Don’t Worry About It?

Viewpoints


A bank failed. One of the largest banks failed, in fact the sixth largest. Spain is the sixth largest European economy and its sixth largest bank just failed. In the U.S. an equivalent failure would be PNC or U.S. Bank. However, market participants seem content that this is an isolated event and not an indicator of a wider crack in the foundation. Should they be?

Shrugged off as an idiosyncratic event, Spain’s Banco Popular was deemed ‘failing or likely to fail’ last week. Regulators implemented the failed bank resolution scheme, fully writing down all of the bank’s capital securities (common equity, AT1s and LT2s). Another of the largest Spanish banks, Santander, bought the failed bank, requiring a significant capital raise and future loss reserving to do so.

How does this happen?

Banks fail either when they make poor lending or investment decisions or when their funding dries up, forcing balance sheet shrinkage. Funding shortages may occur with a run on deposits, which was the case with Popular. The point is: Banks don’t fail out of nowhere, particularly when the following are present:

  • Economic Growth- During a speech on April 6th, European Central Bank President Mario Draghi stated the once fragile European economy is now showing healthy and broad improvement:
    “But things have also been clearly improving. Since mid-2014, the recovery has evolved from being fragile and uneven into a firming, broad-based upswing.”
  • Easing Financial Conditions- Per the Euro Area Lending Survey as of April 2017, lending standards eased (i.e. better terms to borrowers) while loan demand increased across all areas including enterprises, consumer credit and housing loans. While Spain was a bit less constructive than the broader Eurozone, it still has improved significantly over the last several years.

Improving Lending Conditions in European Markets Changes in Terms and Conditions for Loans or Credit Lines to Enterprises
(Net Percentages of Banks Reporting Tightening Terms and Conditions)

Note: “Margins” are defined as the spread over a relevant market reference rate. “Other terms and conditions” are an unweighted average of “non-interest rate changes,” “size of loan credit line,” “loan covenants” and “maturity.” “Overall terms and conditions” were introduced in the first quarter of 2015.
Source: ECB

  • Central Bank Buying- European Central Banks have also played an active role in supporting their lending markets via such programs such as the CSPP (Corporate Sector Purchase Program). Started in 2016, the six national central banks now own over EUR92b in non-financial, investment grade-rated bonds by buying roughly EUR7.5b per month. This means that these central banks have amassed ownership of more than 7% of the European bond market in less than a year.

CSPP Holdings at Book Value, EUR Millions

Source: ECB

Lending terms have eased, borrowing demand has expanded and European employment trends have improved. This should benefit European banks via more lending and lower credit losses with borrowers better able to service their debt.

How similar are the fundamentals?

The major U.S. banks actively recapitalized their balance sheets post crisis, by raising equity capital to deleverage and by writing down troubled assets. U.S. banking regulators played a major role in encouraging and overseeing these efforts. In comparison, the progress of European banks lags considerably for both equity capital raising and troubled asset writedowns. Below is a comparison of the major U.S. banks and the 12 largest Spanish banks. It is evident that Spanish banks, including Banco Popular specifically, have a lower margin of safety given still-elevated leverage and still-present troubled assets/loans. Likely hidden during an economic tailwind, it is more likely that these cracks would become far more visible should economic or market turbulence develop.

Leverage: U.S. Banks vs. Spanish Banks

Source: TCW, Stifel Nicolaus & SNL

Market Reaction

Market pricing for Banco Popular AT1 (Additional Tier 1) capital securities implies a quick deterioration of confidence. Quoted near par (~100) in early May and at approximately 70 at the beginning of this month, solvency doubts appeared modest until only recently.

Banco Popular 11.5% AT1 Capital Securities

Source: Bloomberg

However, a survey of European bank AT1 capital securities outside of Banco Popular implies minimal extrapolation of more pervasive concern to other similar European bank AT1 capital securities.

Price Distribution - Bloomberg European Bank AT1 Universe

Source: Bloomberg

More than eight years into a financial and economic recovery, how likely is it that, absent fraud, such a major bank failure isn’t indicative of financial system fragility? Investor confidence permits such conditions to persist, however fundamental cracks can quickly deteriorate into more severe fractures. In the case of Banco Popular, ECB Vice President Vitor Constancio stated the following last week, implying tenuous stability of even the nation’s sixth largest bank:

“The reasons that triggered that decision were related to liquidity problems. There was a bank run. It was not a matter of assessing the developments of solvency as such, but the liquidity issue.”

Investors should respect such tremors and be particularly cautious investing in banks that either didn’t adequately repair balance sheets since the Global Financial Crisis or have significantly leveraged balance sheets while benefitting from peak earnings/cash flow.

 

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This material is for general information purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any security. TCW, its officers, directors, employees or clients may have positions in securities or investments mentioned in this publication, which positions may change at any time, without notice. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision. The information contained herein may include preliminary information and/or "forward-looking statements." Due to numerous factors, actual events may differ substantially from those presented. TCW assumes no duty to update any forward-looking statements or opinions in this document. Any opinions expressed herein are current only as of the time made and are subject to change without notice. Past performance is no guarantee of future results. © 2017 TCW