temporary closure. A much more harsh & disciplined version of Greece or Cyprus. The decision has already been made to save the DSIB, & the CoCo activation is part of it.

 

The CoCo is attractive as it is anti-dilutive until activation, & comes with an implicit central bank guarantee; your enhanced say (higher % of total ownership) via the dilutive conversion is not going to be challenged. Hence you are willing to accept a lower cash yield. When, & how much CoCo, the bank issues is controlled via the size of the regulatory capital haircut - & market conditions. Issue whenever the after-tax RAROC becomes the cheapest option.

 

A DSIB issuing a CoCo is not a bad thing; any other kind of bank - & it’s a flashing red light.

 

SD

 

 

[ni-co]

I didn't regard the sheer issuance of CoCos as a red light but I think might be the drop in the bucket for the banking crisis. Banks thought that they'd get around diluting their shareholders with CoCos – well, they don't.

 

Deutsche Bank's Woes Threaten CoCo Coupons, CreditSights Says

Given that there are reserves available to make up any shortfall that might prevent payouts, “we would be surprised” if Deutsche Bank didn’t pay coupons on its CoCos this year, which are determined by its 2015 performance, he said.

http://www.bloomberg.com/news/articles/2016-02-08/deutsche-bank-s-woes-threaten-coco-coupons-creditsights-says

 

I wouldn't be surprised if they stopped paying them in 2016.

[SharperDingaan]

DB is operating at the pleasure of the Bundesbank, & the Bundesbank will not tolerate a default. DB will do whatever it is told to.

It will be a very simple matter to make the CoCo payment out of funds allocated to the bonus pool - and it will not be a discussion.

 

We also expect that once the precedent is set (anywhere in euro-bank land), there will be a strong regulatory push to issue more of these. Primarily as an aggressive & proactive way by which to claw back bonus as/when the bank doesn't meet its targets.

 

Agency can be a bitch!

 

SD

[John Hjorth]

DB is operating at the pleasure of the Bundesbank, & the Bundesbank will not tolerate a default. DB will do whatever it is told to.

It will be a very simple matter to make the CoCo payment out of funds allocated to the bonus pool - and it will not be a discussion.

 

...

 

Agency can be a bitch!

 

SD

 

Ohh, well! :

 

http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/12146421/Credit-Suisse-boss-asks-board-to-cut-his-bonus-after-big-loss.html

[CorpRaider]

http://www.bloomberg.com/news/articles/2016-02-08/how-europe-s-banks-got-hit-by-a-perfect-storm-in-five-charts

 

und

 

http://www.bloomberg.com/news/articles/2016-02-08/deutsche-bank-says-it-has-at1-payment-capacity-of-1-1-billion

[ni-co]

http://www.bloomberg.com/news/articles/2016-02-08/how-europe-s-banks-got-hit-by-a-perfect-storm-in-five-charts

 

und

 

http://www.bloomberg.com/news/articles/2016-02-08/deutsche-bank-says-it-has-at1-payment-capacity-of-1-1-billion

 

I don't think they said anything market participants didn't know. I'd be very surprised if this calmed people. Equity/debt plunging at banks is a reflexive process. When people lose trust in the banks' equities and are starting to fear trouble, banks will get into trouble – even if they weren't before. The credit/share price is changing the underlying fundamentals. The dynamics of this are hardly comparable to most other industries.