Reflection on Subordinated Bank debt

Given recent headline news on banks, we have been asked for a comment. For some time in our monthly and quarterly reports we have emphasized the fundamental benefits of owning subordinated debt of the banks due to a multi-year process of capital strengthening. This is mandated by the different regulators and the table below shows the timetable of change which is particularly impressive for “SIFI”’s Systematically Important Financial Institutions.

There are two implications of these changes; first, over time, the buffer of shareholders’ equity against risk-weighted-assets must increase thereby making subordinated debt and particularly structurally senior subordinated debt more attractive and second that Banks must adapt their business models to the new world. One of the most visible consequences of this is the need to reduce the capital that was deployed in the investment banks, where during the crisis, excessive risks were taken.

When we have written and repeated the words “multi-year process” we have done so for a reason. While many banks will adjust gradually in a smooth manner those with large capital consuming investment banks will do so in a bumpier manner. These are the banks that grab the headlines when in the same week good results from ING will be reported in the middle pages.

So, where do we stand today?

In the last weeks two banks, Deutsche Bank and Credit Suisse, have announced large headline losses. They are both banks which in the early 2000’s used significant capital in their investment banking activities and have legacy issues and litigation issues which are coming home to roost. They are also both banks with new hard-headed managers who will aim to reshape their businesses so that the important cash generative franchises that they own will come to the fore and the value for equity holders can be rebuilt.
This will take time and the litigation issues must be resolved. Sometimes goodwill will be written off as in the 16 year old goodwill for the Donaldson, Lufkin & Jenrette acquisition by Credit Suisse. But goodwill is a non-cash item so that investors should look through some of the published losses and focus on real cash generating ability.

When we focus on cash generating ability, particularly in the reshaped or reshaping investment banks, we should also take into account short term gyrations. Credit spreads have widened, stock markets have been poor, but unless there is a major global recession, earnings will be cyclically weak and will rebound as markets recover, even if this is from a lower base. We do not observe that there will be a major global recession but we do believe that there are challenges of structurally lower world growth and the rebalancing of the Chinese economy. (Some emerging economies, particularly commodity producers, will struggle but we are much closer to the bottom than the top and they will also rebound strongly at some stage – even if in some cases the last bottoming out will be the most painful.) Again time for adjustment will be needed but there should be no major systemic shock.

We will hear more about rising default levels, particularly in the energy sector. Analysts will start to talk about unknown unknowns in the bank’s lending portfolios and sure enough we can expect some higher levels of specific loan losses. However, it would be wrong to exaggerate those issues. Unsecured loans to Exxon, Shell and BP will not default and short term energy trade finance will still be profitable. Losses will be taken by banks on idiosyncratic loans and weaker credits which were able to raise money in better capital markets. Just as after an insurance event, the more agile banks will be able to take advantage. But as with insurance companies, some loan losses will occur. However, we would expect this to be manageable for the major banks and it is not expected to derail their capital strengthening. In some cases, banks will need to go back to their shareholders through discounted rights issues as they have done in the past years. In addition, we should note that banks have been obliged to be more cautious since the crisis even if this does not prevent them from making some mistakes. So in conclusion, we stick with banks with high quality businesses and business models that we believe can be reshaped eventually to benefit and rebuild equity values. We will avoid buying banks that are in troubled zones and will avoid banks that have questionable business models. Within our investments we will prefer older legacy securities and will try to benefit from potential liability management exercises as banks reshape their balance sheets for debt that is losing its regulatory capital advantages. Anecdotally the devil in the detail was demonstrated well for our GAM Star Credit Opportunities USD fund this month as some old floating rate notes are being paid back at 100% by Deutsche Bank – they were trading at 60% the day before the announcement. With respect to new contingent capital securities (CoCos) we have and will proceed cautiously: only the best franchises and never more than 10% of the portfolio. Good analysis is required and dogmatism must be avoided. The fact is that for certain issues, the yields are currently very generous, investors will be well rewarded and the current price setback will be regarded as a good time to have bought.

Reflection on Subordinated Bank debt
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