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Financial Industry Insights from Advisors Asset Management
On October 03, 2016
AAM Viewpoints – European Banks are Stinkin’ up the Joint – Opportunity or Canary in the Coalmine?
This past week we have seen a resurgence of market pressure on Deutsche Bank securities. Wisps of Lehman Brothers float in the air as we witness shares of Deutsche Bank carve out new lows. There are proclamations by Angela Merkel that the German government will not bail out Deutsche and that the U.S. Department of Justice (DOJ) is attempting to fine the bank $14 billion for bad deeds committed by the bank in the last financial crisis. To be sure, Deutsche has been on and off the ropes for the past year or so as concerns about the bank’s financial health haunt the headlines. If one were to look at the entire group of European Banks, the market performance has been similar for the entire group and not just limited to Deutsche. Are we headed for another “Lehman” moment or could this be a buying opportunity?
First, let’s take a look at Deutsche Bank and point out a few reasons why we believe this is nowhere near being a “Lehman” moment. As you might recall, Lehman Brothers was allowed to fail back in 2008 which set off a global meltdown that required a recapitalization of the U.S. banking system by the government (TARP – Troubled Asset Relief Program). The banking system in the United States was loaded with illiquid securities which, in turn, limited the banks’ ability to provide liquidity to its clients and markets. In the months and years after the crisis, banks were required to significantly bolster their liquidity both in the United States as well as in Europe. It is highly unlikely that we are on the precipice of another “Lehman” failure because banks are very well capitalized and they have record liquidity. In the case of Deutsche Bank, their liquidity is in excess of $250 million. Deutsche Bank is not suffering from a lack of liquidity.
The other area which could be a problem is their level of capital. Capital is different than liquidity. Capital is the amount of equity that a bank holds. Capital is the money that the bank owns rather than deposits which are liabilities of the bank. Deutsche has very substantial capital, however, it is lower than many other banks with similar sized balance sheets. The fear is that if the bank had to recapitalize at a time when markets were unwilling to invest new capital then there is a possibility that the bank could fail. What adds to this is the reports that the Department of Justice wants $14 billion of that capital to be paid in a fine. Even though this is worth noting, I would strongly suggest that the DOJ would not levy a fine that would in any way put the bank’s ability to survive in jeopardy. A bank failure of this magnitude would have adverse impacts on U.S. banks just like other global banks. So, expect a fine that Deutsche can pay without jeopardizing its ability to operate. Remember, these banks – just like U.S. banks – are put through stress tests that require the bank to demonstrate its ability to fund itself for over a month if markets shut down. Deutsche passed these tests.
Finally, even though Angela Merkel says there would be no government recapitalization, in reality there would be if it came to that point. Banks provide the lubrication that keep economies working. They are a kind of utility that provide for payment transfers, needed financing to enable manufacturing and commerce as well as the transfer mechanism for central bank policy. Everyone recognizes that allowing Lehman to fail was the wrong move given the contagion it caused. We believe that both the European Central Bank and the German government would move to support the bank if the need arose.
What is more telling is to look at the other European banks as well as the U.S. bank share prices. Looking at the valuations of banks, they look cheap as a group. We think that the group have some short-term issues that might point to an investment opportunity. It is our opinion that record low and negative interest rates have done more to hurt the short-term profitability of banks than other problems. Banks do well when yield curves are steep and economies are growing. What we have in Europe is a financial experiment with negative interest rates which has destroyed the spreads for banks.
Central banks took rates to a negative to discourage keeping capital immobile as deposits and to provide stimulus to invest money where returns would be positive. That really has not happened. What has happened is that banks became more cautious with their lending rather than more liberal. What is even more apparent with negative interest rates is that they have caused banks to actually decrease lending in the wake of economic uncertainty. Negative interest rates are not natural and we believe have failed. Look for them to go away soon. Healthy and profitable banks are necessary for the economy to stabilize and grow. We think the global central banks get that. We think you will find that, as a group, the banks should be bought here and not sold.
Is there an investment opportunity for Deutsche shares at these low prices? The answer is, “maybe.” I believe that Deutsche will be fine but we think the volatility and risk will keep most investors away. Deutsche is who is in the headlines.
We think the better opportunity might be in the rest of the group. As a group, banks are selling at very compelling valuations. In prior cycles, one would want to buy banks at prices that are at or below tangible book value and sell when the price to book is between two and three times. Right now, the price to book of the group of European banks and U.S. banks are at discounts to tangible book value. Historically, this would be a time to buy the banks rather than sell or avoid.
We believe there are several reasons to consider adding an allocation of banks to portfolios now.
For those who are risk adverse, maybe sticking to the largest U.S. money center and regional banks takes away the European risk. We think that U.S. regional banks present incredible value. For those who believe that Europe will continue to exist and they will eventually grow their way out of this funk, we think adding European banks as a group is likely a good bet at these levels. For those looking for income, many of these banks have preferred shares with big coupons. A bit of homework could be prove to pay nicely in future years.
CRN: 2016-1003-5565R
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com.
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