Welcome to Variance Capital's monthly newsletter covering key issues of the global hedge fund industry.
If you wish to contribute or comment on a subject in the coming weeks, feel free to
drop me a line.

Virtually yours,
Martin

Disclaimer

By Yann Goffinet CFA*

The European bank sector (DJ Banks Stoxx, SX7P on Bloomberg) is down 32% from its peak on April 20th last year, with the European market down 17% over the same period.

The years leading to the sector’s peak last year relative to the European equity market have been marked by low –but in the end rising- short rates and low bond yields and spreads, giving them and their primarily individual and financial customers, an incentive to borrow and leverage, whilst the corporate sector, hurt more by the TMT fallout remained more cautious. The rise in leverage has taken many visible forms; households have increased their debts, sometimes through re-mortgaging and engaging into buy-to-let investing. For hedge funds and private equity firms, borrowing against collateral and injecting record debt levels in their targets has been the privileged approach. The banks themselves have used an explosive mix of regulatory arbitrage from Basel I (off-balance sheet vehicles), an anticipated reduction in required capital from Basel II, debt-financed acquisitions, share buybacks and hybrid debt instruments among others to increase leverage. In its simplest form, in a research report I wrote with my former colleagues in the banks’ team at Citigroup (“Cracks Beneath the Surface”, December 2006, downgrading the sector), we showed that the increase in the banking sector’s ROE from 12% in 1995 to 22% in 2006 was due to increased leverage (assets/equity) as the return on bank assets (ROA) remained stable at 0.6% between 1995 and 2006.

Needless to say that since the credit crisis of last August, we’re witnessing a partial unwinding of the earlier increases in leverage. When it stops and exactly what can be done to mitigate the impact of this unwind, is hotly debated but beyond the scope of this discussion.

Our point is simply that the last months have showed how disorderly, as shown by the liquidity crisis in August, the support from the superfund in October, bond insurers concerns in January and the Bear Stearns near-collapse in March followed by a recent rally. As for every other crisis that has affected financial markets in the past, opportunities abound which give rise to long-short ideas in the European financial services sector.

Some may be short term trading opportunities, but the purpose of these comments is to outline three long-short opportunities in the European bank sector with an expected investment horizon of one to three years. I would suggest building positions opportunistically and gradually.

The basic premise is that the current de-leveraging phase of the banks (and some of their important clients) is likely to impact the banks and their shareholders in 2008 and beyond, probably at least until 2010.

The three ideas are:

1. Long investment banks — short Spanish/Irish banks
2. Long Bradford & Bingley and Alliance & Leicester — short Bankinter, Sabadell
3. Long Julius Baer — short EFG International

This is perhaps the least consensual call after Bear Stearns, but the near-collapse of Bear Stearns may precisely be the rare event that gives rise to a great buying opportunity. Eight months into the credit crunch, or 15 months since rising subprime deliquencies hit the headlines, sub- or near-prime US mortgage securities (subprime ABS, ABS CDOs, Alt-A) are still causing the majority of losses for the investment banks.

After direct subprime, ABS CDOs and Alt-A, it is hard to think about another segment of the US mortgage market that will trigger losses of the same magnitude. Beyond mortgages, losses on leveraged loans and commercial real estate are manageable, and most banks have halved their exposure already. In short, the bulk of write-downs and capital increases for the investment banks is probably behind us. Does that apply to more traditional banks? Probably not.

There are two points here. First, the impact of fair value accounting. For investment banks holding mortgage-backed securities, fair value accounting requires valuing on the basis of observable market prices (ABX indices for instance), often depressed as used as hedges, leading to immediate recognition of losses. Contrast this with traditional banks with loans in their balance sheets, and for which accounting is held-to-maturity. Typically, the recognition of losses, for a loan that may be similar in performance and risk as a security, is slower.

The second point relates more to geography. Loan losses are increasing in the US in the consumer segments (credit cards and other consumer loans). In Europe this has been slower, but as economic growth forecasts are sharply revised downwards, in particular in the UK, Spain and Ireland, bad debt charges are starting to increase as well. The increase in specific provisions recorded in 1Q08 by Banesto and Bankinter, the only two European banks to have published their 1Q08 numbers so far are a good case in point.

Overall, the most exposed banks to a rise in consumer bad debt charges are retail banks in countries where household indebtedness and in particular mortgages have risen the most in recent years. In a descending order of concern, research I did with my former colleagues at Citigroup in June 2007 (“Hot Property”) showed the banks most at risk are in Ireland, Spain and the UK. In these countries, house prices have tripled over the past 10 years. Household indebtedness to GDP is close to 200% in Ireland, about 120-130% in Spain and the US. Household debt to income is about 5x in Spain and Ireland. So whilst the outlook for loan losses of the Irish and Spanish retail banks is likely to deteriorate, the worst is probably over for the investment banks. Investment banking may remain a difficult business for the next quarters, but the incremental news flow is likely to be less negative than for the Irish and Spanish retail banks. Year-to-date, the three European investment banks have underperformed the European banking sector by 10%, whilst the Irish banks underperformed by 3% and the Spanish banks have outperformed the sector by 4%.

