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Wednesday, 21 December 2011

Putting the thermometer in the banks (4); on austerity measures and a new found love for Mortgage Backed Securities at the Dutch banks

In this continuing series, I bring the latest news on the (Dutch) banks. ´

The Basel III policy for banks, with its strict demands for Core Tier 1 equity of (system) banks and its outrageous liquidity rule, forcing banks to be able to endure a 30 day liquidity shock, makes the current earnings models of banks obsolete. To summarize the two most radical measures of Basel III:
·    Capital rule: The Core Tier One equity, consisting of stock equity and state guarantees, should be at least 4.5% + 2.5% buffer capital, totaling it to 7% of (risk-bearing) assets
o    However, (global) system banks must have an additional capital ratio of up to 3% of risk bearing assets, totaling the capital ratio to 9-10%
·    Liquidity rule: A bank should keep enough cash at hand to withstand a system-wide liquidity shock of 30 days ( I presume that this excludes a bank run)

The first rule means that a lot of capital (shareholder capital and reserves) of the bank is locked in equity and can´t be used for investments, thus making the return on investment much smaller.

The second rule means that a bank must keep a gargantuous amount of cash to withstand a liquidity shock of 30 days, wherein (for instance) 20% of savings is withdrawn from the bank. In case of f.i. ING Groep N.V. (ING) this 20% cash buffer means that €91.6 bln needs to be kept in cash, as savers have brought in €458 bln in savings’ money!

Both measures make it virtually impossible to earn more than 3%-5% return on equity. A complicating factor on top of these rules is that banks currently show a wide distrust in other banks and store their excess money rather at the ECB than at other banks, although this would yield much higher interest rates.

As issuing new shares is a dead end-road currently for gaining more equity capital, the only solutions for banks are:

Today, the Dutch financial newspaper Het Financieele Dagblad  ( wrote two stories on the Dutch banks. Both have – how surprising – to do with cutting expenses and gaining extra yields on investments.

ABN Amro NV investigates the present options to make its salary costs more flexible. One of the scenario’s of the bank is to let the salary costs ‘breath’ in synch with the results of the bank.

Now the variable part of the salary for all 23,000 employees is totally dependent on the way that the individual and his department operated. The variable part is maximum 9% of the annual salary. When the salary breaths in synch with the bank, it means that the variable part can be higher in good times and lower in worse times.

The scenario’s of this system bank are not unique. In the whole financial industry pressure grows on salary costs, now financial institutions suffer from market fluctuations and stricter regulation. A more flexible salary can reduce the number of lay-offs and might stimulate customer-oriented operations.

SNS Reaal’s CEO Ronald Latenstein stated earlier that he wanted to downsize the salary construct of the bank-insurer¸as the remuneration is currently too generous. The expectation is that also Rabobank and ING move in synch with ABN Amro when encountering future salary issues.

The glory days of the big bonuses and the big variable rewards seem to be over in The Netherlands; this in itself is a good development. The banks cannot yield 10%-15% Return On Investment (ROI) anymore, as Basel III makes this virtually impossible. Paying more conservative salaries attracts more conservative employees. People that take less risk while doing business. And please don’t feel sorry for bank employees. Even with a modest salary, the perks of a bank job (discount on mortgage, higher interest, a pension totally paid for by the banks) are still unrivalled in any other industry.

Not every bank, however, sees the truth in these words. Some banks try to gain extra yields on investments by either starting up opaque trades again or by doing riskier business. And therefore we can see the return of an ‘old friend with whom we share an interesting past’: the Mortgage Backed Security. The FD writes on this story:

A type of financing that is crucial for Dutch banks, but ran almost totally dry during the credit crisis, might get another shot at the target. European banks and insurers joint forces to reintroduce this type of financing: the Mortgage Backed Security (MBS).

In this form of securitization, mortgages are gathered in so-called bundles (or vintages) with a certain risk profile and sold to investors. This is especially important for Dutch banks, as the totalized mortgage debt in The Netherlands is extremely high. The available savings at the banks are nowhere near enough to cover this stockpile of loans.

The European umbrella organizations AFME and EFR investigated the idea of having central quality demands for securitizations. These should regain the trust of the investor. Even more important is that supervisors treat the securitizations with a ‘quality stamp’ more favorable than currently. Now the new rules (Basel III) make it unattractive for insurers to invest in MBS’s

To these two organizations the signals from the banks and supervisors are positive enough to continue the project, they decided shortly. Deployment of approved securitizations will happen during the next half year.

Dutch bankers were always hesitant towards the European initiative. They were afraid that the established quality demands for mortgages would exclude the very common Jumbo mortgages in The Netherlands, where loans exceed 120% of the purchase value of the house. This would bring the banks no advantages. The deal is set, however, that the quality demands may vary between countries.

It is hard to be not cynical on these kinds of ridiculous ideas. Everybody with a bigger memory than a slug remembers that this kind of Mortgage Backed Securities started this whole credit crisis to begin with.

And my regular readers know by heart that the Dutch housing market is one giant bubble that is now slowly deflating; a process that might gain much speed in the recession/depression year of 2012.

Everybody that buys those MBS´s is slightly eccentric and people that buy an MBS based on Dutch Jumbo´s are totally out of their minds. The only thing that will help the Dutch housing and mortgage market is plain debt destruction. This can happen in two ways:

Also banks should be forced to write off on their stock of Residential Real Estate (RRE), as many banks still keep their housing stock against a book value that widely exceeds the current (and future) market value.

But this is The Netherlands were the banks, the homeowners association, the realtors and the government kick the can down the road for eternity, hoping to avoid the inevitable deflation of the RRE market. Considering this, I would not blink if the MBS makes a ´happy revival’ again in The Netherlands and the Dutch fairytale goes on and on.

  • People must be forced by law to pay redemption on their mortgage again, instead of keeping the principal amount forever.
  • Banks must write off on all mortgages where the houseowner is heavily ´under water´ and more than three or four months in arrears.

  • Cutting expenses to a level far below ´discomforting´.
  • Taking more risk again to generate higher yields on investments.

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