Thursday, 10 April 2014

One more time with feeling . . . 200km in the rain

No one, just no one on the planet Earth is so important that they alone control their entire destiny. Granted, at certain moments you can make a decision that can be path defining, but essentially there's always someone or something else that can throw a spanner in your "works".  At the moment I'm in somewhat of a twilight zone and I can't do a lot about it and that's why it's been a few weeks since the blog had a new posting. Apologies to long time readers and casual web surfers.

One of the big themes of this blog since inception has been the recapitalisation of the banking sector. I've been preparing a presentation on this and in it I was arguing that the current cycle of equity issuance was in fact not over. Confirmation of this leaked into the FT on Tuesday when Fed Governor and regulation supremo Dan Tarullo "signalled that the Fed might impose an additional risk-based capital charge on the biggest US banks, bringing it “to a higher level than the minimum agreed to internationally” to discourage short-term wholesale funding." Right now the banks have to hold a minimum of 3% equity to assets, but the Fed is indicating that it would like an additional 2% for the eight systemically important ant banks (SIBs) in the USA (Bank of America, Bank of New York Mellon, Citigroup, Goldman, JPMorgan, Morgan Stanley, State Street and Wells Fargo). That means that they will have to hold an additional $68bn in equity or shrink to match what they have. Without doing that numbers yet some of these banks are probably well on the way to either having or raising this equity.

The significance of the Fed adding additional capital requirements is that other central banks will be forced to look in a similar fashion to their own SIBs. Central bankers no matter how independent they are from their political masters are nothing if not risk averse. Think about it this way, say you're a central banker and you decide that the 3% requirement is enough and one of your big banks gets into trouble; surely the first thing that happens is that politicians are going to knock on your door and ask how come you didn't follow the Fed? No central banker will want that and if the payment for this is a lower return on equity amongst the banks administered by that central banker then so be it.

This brings me back to Australia, which has formed the basis of the presentation that I've been doing. The Reserve Bank of Australia (RBA) helpfully puts out a statistics pack to give you an idea as to the capitalisation of its' own banks and financial institutions. The theory here in Australia is that most of the capital raising is over after a deluge of hybrid issuance (CoCo type structures) was approved by local regulators to be a suitable substitution for common equity, with any additional top-ups being possible via the retention of profits or use in underwriting their own dividend re-invest plans. Here's what the major Australian banks looks like in respect of Tier 1 capital (i.e. equity and "equity like"):

The RBA is probably quite happy with this, but given what the Fed is saying and taking for example what the Swiss are doing in respect of their own SIBs that might not be enough going forward. I would consider that Australia runs a banking system closer in nature to (say) Switzerland in terms of concentration, than the USA. In Switzerland the law goes beyond the Basel III rules and requires Credit Suisse and UBS to have capital ratios of at least 19%, of which 10% would be common equity because of their systemic importance to the country. Australia at least has the argument that the four major banks here tend to concentrate their business locally and thus external shocks might not have the same effect here as they will to the Swiss. Even allowing for this the argument for adding to the current capitalisation buffers is persuasive. The question for bankers is can this be done through the current earnings or not?

Given Australian banks are amongst the best in terms of RoE and profits have been rising it's hard not to take the view that there's nothing to see here. Having said that the RBA is already signalling that the easing of the interest rate cycle is over and that with the institutions down here focused on housing financing it seems to me that they might be inclined to require a bit more issuance. Consider this; charges for non-performing loans are at multi-year lows. In the G7 countries this is because the system shock of the crisis has passed, meaning probability must be that if a loan was going to go "sour" it probably already did. This is not the case in Australia where charges during the crisis topped out at only 0.5%.

Maybe I'm being a bit too "glass half full", but rates have only gone down. If rates kick-up you're reliant on the RBA's modelling to say what might happen to the banks. I tend to think they'll ere on the side of caution. Investors should expect more equity to be issued.

While on the subject of issuance I think it's wise for investors to review their holdings in Hybrids. CoCos have become a kind of deposit substitute here in Australia and in several other major economies. Investors in my mind have somewhat ignored the short optionality imbedded in these instruments and a recent event in the UK should see some novices in the area to start re-examine prospectuses. On January 20 one of the worlds biggest steel companies Arcelormittal announced that it was calling a $650m hybrid bond paying a 8.25% coupon it had issued less than 18 months beforehand. The trigger for the call was a "Ratings Agency Event" that occurred when Moodys said it would give zero equity credit to sub-investment grade hybrids, effectively handing the company's balance sheet a $325m increase in debt. The result was that a bond that had been trading above 108 in the secondary was immediately repriced in the market at 101 (the call price), effectively handing a mark to market loss to holders. The same thing happened in respect of a Telecom Italia hybrid bond only a week later, though the loss was not as large. Leaving aside the specifics of these two companies the lesson for investors is that you need to read the documents, as holding lower graded hybrids trading at a premium to their call is asking for trouble. In the case of Mittal that was 7 bond points. It could have been worse as in the case of a bank that looks to be in trouble and has the ability to convert debt to equity in a falling market. Either way you're short an option and need to understand the risks. 

During a break in the charity bike ride I was participating in last Friday I got a call from someone who heard about hybrids being called and as I was an old hand in the convertibles market wanted to get some advice from me. I was actually a bit too wet and exhausted to be much, if any use. I had already ridden 120kms in dark overcast skies, including a rain shower right at the events start at 7am. 

The ride was for the Children's Cancer Institute of Australia and I was on a team of six ridding for a maximum of 12 hours. It was a last minute thing and I had been asked if I could make up the numbers. Luckily for the team CCIA was an old family favourite as my father had specified them for donations instead of people bringing flowers to his own funeral when cancer took his life. I was the weakest of the six riders in the team, but still managed to grind out 201kms before giving up with about 90mins to go. I hate the rain and even though I'd filled my kit bag with 4 pairs of socks, two back-up jerseys and two rain jackets I really wasn't enjoying things.  It was pretty pathetic of me not to be able to get to 250kms, but I did what I could. I rode the race on my Cannondale, shod with Campagnolo Boras. In fact I was surprised how many participants chose to ride carbon wheels with tubular tyres. Perhaps like me they wanted to take advantage of the fact that as we were riding a motor racing circuit (Eastern Creek 3.9kms) a puncture was really not the end of the world as walking back to the pits was not likely to be anything too severe. Of course the rain meant that braking was problematic and for those who haven't been to motor racing tracks they're not as flat as they seem on TV. This one had a couple of nasty little climbs, including a 9%'er that was easy in the early going, but somewhat more annoying later with shoes full of water and 7 hours on the bike. I did 2300m of climbing which is proof of the constant rolling nature of this particular circuit. Anyway it was for a good cause and I did get to meet some really nice people. Would I do it again . . . mmm part of me just wants to write a check, but that's a little weak right? 


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