INSIGHTS

On February 16, 2012

Seriously? Worried About Europe? Still Worried About Banks?

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This morning Moody’s Investor Service is reportedly warning about a possible downgrade of a plethora of international bank ratings citing risk coming from Europe.  It seems that potentially this “possible downgrade” move might be a BIT late to the game.  Could it be that this is yesterday’s story and that the markets have already digested the potential Europe risks?  Our view is that, as usual, the ratings agencies are late to the game telling us of risks that the markets have already discounted.

We believe that the markets are telling us that the risks coming from Europe have significantly decreased.  In August of last year the financial markets began to slide precipitously as many famous market prognosticators told us that an eminent U.S. recession was in the process of dragging the country down for a second time.  All the while, U.S. economic data kept coming in reasonably strong suggesting that modest growth in GDP and decline in unemployment was afoot.  U.S. banks seemed to turn the corner as nonperforming assets dropped and loan demand slowly returned.  Many of those prognosticators are still preaching recession and still waiting for the Euro crash that is so certain to be on the horizon.

Our thesis is obvious.  If you strip out the noise and just look at the facts, the world – and specifically the United States – is in a better place.  Let’s start out by noting the significant yet measured progress in the jobs markets.  This is a requirement for any U.S. recovery.  We think it is well beyond a statistical anomaly.  Housing has perked up as builder sentiment is at a level not seen since 2007.  We have underbuilt the housing market in each of the past three year as we have bled off a huge overhead supply of foreclosed homes.  The recent spike in building is happening quite simply because the value of homeownership, as measured by price of the new home and mortgage rates, is at an all-time high.  We think these trends may get stronger as refinancing options for underwater homeowners are now very enticing and the shadow inventories are being shopped in mass to institutional buyers.

Moving to Europe, we note that the European Central Bank’s Long Term Refinancing Operation (LTRO) has almost single handedly taken the nuclear melt risk off the table.  I know people like to highlight the wrangling that goes on as countries struggle to make structural changes to correct fiscal issues.  Yes, it is unpleasant and causes anger in those affected.   We feel the truth is that the European bond markets are telling us that we are PAST the apex of risk and are squarely on their way to mending.  Look at the major euro weaklings including Portugal, Ireland, Italy and Spain.  All of these countries suffered blowouts in their debt markets and have seen a sharp reversal to lower yields and higher prices as investors have flocked to be buyers of this debt.

The LTRO was a game changer because it was essentially a huge quantitative easing.  Lending to banks on a long-term basis for basically any collateral they could push, pull or drag to the window causes a huge amount of liquidity to be injected into the markets.   The first LTRO exceeded $600 billion and the next one scheduled for February 28^th may exceed $1 trillion.  Mario Draghi, President of the European Central Bank, appears to have taken a page from the Fed and has played it wisely.  The long-term funding will allow banks to fund, and to orderly shrink, their leverage over time.  It also entices banks and their clients to create demand for the sovereign debt that has since rallied so much in price.  This supports the market in a very clever way.

We are still debating whether Greece will default.  Seriously?  Let me be clear; Greece will default.  I know it, you know it, and most importantly the market knows it.  The current deal on the table is an “orderly” reorganization of Greek debt offering thirty cents on the dollar for outstanding bonds.  In my book, a compromise of the terms of your outstanding obligations is a default, voluntary or otherwise.  This is old news as the holders of this debt have already written down the values.  What would worry us would be if we saw other countries line up for a similar debt compromise.  Could they?  Well sure they could, but let’s face it; the scenes from the streets of Athens are not what any official wants to see in their country.  Default ruins those in power.  History is replete with a certainty that not paying your debts leads to a change in leadership.  Fiscal distress somehow gives politicians a “fiscal backbone” to make the hard decisions that they normally couldn’t muster.

Could there be more calamities to follow?  Certainly there could be, but the probability is that what will follow is prosperity.  This is not the first default we have seen by a sovereign nation or group of sovereign nations.  Let’s go back to the 1980s with the Latin American defaults, or in 1998 with Russia and Indonesia (Asian Contagion).  In all of those cases a restructure of the countries fiscal obligations resulted in a period of prosperity.  This is what we think will be the most likely course in Europe.  We think that selectively adding to exposure in Europe makes some sense.  We are not sounding the all clear but we feel there is some extreme value in Europe that should be bought not sold.

Does that mean we should buy the banks that Moody’s is threatening to downgrade?  The answer is yes for U.S. banks and selectively for some European banks.  U.S. banks have been strengthening and de-risking their balance sheets since 2008.  The progress is substantial.   Do they have some work left to do?  Yes, but they are on their way to recovery.  I know there are still issues surrounding Dodd-Frank and the Volcker Rule, but these will be resolved and dealt with over time.  Euro banks did not raise capital as their U.S. brethren did and now are faced with having to reduce leverage and increase capital.  They will get it done.  It might not be pretty but this will create value.  Our way to play them might be in the debt or preferred markets as raising capital will dilute the common shareholders.

The bottom-line is that banks are a necessity for any economy.  Banks only exist if there is confidence in their viability.  That confidence was delivered by TARP in the United States and by the LTRO in Europe.  Banks in the United States are much further on their way to recovery and are clear values to us.  We view the risks of ownership as declining rather than inclining.  It seems that Moody’s is too late on this one.  It seems the markets have learned that the ratings companies have much less impact on capital markets now than when everything was rated AAA.  Go figure.

 

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