Blain’s Morning Porridge – May 12th 2020
“She said, “there is no reason”, and the truth is plan to see..”
So much to think about this morning in terms of debt, equity and politics. Where do we go from here? A number of chartists are warning about big tumbles to come. Sell and May and run away?
We’ve got confusion upon confusion in the Anglo Saxon world about how to reopen the UK and US – but the read is: non one is being forced back to work so be pragmatic, be self-reliant and take responsibility for your safety. Unless economies start to reopen safely – the economic damage will expand quadratically.
Will Elon Musk get arrested for breaking the law and reopening a California factory he’d been told not to? His disciples will cheer his painless and delusional patriotic
self-promotion martyrdom and buy the stock, pushing up his obscene bonus. The smart money will continue wonder about the quality of corporate governance at Tesla, and for how much longer to take it seriously.
Meanwhile.. Banks? Better than we think?
Anything Deutsche Bank does gets my attention. It issued a new bond deal yesterday: Euro 1.25 bln of Tier 2 subordinated debt straight into a market screaming for European bank capital risk. Surely that is madness? Knowing the perilous state of most European banks (essentially still broken and unresolved since the last banking crisis), why would you lend capital to a German Bank ahead of the likely global recession triggered by C-19?
RBS did the same thing last week in sterling.
Investors are taking an informed bet. Its likely Europe’s banking sector is going to come out of the coronavirus crisis battered, but essentially intact. It’s a point I made a few weeks ago: “Buy European CoCos and bank paper when prices collapse – they will be a screaming buy!” As the virus kicked off, sure enough prices fell – just not as much as I expected.
(A new DB Additional Tier 1 capital deal – more deeply subordinated than yesterday’s deal – did lose half its value at one point in March. But Rule 1 is – don’t buy DB. An investor quoted in an FT article described the bank as: “not everyone’s cup of tea”. That deal has partially recovered – and should get a further lift from this deal because it makes triggering the negative aspects of the AT1 deal less likely.)
Governments were too quick for me. As the wobbles began and stocks tumbled, our leaders were swift to nationalise wages through furlough schemes alongside unlimited SME and corporate lending. Central bank QE Infinity reversed the slides and markets rallied. These actions reassured the market the authorities will do the same thing for banks in the event of a new European banking crisis.
When it comes to The United States of Yoorp, there is no domestic interest governments will fight for as strongly as their own banks. National governments will insist on saving national champions – there is no such thing as “Too Big to Fail” when it comes to domestic pride.
But there is even more going on under the surface….
We know the C-19 crisis is going to impact some lending sectors particularly hard – including SMEs, Consumer Finance, Tourism, Oil, Shipping, Aviation, Aerospace, Retail and Hospitality. The one thing we definitionally know about the C-19 contagion is there will be massive credit losses from these sectors. As the crisis is likely to crater the 12% of Southern Europe’s economies reliant on tourism, in addition to all the shorter-term damage – it’s clear these losses will be… significant. Spectacularly significant.
The rating agencies have got terribly excited, and sharpened their red downgrade pencils. Ignore them.
High capital ratios exist to project banks by absorbing losses that could otherwise make them insolvent. As losses mount, the capital buffers will deteriorate. Rating agencies have very complex models to predict just how resilient the banks are, they talk in terms of capitalisation as a key ratings driver. They’ve been warning about how banks will be increasingly vulnerable to rising losses (“skewed to the downside” in rating agency speak) until a vaccine is found.
However, this crisis is not about banking stupidity – the last one was caused by banking overleverage. This time, you can’t blame banks for the virus. And, much of the risk which once resided in banks now resides in the assets management, pensions and insurance sectors.
High capital ratios exist to absorb losses. Some deft re-jigging of capital rules that govern how much capital banks must reserve against losses also helps. The European Commission is allowing looser capital rules in terms of how banks prepare for coming losses. They say easing capital rules will enable banks to “support credit expansion” by loosening lending constraints – but I’ll be surprised if that really happens. But, looser capital rules will improve the solvency position of banks by making the buffer available to absorb the losses wider.
A cynic might suggest recent easing of European bank capital rules to enable them to weather the coming credit losses storm means these banks are ultimately less resilient. A pragmatist might consider eased regulations mean the banks aren’t so likely to get bogged down in declining credit metrics when the storm hits.
Since the banks are generally well capitalised, and we know there will be losses.. the pragmatic approach is best. Let capital be capital – let it absorb the losses, and after the crisis passes, let’s build up prudent capital ratios again.
To explain what the ECB did – and you might want to skip this bit lest it make your head hurt. (I was head of Financial Institutions at a bank back in the 2000s, and even though capital rules were simpler then.. my head hurt a lot..)
Bank capital is a complex topic. Understand the quantum and quality of what capitalises a bank, and you understand its ability to withstand a market shock. Over the past 12 years since the 2008 banking crisis we’ve seen regulators and risk committees unleash rules, regulations and a cataclysm of acronyms on an increasingly befuddled market. Critical ones include:
CET1 – Core Equity Tier 1
ECL – Expected Credit Loss
AT1 – Additional Tier 1 Capital
LIC – Loss Impairment Charges
CoCos – Contingent Capital – or the “illegitimate children of insane regulators and desperate banks” as I once famously described them.
MDA – Maximum Distributable Amount – the difference between Total Capital and Regulatory Capital (don’t ask…)
Accounting for ECLs has been the subject of much angst. The IASB (the accountants) introduced IFRS ECL impairment methodology to reflect rising losses based on economic models and expectations. However, this can make ECL overly volatile, as a signal of rising economic pain one month might be reversed the next. The EU did a simple Jedi mind trick – these are not the losses you are looking for.
I do hope that made it all clear.
If not: In the face of everything else coming our way, don’t waste too much time worrying about European banks. The EU will fudge them through the coming storm.. Probably…
5 Things to Read Today
FT – How Can Europe solve the crisis created by Germany’s Highest Court?
FT – Investors struggle to hear signals from bond markets
WSJ – Bill Gates Has Regrets
BBerg – Boeing CEO Says a US Airline will Most Likely Fold This Year
Torygraph – Lifting the lockdown won’t save the doomed housing market
Out of time and back to the day job…