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AT1: Banks suffer a fundamental sell-off

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It’s easy to blame technical factors and investors’ misunderstanding of the new AT1 market for February’s sharp sell-off across the bank sector, but investors may have a firm grasp of the fundamentals.

Canary Wharf camera-R-600
'It's easy to scoff and say that investors panicked and lost sight of the fundamentals'

What does the extraordinary sell-off in European bank equity, AT1s and CDS tell us about the health of the banks and what does it tell us about the health of financial markets?

It's almost easier to diagnose the markets. Credit markets, rates markets, markets in new capital instruments of banks and senior debt now subject to bail-in as well as equity markets are all alike becoming thinly-traded, as traditional market-makers reduce capital commitments. They are all becoming highly volatile and prone to price-gapping.

It's easy to scoff and say that investors panicked and lost sight of the fundamentals: that none of the major banks is even close to skipping an AT1 coupon or breaching an equity conversion trigger. They all have much sturdier equity cushions than in the first years after the financial crisis and better liquidity buffers too.

UBS still predicts eurozone growth of 1.6% this year and calculates that the region would have to fall into outright recession for NPLs to start rising so far as to turn banks loss making.

But while bank stocks rallied since late 2013 as the geared play on eurozone recovery, investors' faith in the investability of bank stocks has remained tenuous. Even with NPLs at record lows, banks still found ways to turn losses, owing to litigation charges, compensation for wrongdoing and restructuring costs.

Long-supported by low rates, quantitative easing and faith in central banks while they hoped for self-sustaining economic recovery to take hold, financial markets are now once again gripped by macro fears of slowing growth and even deflation. The prospect of an added tax from negative interest rates on bank profits and worries over rising NPLs spreading from the commodity and oil and gas sectors quickly persuaded investors to ditch these unloved stocks with their wretched returns on tangible equity.

Now, it remains to be seen how the feedback loops will work between stock markets, AT1, bail-inable bank senior debt and deposits.

Death spiral

We saw in February small markets in subordinated debt and AT1s exerting a multiplier effect as the transmitted investor anxiety between the larger equity and senior debt markets. As equity sold off and AT1s collapsed, investors looking to hedge bought protection in any market they could, including single name CDS on subordinated and senior debt, even though these wouldn't protect them against AT1 losses.

For a couple of days, it even felt like the tensions whipsawing along the capital structure might tip Deutsche Bank into some kind of death spiral.

While that anxiety fades, markets for bank paper are now re-pricing upwards, hitting banks' interest margins, further depressing profitability and in the process the allure to investors of the bank equity story.

The pessimists see this as just the latest in an unfolding horror show for the banks, suggesting that the investors with the firmest grip on the fundamentals are the ones that have got out already.

Analysts at Berenberg see banks struggling to cope with the unwind of a 60/70-year debt cycle, leading to weaker economic growth, interest rates lower for longer and European banks turning Japanese as they shift their balance-sheet mix toward low yielding public sector debt.

Forbearance and low policy rates have kept provisions low as banks squirm out from under the burden of misallocated private debt. But the best argument for buying bank equity today remains the same one that has been touted continually since the financial crisis: it is cheap. If the credit cycle is now turning - led by commodities, oil and gas and emerging markets - and credit costs rise from here, there may be no need to rush back in and grab a bargain.