The Fed’s refusal to provide the necessary capital to rescue Lehman Brothers led to the collapse of financial markets in the second half of 2008. The US Department of Justice’s $14.5bn fine handed to Deutsche Bank (DB) could place the bank in an insolvent position with very little chance that Angela Merkel’s government can use taxpayers’ money to save them. Will the risk of DB as one of the most systemically important banks’ demise (via its very large role in the derivative’s market) lead to a repeat of 2008? Are we heading to another collapse of confidence in the banking system?
The short answer is “No”.
Here are some of the reasons why
- DB has more than $220bn in liquid reserves and $1.8 trillion in assets.
- The $14.5bn fine is excessive and a bullying tactic. Yes, DB’s behaviour in 2008 warrants a large fine and censure, but $14.5bn is outsized compared to similar fines settled on to date. The US Department of Justice knows the effect of such a fine will have in terms of client confidence in the bank and hence DB needs a quick settlement.
- Current opinion is that (based on fines paid by other banks) the fine settled on will be between $5bn-$8bn, for which DB has sufficient reserves and cash flow.
- Deutsche Bank, whilst being in reconstruction mode, is not unprofitable or bankrupt as Lehman’s was. I’m not saying that DB is a strong bank and will survive in its current format (recently appointed CEO John Cryan is busy with a dramatic restructuring exercise), but it is not sitting on a time bomb of client exposures that has to be defused as was the case with Lehmans. I highly recommend two easy-to-read and fascinating books, the first is by Vicky Ward, called “The Devils’ Casino” (about the rise and fall of Lehman Brothers) and the second is “The Big Short” by Michael Lewis (about the US mortgage backed securities scandal). Both these books give good insight into the wild pre-2008 days. The global system had been leveraged, a wild drunken party was on the go and many banks were selling invitations to the party to clients.
- We now live in the opposite nightmare. A world driven by regulators and politicians who are pushing the pendulum too far by overreacting in their zeal to protect the public against the excesses that were missed/overlooked by regulators that weren’t doing their jobs in the first place.
- More important, global banks have been recapitalised and have excess reserves (refer our article on US banks) – Europe still being the exception (next article).
- Besides, low interest rates mean there is little demand for lending which means the banks have built up excess liquidity. Besides, the new capital rules have made the products they were pushing pre-2008 unattractive.
- The risks we now face are not on the private sector bank balance sheets, but on the central bank balance sheets.
Are we worried about a collapse?
Deutsche Bank is a giant in the derivatives market, so yes, a disorderly collapse of DB would trigger panic and on Friday rumours that (smaller) hedge funds were transferring their exposures to other investment banks causing a 9% fall in the share price (and a 20% swing on the day). A run like that easily turns into a stampede. I’ve seen enough banking stampedes in my life to not say “it can’t happen”.
But will it trigger a banking system collapse? Again: Very unlikely.
Deutsche Bank’s problems have been visible for quite a while and large banks are not as geared, nor as interlinked as they were in 2008.
We’ve just visited the major (and also the smaller and more profitable) banks and insurers in Europe and the UK and yes, if you’re invested in a large bank or insurer: “It’s a dark and stormy night,” but they’re generally well capitalised and have de-risked their balance sheets.
I must add that none of our funds are invested in any of the potential problem banks or Wells Fargo, but this is due to our investment philosophy. I’ve seen and lived through quite a few banking crises since the early 1980’s and as a team we’ve learnt (by back testing) that in uncertain environments (such as the current one) it is better to invest in a franchise that is on the front foot and gains market share during a crisis, rather than one that loses market share.
Hence you’ll find that the bank and insurance holdings in our funds have no legacy issues or have solved legacy issues and they are on the front foot. Some of these are One Savings Bank, Legal & General, Novae, Arrow Global (UK), Axa and Scor (France), to name but a few.
During the past three years the above six companies have grown shareholder value in excess of 15% on average and trade on a current dividend yield exceeding 4% including generating a return on capital of well over 13%. With opportunities like these, one does not need the risk of investing in turnarounds like Deutsche Bank.
But what does the future hold?
- The probability is high that Deutsche Bank and the US Department of Justice will settle on a fine of $5bn-$8bn.
- John Cryan (CEO) will have to raise more capital at some stage but it will be a manageable amount and he will step up his plan to downsize the business.
- In the meantime competitors like BNP Paribas, JPMorgan, Bank of America Merrill Lynch and Citibank will have a free lunch gaining market share.
- Something similar will be happening in the US to Wells Fargo where the client-driven culture was shown to have morphed into an incentive-driven culture. Warren Buffett: “Were you not watching?” On a side note: Does the Wells story highlight that Berkshire Hathaway’s empire has become too big for Warren and Charlie? I don’t think so, they’ve always believed in selecting the right management and then be “hands-off”, letting them run the business and only keeping their hands on the purse strings in terms of the capital that the businesses generate.
- Deutsche Bank’s fine will soon be paid and forgotten and investors will focus again on the fact that we’re in a low growth world, but that the financial sector has been pushed down to very attractive levels, have restructured and are compounding shareholder wealth at 8%-12% per annum (on a total return basis).
- Dynamic emerging markets and their banks will outperform developed markets due to their less restrictive regimes, young and entrepreneurial populations.
I hope to soon complete the two articles promised:
- Opportunity in European banks and insurers?
- Why has our global financial fund performed so well recently and in fact over the past 16 years?