Trump Is Bad (Or Good) News For Bank Regulation
Guest post from Jonathan Rochford, CFA Portfolio Manager of Narrow Road Capital.
Bank regulation on the back foot?
The outcome of the US presidential election is a potential spanner in the works for the Basel IV negotiations. The old position had the Swiss already implementing much higher capital levels, the US pushing for higher capital levels and the Europeans resisting these efforts. Morgan Stanley has banks in Europe and Australia needing a lot more capital when the likely changes are implemented.
Trump’s election could bring two main changes for US banks. Firstly, repealing at least parts of the Dodd-Frank legislation to free up banks to conduct a wider range of business activities. Secondly, increasing capital to ensure that banks failures don’t require taxpayer bailouts, similar to Switzerland. Chairman of the House Financial Services Committee Jeb Hensarling is a strong supporter of both measures and is expected to be influential in Trump’s administration. The post-election bounce for US banks seems to be acknowledging the former and ignoring the latter. If banks are able to engage in a wider range of business that is likely to allow for higher margin (and usually higher risk) activities to grow, which should grow profits over time. But a requirement to substantially increase subordinated capital will materially reduce the return on equity for banks.
For the Basel IV discussions the much higher capital levels proposed by Hensarling will almost certainly be unacceptable to the Europeans. For Deutsche Bank, Societe Generale and UniCredit a tangible leverage ratio of 10% implies a tripling of their current capital levels. The push to allow banks to engage in riskier activities that have been curtailed since the financial crisis may also be disputed. It’s possible that proposed Basel IV changes may not be agreed or may only be adopted piecemeal with national regulators picking and choosing.
If the Europeans banks win concessions that would be a bad outcome for taxpayers with future bank failures far more likely to involve taxpayer bailouts. The European resolve is already wavering on their recently implemented bail-in rules. These rules could be tested soon with eight Italian banks treated with bail-ins. Monte dei Paschi shareholders have approved a restructure which involves a capital raising and subordinated debt being converted to equity. However, legal claims and the Italian referendum mean that a bail-in of senior debt is possible. Steve Eisman, who was profiled in The Big Short, has warned about Italian banks and Deutsche Bank.
Another area of change that the Trump administration may bring is with the handling of Fannie Mae and Freddie Mac. After being bailed out in 2008 the US government has been stripping the capital of both loan aggregators. There has been ongoing litigation with the non-government shareholders claiming they were short-changed when the bailout occurred. Whilst all of this has been happening the quality of loans has fallen. It is eminently foreseeable that the very low level of capital remaining in these businesses won’t be sufficient if another economic downturn occurs. For those who don’t think there’s a problem here, a CDO of Fannie and Freddie securities will be right up your alley.
With a new administration, there is the opportunity to completely re-evaluate the business model. Ideally, Fannie and Freddie would be private companies with no explicit or implicit government guarantees. An IPO of the businesses, where the funds raised from selling new shares is used to lift the capitalization of the businesses would be ideal. This would see the US government taken out of the picture. It would see the cost of mortgages rise a little, but whilst mortgage rates are very low now is the ideal time to implement the change. The politics mean that a less than ideal solution is likely, where the government remains an implicit guarantor but the private sector takes back control.
Bank Regulation – Meanwhile in China
Chinese economic data continues to be pretty good, which leads some to ask will China ever bust? The recently retired chairman of ICBC, a self-proclaimed connoisseur of crises, don’t see any signs of trouble. The Wall Street Journal sees bubble everywhere. China’s housing is really expensive even on a global basis. Some academics say high property prices can hold if the government buys excess stock for social housing and new supply is stopped. Others see problems with banks and wealth management products being increasingly reliant on short-term wholesale funding. Investment flows are switching back to commodities, which may explain the big moves in iron ore prices. A free float of the Yuan is becoming more likely as capital controls and currency depreciation are encouraging higher outflows.
Chinese banks shifting their non-performing loans to asset management companies may create more problems than they solve. Bankruptcies are up by 53% but non-performing loans haven’t risen nearly as much, yet. A struggling Portuguese bank raises capital by selling shares to a highly leveraged Chinese conglomerate. Chinese buyers are creating a surge of development on the Malaysian side of its border with Singapore. The Chinese government has reminded investors that local government debt is not guaranteed.
Bank Regulation – And in emerging markets
Since the US Presidential election emerging markets have been thumped across equities, bonds and currencies. Egypt dropped its fixed exchange rate and its currency fell by 45%. Nigeria’s government is trying to set limits on exchange rates but has instead created a flourishing black market. Mexico can’t do much to stop the Peso falling, with trouble brewing for companies with US dollar debt. If you haven’t been scared off by any of these currency collapses then the high yielding Russian carry trade might be one for you.
Emerging market debt has given back half of this year’s gains in two weeks. Mozambique is in a three-way fight with bondholders and the IMF over its debt restructure plans. Angola’s state-owned oil company is in such bad financial shape it can’t buy toilet paper. India’s withdrawal of high denomination notes was very poorly planned in a country where many can’t access ATMs.
The Venezuelan currency was having a bad month down 45%, then it fell another 15% in a day. The locals are relying on a guy in Alabama to calculate the “official” black market rate, using quotes gleaned from social media. Some are using free electricity to mine bitcoins in order to earn a living. The state-owned oil producer missed some of its debt payments and blamed banks for its failure to pay. Debt haircuts of 50-60% are likely for Puerto Rico. The proposal to replace its old bonds with new bonds linked to GDP doesn’t look good for creditors as GDP has fallen by 9.1% over the last 10 years.
Amongst all of this carnage Greek bonds have surged this month as some investors are betting the country will receive debt relief soon. Time will tell whether