Crispin Odey, founder of London-based Odey Asset Management, says there is no economic reason for investors to own European banks, including those in Britain. It is a broken banking system that is at the heart of Europe's financial crisis, not sovereign debt, he says on a recent visit to Hong Kong.
AI: You are famous in the UK for successfully shorting Bear Stearns. What are you short now?
Our fund was net long in 2011. I went short European banks in the first quarter, along with tech losers such as Nokia. Europe looks more like Japan. Its credit cycle is broken. It will only get these brief inventory cycles. Once you break the credit system, equity becomes unpopular. Banks want their money back, so shareholders are forced into rights issues. Profits are retained rather than distributed or reinvested.
What does that imply for Europe's ability to help the world grow out of its present problems?
I’m extremely pessimistic about Europe’s chances of growing its economy. They haven’t solved the credit crunch, irrespective of the sovereign-default risk. The problem is Europe’s banks. Less than 50% of the loan book is backed by deposits. It’s backed by other things such as convertible bonds, notes or interbank loans. That kind of money doesn’t get out of bed for less than 3%, and on average, banks have been paying out 5% to this funding base.
The average funding costs for European banks is 2.5-2.9%. So the interest rates they charge never go below 2.5%. We need the economy to adjust to credit shrinkage and inflation, which means cramming down that bank lending rate to 1%. But the banks cannot lower interest rates because their financing is too expensive. The alternative is to boost their deposit base, and that isn’t happening. So we’re left with the ECB printing money in the form of the LTRO in order to provide banks with liquidity.
Hasn't the ECB's long-term refinancing operation (LTRO) helped ease the liquidity crunch in Europe's banking system?
Banks have a €25 trillion asset base, but only half is backed by deposits and half is backed by the expensive interbank lending market. The LTRO so far has involved €1.1 trillion. It’s nothing, really.
The first problem is that the LTRO is nowhere near enough to make a difference. The second problem is collateral. For that €1.1 trillion in LTRO financing, the European Central Bank demands €2.2 trillion worth of high-grade collateral. This further reduces banks’ lending base. So they are borrowing at 2.9%, lending at 4.1-4.3%, and enjoy a net interest margin of only 1.3-1.4%.
On top of this, banks have to pay around 1% of their balance sheet in commissions. That means they have revenue of 2.4% but costs of 1.7%. European banks are making 70 basis points of pre-provision operating profits.
But they have NPLs that cost them around 100bp, in reality. They make losses, but they hide these. They show only 50bp in provisions; the rest isn’t provided for. This lets banks show a 20bp return on equity, which is not only crap, but it is also false. Under Basel II they need to reserve 9% of tier-1 capital. Add it together and there is no business case to own a European bank.
What about banks in the UK?
Sadly the UK has the same problem. From about 2000 onwards, UK banks became European. They lent well in excess of their deposit base. Northern Rock was the poster child, but look at Lloyds: its borrowing cost is 2.5%, not the 60bp it pays depositors. But its non-deposit funding is around 30% of its balance sheet.
It is mortgage lending that’s gotten UK banks into trouble. On day one of the financial crisis, banks were forced to re-price their assets, including mortgages. Finance became seven times more expensive but most of the mortgage book pays only 50bp over Libor on a 25-year basis. This is a legacy issue, and it’s horrible. UK banks are on average borrowing 2.5% for mortgage books paying Libor plus 50bp. They’re just losing money.
What's your take on banks in the US?
The US is different. There, 70% of bank loans are in government hands, via Freddie Mac and Fannie Mae. Housing prices have fallen by around 70%. Rents in America are only about 15% of household disposable income, not 30% like in Europe.
In the US, for the likes of Wells Fargo and JP Morgan, the loan book is 66-80% of the deposit base, not 150% like in Europe, and interest paid to depositors is only 0.5%. Wells has a net interest margin of over 400%, not 110%. These banks are very profitable, and JP Morgan can easily write off its trading loss.