18 February 2016
Are worries about banks overstated?
CoCos for conversion?
by Frank O’Nomics
CoCos (contingent capital convertible instruments) should not be confused with Ko-Ko, the Lord High Executioner in the Mikado – or maybe they should given that they could result in some bank executives getting the chop. A great many investors will not have heard of CoCos until last week, when they were cited as one of a number of reasons to be concerned about the viability of the global banking sector. Few have been unscathed by the sell-off, with UK banks shares falling around 20% since the start of the year and those in the US more like 25-30%. Such movements would suggest that we were in danger of approaching a Lehman-esque moment in markets and should be asking questions regarding banks liquidity buffers as we did in 2008. CoCo worries have come at the same time as Sir John Vickers (who headed the Independent Commission on Banking) has questioned whether Bank of England proposals to ensure that banks have enough capital are sufficient given that they are less strong than the ICB’s proposals.
The banks themselves have taken steps to reassure markets, with a “rock solid” Deutsche Bank saying that they had plenty of capital available to pay the interest on its debt, with Eur 1 billion available being more than enough to pay the interests on its CoCos and other obligations this year, and they are also looking to buy back around $5.4 billion of bonds. The CEO of JP Morgan, Jamie Dimon has gone so far as to invest $26 million of his own money in his company’s stock. Bank CEO’s are not renown for throwing their own money away – although it is worth noting that Barclay’s new CEO has so far lost around $3 million on the stock he bought on assuming the job less than four months ago. So what are the real worries about banks and to what extent should we be concerned?
The list of concerns has been growing over the last few months and reached a crescendo last week with the addition of CoCo triggers. In no particular order the issues seem to be: the slowdown in Chinese growth creating a global slowdown and the prospect of an increase in bad debts; a growing trend for domestic central banks to institute a regime of negative interest rates which will undermine banks profitability; the uncertainty of the extent of fines that are still to be imposed on banks for misdemeanours over the last 10-15 years (equity dark pools have been added to Libor and FX manipulations as well as PPI miss-selling); and lastly, concerns that bank capital ratios could fall sufficiently to trigger clauses in CoCo bonds that would force the conversion of the debt into equity. This is a long list to which others might add, and the worst aspect is the uncertainty regarding magnitude. If we could put a number on each one we could assess to what extent they offset the profitability of the sector. However, in examining each of these issues in turn it is possible to argue that the level of bank stocks already more than adequately reflects a pretty extreme scenario and, more importantly, our deposits should be safe.
The global growth issue is going to be key in assessing the value of any asset, and the uncertainty surrounding the extent of the Chinese slowdown and its knock-on effects generates understandable caution. Banks have lent a lot of money to the mining sector and there are serious doubts about whether some of these loans will be repaid (Glencore being the most high profile potential casualty having recently raised Eur 1.25 billion via a bond issue arranged by Barclays and Deutsche). However, the fact that the US felt comfortable in putting up rates just a few weeks ago, and that European growth has been gradually turning up should not be ignored, and in the UK and the US unemployment levels are such that the current high levels of personal debt should be serviceable.
Much of UK bank lending (particularly that of RBS and Lloyds) has been for domestic mortgages and the buoyancy of the housing market; stable income and positive equity should limit the need for bad debt provision. Further, banks have, over the last seven years managed to close what the Bank of England calls the “customer funding gap”, which was the difference between the amount that they had lent and the size of their deposits, the very problem that prompted the demise of Northern Rock.
Japan surprised the markets with a further cut to their already negative interest rates, suggesting that the current programme of Quantitative Easing is not working. What is worse is that 10yr JGB yields (briefly) turned negative and this has been met with flatter yield curves across developed markets. Negative rates have pushed investors further and further out along yield curves, leading to much smaller margins between short and long-term rates . This is an issue for banks, who typically make their money by borrowing short and lending long. In addition, banks have been forced by regulators to hold greater provisions for loan losses in high quality short-dated paper, the very stuff that carries a negative yield.
Negative rates are then undoubtedly a headache for banks, but they do carry a benefit in terms of it making it much more likely that borrowers will be able to repay them, and they should ultimately help the global economy to progress as banks are forced (where their capital ratios allow) to lend at a low rate rather than keep cash with a negative return.
How many more fines are still to be paid by banks? So far banks have paid out considerably over $250 billion since 2008. Just because this is such a high number does not mean that we are near the end, but most of the issues (libor, FX, PPI) are largely resolved, and it would need some new revelations to suggest that provisions for fines will have to remain at the high levels of recent years. Take these provisions away from the numbers banks have reported and their profitability looks a lot more impressive.
Finally what about CoCos? A triggering of a switch from debt to equity would be more of a symptom of problems for banks rather than an issue in itself. These instruments were designed in the 2008 crisis, with the encouragement of central banks, to help banks to increase their Tier 1 capital ratios back to levels that made them resilient to any future crisis. CoCos are essentially bonds that pay a high level of interest in return for the risk that, should the issuing banks Tier 1 ratio fall below a trigger level, they would be converted into equity. These bonds were regarded as a good investment as the banks have maintained ratios well above the trigger levels. However, more recently concerns regarding potential bad debts have prompted markets to question whether banks can continue to service their CoCo debt, with the risk that holders will suddenly not own a high coupon bond but equity instead. This is a worry, as any holders would struggle to find someone to buy the debt and would probably finish selling it to hedge funds, who would be merely using the debt purchase as a cheap way of buying bank equity. While it could well be argued that many were foolish in buying this debt, in not giving full weight to the risks, it does seem that we are a long way from getting to the trigger levels and conversion would seem only a remote possibility. The Tier 1 level that would trigger conversion is typically 7%, yet average core equity tier 1 levels rose from 9.7% in 2011 to 12.6% last year. It seems that CoCo concerns are being exaggerated in very skittish markets.
So that leaves the question of whether current equity valuations overstate these issues for banks. If one looks at net asset value that would certainly seem to be the case, with UK banks trading at around a 30% discount to net asset value. More international banks, which face the uncertainties within emerging markets, have suffered more, with Standard Chartered having seen a 60% fall in its stock price in the last year to leave it trading at a 55% discount to NAV. When one comes to look at dividends, the yields look attractive, with HSBC yielding 7%, and Barclays 4%. Clearly you can question these yields if you think that the dividends will be cut, but the banks are mindful of keeping their shareholders happy. Overall this would suggest that banks are relatively cheap even with the high level of economic and regulatory uncertainty.
Clearly if there is a major downturn banks will suffer, but it does not have to be terminal and it may well be that Jamie Dimon’s $26 million additional personal commitment is money very well spent.
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