2. Long Bradford & Bingley (BB/) and Alliance & Leicester (AL/) — short Bankinter and Sabadell

Although the above ranking points to higher risks from a hot property market for Spanish than UK banks, this long-short idea is not predicated on that. Rather, the rules governing the nature of collateral that central banks require to provide short term liquidity is central to the idea of going long Bradford & Bingley and Alliance & Leicester and short Bankinter and Sabadell at this stage. In the UK, the Bank of England does not yet lend short term against mortgage-backed securities, unlike the Fed or the ECB. Coupled with a weak business model to start with, this has proved fatal for Northern Rock. In 3Q07, this has triggered Bradford and Bingley to sell about 10% of its loan book (£4bn) at book to secure funding, whilst Alliance & Leicester pre-funded its liquidity requirements for 12 months through a £4bn loan from Credit Suisse. Asset sales mean lost revenues and external funding is costly, but his was the price to pay for the refusal of the Bank of England to lend again mortgage collateral.

Under pressure to relieve the banking system, the Bank of England is now also prepared to accept AA-rated and higher mortgage collateral, to the tune of £50bn. By contrast, the ECB has for long accepted mortgage-backed securities of the strongest quality (typically the large AAA-tranches) and the facility is unlimited in size. Also the haircut is only 2%, at a time when the repo desks of the investment banks have raised their haircuts for similar collateral to 5-10%.

So the smaller Spanish banks, which, similar to their UK peers, rely increasingly on securitisation for funding (all four have loan-to-deposit ratios above 150%, i.e. above the European average of 120%) have been able to obtain funding that their UK peers might gain limited access to in the coming weeks.

From here and as the expected move by the Bank of England suggests, there might be more pain to come from deleveraging for the shareholders of the smaller Spanish banks relative to the small UK banks, all the more given that Bank of England is lowering rates whilst the ECB remains unlikely to do so. Since the liquidity crisis in mid-August, Bankinter (down 20%) and Sabadell (down 14%) have outperformed their UK peers BB/ (down 57%) and AL/ (down 48%). It’s true the UK banks, unlike their Spanish peers, have suffered from structured credit write-downs. However even year-to-date, with structured credit exposures well documented and the expected move by the Bank of England, the performance gap remains; the Spanish banks are down 8% and up 1% versus down 32% and 13% for the two UK banks. Valuation-wise, the Spanish banks remain expensive, trading on P/Es (09E consensus) of 9.9x and 12.7x (above the European banking sector) versus 5.6x and 8.9x for the two UK banks.

3. Long Julius Baer — short EFG International (EFGI)

This third idea, consisting of a trade on two Swiss private banking groups can also be a play on the theme of deleveraging for the European banking sector. In the bull market years, both banks have re-leveraged; Julius Baer through the acquisition of the UBS assets in 2005 and EFGI through numerous acquisitions, which have also used the proceeds of the group IPO in 2005. However, there are differences. As part of the UBS assets, Julius Baer acquired GAM a fund of hedge funds. In last December, EFGI also acquired a business in the absolute return world, the acquisition of the hedge fund Marble Bar. As GAM with Julius Baer, it complements the group activities well, but is a different risk proposal than a fund of funds platform. Also, EFGI’s latest acquisitions –the group announced four within a month in last December- have further stretched the balance sheet to such a point, that without obtaining a special accounting treatment for the earn-out portion of its acquisitions, a capital increase would have been necessary. EFGI has also benefited from the increased leverage of its clients. Unlike other private banks, lombard loans made to clients (approx. 80% of total group loans) have contributed to the rise in AuM in recent years. This has largely stopped over 2H07, and was accompanied by weaker money inflows, but EFGI has yet to see its clients de-lever, which could have a double negative impact on AuM and revenues.

To some extent, these concerns have been voiced and EFGI trades at a 20% discount to Julius Baer on consensus 2009E EPS (year-to-date, EFGI underperforms Baer by 6%). Yet these concerns may grow further. Both Julius Baer and EFGI have announced new targets with their full year 2007 results. The market did not react to the conservative new targets of Julius Baer, but applauded the aggressive EFGI targets, reducing the performance gap between the two stocks to 5% in favour of Baer.

However, in the face of a challenging environment, EFGI’s targets, in terms of recruitment of new CROs (from 554 end 2007 to 675 end of this year and 1000 in 2010) and acquisitions (CHF 10-15bn this year), may be a stretch. There is a risk that either the targets will not be achieved or that current shareholders will be diluted before these are reached. After the positive reaction to the new targets, disappointment might be on its way, sooner (1Q08 business update?) rather than later. Julius Baer is a safer play, even more so in a challenging environment.

*Yann Goffinet was a banking analyst with Citigroup in London. Prior to that, he managed a global financials fund for Vontobel in Zurich.