Chief Investment Strategist
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Fear of Past Risks, Less Recognition of the Present’s.
Like a juggler, markets have to keep many balls in the air at the same time. Focus globally has shifted to US election issues from Brexit. For the European continent, meanwhile, there are many complex issues to cope with including the fresh precedent of the UK’s pending withdrawal from the European Union (EU), the ongoing refugee crisis, and unresolved banking woes.
Since the June 23 Brexit vote, shares of Germany’s largest bank, Deutsche Bank (DB), have slipped 26%. They’ve fallen 49% in the year-to-date. A broad measure of Eurozone banks including DB has fallen less, 11% and 28% over the same two time periods. Across the continent, negative interest rates and relatively flat yield curves are a challenge to bank profitability amid gradually improving credit conditions.
According to Bloomberg, DB shares now trade at a price-to-book ratio of 0.26. This is comparable to Italy’s largest multi-national bank, UniCredit, but above the level of another large domestic Italian bank which is seeking an outside recapitalization.
The German and Italian governments have reportedly disagreed about the handling of troubled banks going forward, thus re-elevating the fiscal authority’s role in the financial system to the list of domestic political issues. It adds yet another argument to the debate about the political cohesion of the Eurozone. With this as a backdrop, according to press reports, a proposed U.S. fine linked to the 2000s mortgage crisis could result in Germany’s DB falling below European regulators’ minimum capitalization standards.
Our point here is not to speculate on whether DB securities are a bargain given a potential recovery without new capital or some anguished, state-driven rescue that wipes out current shareholders. Given the range of legal and regulatory issues discussed in the press, we would have to consider any answer speculative with regards to securities at the lower end of the capital structure (though significantly more secure higher up). What we dispute is that the financial system as a whole is vulnerable to a repeat of the 2008-2009 solvency crisis, as we’ve heard from some quarters in recent days. The DB story has been held up by some as comparable to the "Lehman event" that would catalyze a replay of the crisis years.
Several relevant factors have changed substantially since Lehman:
1) A massive increase in equity capitalization of most DM banks and significant reductions in bank leverage have occurred. While there are some weak banks, unlike in 2008, most banks are strong. Achieving growth is the question for most banks rather than solvency,
2) Private and public markets are starved for yield opportunities and are not averse to taking risk if given sufficient reward through price concessions. Equity capital can be costly, but liquidity for those with a strong balance sheet and a willingness to take risk has likely never been more abundant. While there are caveats, others can stand up and take risk in a way that was not possible in 2008.
3) Central banks have shown willingness to take direct credit risk with or without the help of fiscal authorities. They are highly likely to provide liquidity, directly or indirectly, to those taking on risks if a bank needs to be wound down.
Most Banks Solvent and Strong, But Lacking in Growth
As figures 1 and 2 show, compared to the pre-crisis period, there has been a dramatic and most unusual rise in equity capital relative to liabilities across the U.S. and European banking systems. Whatever their inadequacies, U.S. and European bank stress tests show that the rise in loss-absorbing equity capital is widespread, applied institution-by-institution. Some banks lag peers somewhat, others lead.
This should come as no surprise at all given post-crisis regulation, most importantly Basel-3 capital standards. More controversially, how well authorities could resolve a failing institution of systemic size is un-tested in the post crisis period. Merging "bad banks" with "good" is a more limited option given a focus on the perceived systemic risks of large institutions. As noted above, the public’s involvement in any bailout is a powerful political issue that suggests creditors and shareholders of a troubled institution would be called on first to take losses before taxpayers. This can cause a higher level of worry for the whole banking sector than is warranted by the troubles of a few firms. Yet healthy banks can win the customer business of a troubled institution when the credit challenges are not as severe as the widespread mispricing of mortgage risk during the 2000s. Private capital pools from outside the banking sector may be well positioned to take advantage of troubled assets if regulators encourage or require action.
Unlike the pre-crisis period, there has been a great deal of planning for negative events in the financial sector. Some important gaps in the regulation of non-bank financial institutions have been closed. While some risks have migrated from banks, the level of worry over bank capital seems dramatically higher to us now than in the pre-crisis era, before the large risk-mitigating steps shown in figures 1 and 2 were taken.
Analyzing business cycles requires identification of the common characteristics of recessions and recoveries. Certain industries are routinely impacted more than others. Leveraged industries like banking are never unscathed. We expect no different in any coming downturn. We have also warned routinely that a downturn is possible even if interest rates are never purposely driven higher (please see the Credit Market Strains Isolated, But Building section of our August Quadrant for examples).
At the same time, the 2008-2009 crisis was unique in the Post-World War II era. It was significantly driven by a dramatic rise in mortgage credit with safety assumptions that in retrospect were proven absurd. Even looking more widely to the present or and recent areas of lending strength such as auto loans and commercial real estate, no repeat of the prior lending boom has been seen in the US or Europe (see figure 3). Those who, in effect, say nothing has changed should show us data as evidence.
As with other downturns of our experience, the public uses the previous episode as a template for any future crisis. When the last downturn was the worst in 80 years, this is heavy psychological "baggage." However, it can mean that attention is shifted to the incorrect sources of risk. Emerging vulnerabilities and even opportunities can be missed. While there will of course be new downturns and recoveries with many things in common, the next downturn will not be a replay of 2008-2009 in our view.
Note: For the Euro Area this includes consolidated loans to all nonfinancial corporate business, and for the US this includes C&I loans, Real Estate Loans and Consumer Loans. Source: Haver Analytics as of October 3, 2016.