Macro Wrap-Up

Feels So Good Being Bad

Topics - Macroeconomics

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Feels So Good Being Bad

There is an almost universal belief that banking crises can damage economies for years if they are not addressed properly. The simple reason is that ailing banks can’t lend adequately, and this hampers liquidity, investment, and spending. When faced with a group of ailing banks, conventional measures such as lowering interest rates are often inadequate. If multiple large banks become insolvent, regulators often see the need for the government to recapitalize them to prevent financial contagion and more severe consequences. This can be very expensive and politically unpopular. There are always concerns that bank assets can be so toxic that the costs of righting them are prohibitive. Even large bailouts may not be enough to stabilize the banks if private creditors think that legacy assets will continue to haunt them. They will always fear further losses and be reluctant to fund banks. 1 1 Close One can recall the cliché, “no one wants to throw good money after bad.” That is why we have seen the emergence of so-called “bad banks.” Bad banks have been around almost as long as the mortgage loan but came into prominence during the Global Financial Crisis and gained more fame during the European Sovereign Debt Crisis. Many economists believe that they were a successful part of the efforts to get the financial system functioning again.

“Bad bank” is a misleading term. 2 2 Close Sit, roll over, shake hands. No. Bad bank. Stay away from those sub-prime mortgages. Bad Bank. BAD BANK. No treats for you. It sounds harsh, though if you listen to certain politicians, you’d think it was tautological. They’d probably tell you that all banks are bad banks. In fact, “bad bank” does not make a moral judgement, but rather refers to a specific tool used during restructuring processes. Here’s how a bad bank works: first a troubled bank splits into two units. It holds on to what it considers to be quality assets in an entity that usually retains the bank’s original name. Then it puts its impaired assets into another entity, which is known as the bad bank. The “bad” refers to the assets this entity holds. 3 3 Close Sometimes this entity remains part of the bank but they are “ringfenced,” meaning separated from the other assets. This distinction is not always made.

The purpose of a bad bank is to allow the institution to make a clean break from past troubles. The bank can sell its bad assets and be left lean, healthy and ready to lend to all of those great projects in the economy. Now this raises the question of who would want to buy the assets in a bad bank. The name “bad bank” would seem to be poor marketing. However, many so-called bad assets still have some value, and there are plenty of funds that specialize in buying such distressed assets. For example, a portfolio of bank loans, half of which are in arrears, would be considered a very bad portfolio. The remaining half, however, could be paid in full and make the portfolio very desirable at the right price. Another portfolio might be impaired but have some recovery value on the collateral on its loans. It’s rare that the assets are so worthless that they have to be wound down.

It may seem that a bad bank is too good to be true. 4 4 Close Why can’t I create a bad bank and put my mobile phone bill in it? The previously insolvent bank can sell its worst assets for real money and suddenly become a healthy institution. Unfortunately, it’s not that simple. While a bank may be able get some compensation for its assets, it is usually less than the value the assets had on the balance sheet prior to the restructuring. This means that the banks must make write-downs and take losses when they create the bad bank. Some banks have enough capital to withstand write-downs, but not all do. If the losses exceed the amount of capital a bank can raise, it will have to seek bankruptcy protection or be rescued. That is why the government often chooses to step in to recapitalize the banks. Sadly, the bad bank solution doesn’t suddenly make the bank solvent. It is helpful because it isolates the problem and creates a path forward without lingering doubts. But, like pulling out a splinter, it is painful in the short run. 5 5 Close A splinter maybe understates it. Maybe it’s more like a heart transplant.

Bad banks may seem trivial to investors right now. Despite some isolated issues, credit hasn’t been a source of stress in developed markets in the past few years. That doesn’t mean we’ve solved the problem of leverage and bad loans. While the financial system may be more sound than it was twelve years ago, the issue of how to deal with troubled banks persists. There is no global consensus on who should bear the expense. Bondholders were generally spared during the last big set of bank restructurings, but many people think they should take some of the losses. As a result, we’re starting to see more private participation in European bank restructurings. More importantly, public bailouts were so unpopular that it’s not clear if policymakers will have the ability to recapitalize insolvent banks.

For investors, the willingness and ability of policymakers to react could become very important in determining international capital allocation in the future, almost as important as the financial soundness of the countries. A country with an okay banking system and strong resolution plans and a solid legal system is probably preferable to one whose banks are slightly better capitalized but will be caught off guard if that capital doesn’t hold up. Bad banks and other mechanisms are part of a good plan, but it really comes down to resolve. The countries that acknowledged their problems early and acted decisively tended to recover more quickly out of the last crisis than those that waited to act. It will probably be similar in the next one.

What We Are Watching

U.K. Employment Report (Tuesday)
Despite continued uncertainty around the outlook for Brexit, the labor market has remained a bright spot in the U.K. economy. The unemployment rate, at 3.8%, is at its lowest in over 40 years and wage growth has been trending higher for five years. 6 6 Close U.K. Office for National Statistics. More recently, wage inflation surprised to the upside in the June release, supported by strong gains in public sector pay while private sector compensation growth remained steady. Job growth has averaged around 100,000 per month in the past twelve months, slightly above its 10-year average. 7 7 Close AQR, U.K. Office for National Statistics. With U.K. business investment in decline and growth slowing down globally, domestic labor market strength has been a key positive factor in the BoE’s outlook. Next week’s report will provide an update on whether this continues to be the case.

Germany ZEW Survey (Tuesday)
Since 2018, Germany has seen its economic momentum slow. GDP growth has slowed from a high of 2.8% YoY at the end of 2017 to 0.7% YoY as of the end of the first quarter of 2019. 8 8 Close German Federal Statistical Office. Looking at Germany’s PMIs, a stark divergence has occurred between its manufacturing and services sectors. The latest reading from the June survey of Germany’s Manufacturing PMI was 45.0, well below the breakeven 50 level, while Germany’s Services PMI was 55.8, well above the breakeven 50 level. 9 9 Close Markit. Because Germany’s economy relies meaningfully on manufacturing and exports, this divergence has been cause for concern. Weakness in the auto industry, increased odds of a no-deal Brexit scenario, increased tensions in the Middle East and ongoing uncertainties in global trade have all been cited as reasons for weaker German growth. This week’s ZEW survey data, which polls around 350 economists and analysts on the current situation and future expectations of the Germany economy, will be closely watched to see if the consensus believes these headwinds have worsened. A downside surprise to either the current situation or more forward-looking expectations component could further support market pricing for additional easing from the European Central Bank.

U.S. Retail Sales & Industrial Production (Tuesday)
U.S. economic data has shown a divergence between consumers and businesses, with the consumer faring better. This week, both retail sales and industrial production data will provide further insight into this trend. U.S. retail sales have held up well, increasing 2.9% YoY as of the May 2019 release. 10 10 Close U.S. Census Bureau. Supporting evidence of a resilient consumer is seen in healthier consumer balance sheets, the strong labor market and surveys on consumer confidence and sentiment that have fallen slightly, but remain near their cycle highs. Evidence of concerns for businesses have been seen in the slowing pace of Manufacturing and Services PMI survey data and durable goods data. This week’s industrial production data will serve as the latest read on this trend. A downside surprise in either the retail sales or industrial production data could lead to further concerns around slowing growth in the U.S. and the potential for further easing of monetary policy.

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