We believe U.S. banks are well-capitalized, well-managed and good value.
When the market was throwing its tantrum the week before last, I happened to be on the road, meeting with clients in Toronto and Montreal. The local financial press marveled at how strong Canadian banks were, having “only” lost 7-10% of their equity value year-to-date while their European and U.S. counterparts were down 20-30%.
To be frank, I was marveling, too. One of the many explanations offered for the panic around U.S. bank securities was the amount of bad energy-industry debt they may be exposed to. But if anything, Canada’s banks are even more exposed to these risks. Muted loan demand, negative benchmark rates, flat yield curves, oil and gas exposures—there’s a bit of truth in all of these explanations for the global banking sell-off. By far the most important thing, however, was simple technical selling pressure.
When your core business is borrowing money short-term and lending it long-term, the current environment is not great for profitability. That is meaningful for shareholders, but in most businesses profitability has to deteriorate a lot before it affects creditors—in fact a small hit to profitability can be good for bondholders because it can make management more cautious.
Banks are different, of course. Because bank leverage is increasingly tightly regulated, sentiment that hits equity valuations can be very damaging if it brings a highly-leveraged bank close to its minimum regulatory-capital ratio. That can make nervous bondholders demand a bigger premium to take the risk of being “bailed-in” in the event of a bank failure. Additional tier-1 capital in Europe’s banks can even be written-down or converted to equity before a bank fails.
But the fact is that U.S. banks are not highly leveraged. Since the financial crisis, capital-to-asset ratios have climbed from around 9% to 12%, on average. Moreover, after plummeting in the aftermath of the financial crisis, return on equity has climbed back above 9%. We also think U.S. banks are the best-managed in the world and most have good succession plans in place.
That is why we think U.S. bank debt is such good value now. We were pleased to see one of the most respected bank executives, JPMorgan’s Jamie Dimon, agree with us: his purchase of $26m worth of his own bank’s stock proved the catalyst for some correction of the mis-valuation we’d identified.
It’s more difficult to enthuse about Europe’s banks. There are bright spots. For example, many Scandinavian banks entered the 2007-09 crisis efficient and well-capitalized, and have since captured more market share. Elsewhere, high costs, a fragmented international market that discouraged competition and a greater focus on less profitable relationship-based businesses led to structurally lower return on equity and, to compensate for that, higher leverage than in the U.S.
When the crisis hit, Europe’s regulators were much slower to demand action—Eurozone banks still run with only an 8% capital-to-assets ratio, on average—and return on equity has barely recovered from the 4-5% levels it fell to in 2008-09. That is why we saw a much sharper reaction in European bank bonds than we did in U.S. bank bonds. Some additional tier-1 capital convertible debt fell in value by 20%, in line with the equity itself—just as it was designed to do when things got tough.
Europe’s banks find themselves straining to build regulatory capital ratios and drive efficiency to raise return on equity—while their regulators get bogged down in politicized debates about banking unions. It’s do-able, but it’s hard and painful, and it’s the sort of thing that U.S. banks went through much more quickly six years ago within a much simpler regulatory framework.
As a result, looking at fundamentals today, we see an ocean between European and U.S. banks in more ways than one. That the market sometimes fails to register this allows steadier hands the opportunity to build positions at potentially very attractive valuations.
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