Last week, I spoke in London at a conference, “Investing in Bank Assets” sponsored by the Association of Financial Markets in Europe (AFME). The Conference had a titillating, if a tad alarming, subtitle “The European Purge Begins”.
The question is, of course, is it true? The purge, I mean. Is there a European purge afoot, and are there massive opportunities to invest in European bank assets? I, for one, certainly hope so.
Let’s test the case. Those who read this blog regularly will be aware we’ve been chirping about these opportunities for quite some time. Having participated on one side or another in most of the recent European banks’ initiatives to dispose of dollar denominated US assets, we’ve become quite fond of this nascent trend. And, not to bury the lead, we think there is a very large opportunity in the disintermediation from European banks, and a particularly large opportunity with respect to US commercial mortgage loan assets held by our European friends over the next 12 to 24 months. By the way, kudos to AFME, Gilbey Strub, Managing Director for Resolutions and Crisis Management at AFME and her colleagues for putting on a terrific show. It was co-sponsored by Dechert and by Alvarez & Marsal.
The one-day program was eye-opening and fascinating. The speakers, present company excepted, were extraordinary. The keynote was delivered by Chris Flowers, one of the savviest investors on the planet. Speakers included Jim Lockhart, who’s Vice Chairman of WL Roth & Co. and currently running what’s left of the UK bank previously known as Northern Rock, our partner Tom Vartanian who is a genius on structuring private equity to save open but damaged banks, John Moran, the Secretary General of the Department of Finance of Ireland, Nils Melngailis and Steve Franck, Co-Head and Senior Director respectively of the Financial Industry Advisors team at Alvarez, Mike Krimminger, the General Counsel for the FDIC (who has certainly seen this movie before), Sophie Bertin-Hadjiveltcheva, the Head of State Aid for Financial Services of the European Union, Andrew Gracie, the Head of the Special Resolutions Unit at the Bank of England, Piers Haben the Director of Oversight for the European Banking Authority, and a host of others. A financial glitterati prepared to slog into the detritus of a bruised, if not broken, bank system.
A lot of great take-aways:
- Every bank on the continent is engaged in the naval gazing exercise of dividing risk assets into core and non-core. In some significant measure, and because of politics, “non-core” is code word for the financial NIMBY: “Loans not made to my citizens.”
- When folks like Chris Flowers and Jim Lockhart of WL Ross & Co. think it’s worth hanging around the European bank rim, it’s worth hanging around the European bank rim.
- The European Commission has provided in excess of €5 trillion in aid to the European financial service sector. €5 trillion. There’s an attention grabber!
- The recent massive infusion of liquidity into the sector by the ECB will, on balance, make it slightly easier and more likely the European banks will dispose of non-core assets. The notion that this liquidity means assets will not be sold is wrong-headed.
- There’s something like $2 trillion in commercial real estate assets on the balance sheets of the European banking community as a whole. Largely, it’s marked at par. Largely, it’s worth 80 cents on the dollar. That’s a $400 billion hole in the collective balance sheets of the banks. Because of Basel III, the ECB is requiring that the banking community provide something in the range of $300 billion of additional capital before summer. Is that really $700 billion?
- The ECB defines capital needs as a ratio of capital to risk assets. Adding liquidity doesn’t fix that ratio. Raising equity or selling assets does. The bet is assets will get sold before capital will get raised. John Moran, the Irish finance minister, pointed out the Irish government is way out ahead of largely everyone else with a creative and aggressive assault on bank solvency with a comprehensive bad bank, good bank, government assisted scheme. The herd is not following the Irish bell cow here.
- Major EU banks are enormous. Many of these institutions have assets exceeding the gross domestic product of their host countries. Note that Lehman at its height had assets amounting to about 4% of US GDP. How does the mouse hoist the elephant?
- The European banks are also woefully at risk because of their reliance on wholesale funding. US deposits as a percent of bank liabilities are almost 60%. In the Euro area, just over 30%. Yikes.
- To maximize the opportunities for buying European bank assets, we need a Goldilocks moment. If the banks’ capital is too low, kicking the can becomes the only strategy and they simply cannot sell assets to improve capital ratios. This compels a strategy of comprehensively fibbing about capital and hoping cheap liquidity will somehow fix the problem. If they are lavishly recapitalized by their respective host governments (see above; not likely in most cases), then they can afford to kick the disposition can down the road. Bet is we’re getting Goldilocks. The EC and host countries are doing everything they can to prop up these banks. It’s likely to be just enough to allow the banks to sell non-core assets but not so much that they can ride out the storm and just hope for a tsunami of appreciation.
- Assisted deal to fix open and at least notionally solvent banks is the best way to fix the European bank problem. There are, regrettably, massive headwinds in the way of this getting done. The bank regulatory structure of Europe is vast, diffuse, overlapping, confusing and highly politicized. One thing the regulatory community agrees on though, is that Anglo-Saxon private equity is pretty much evil. If you cannot invite in private capital, assisted with a modicum of state aid, and you cannot face the dilutive consequences of selling vast quantities of common stock, you better sell assets.
From where I sat on the podium, all of this seemed to be a validation of our view here at Dechert that the disintermediation of the European banks is a trend that will continue to provide real opportunities to entertain the US players for the next couple of years. I love validation. Next time, practical pointers on how to buy and sell pools of bank assets.
By: Rick Jones