New York | Watching the related financial dramas of China’s HNA Group and Germany’s Deutsche Bank AG (DB), we are reminded of Timothy Dickinson, who reminded us that the image of purposeful design and order imposed from above by experts and regulators is largely an illusion. The world is filled with ill-considered people and strategies, and no realm more than the intersection of public policy and corporate governance.
The Federal Open Market Committee is raising short-term interest rates as though it matters, yet in fact Fed policy remains relatively easy in terms of the cost of credit -- the duration. The problem comes because of the scarcity of assets, one reason why high-yield credit spreads have been tightening even as short term funding rates have risen. And the fat part of the Fed’s passive portfolio runoff is in the mid-2020s and thereafter. The chart below shows "AAA," "BBB" and high yield bond spreads.
Of course, everybody is so excited by the move of the 10 year Treasury bond to a three percent yield. The move of the short end has been even more pronounced, however, one reason why so many banks are reporting shrinkage in net margins even as shareholder payouts of capital surge. The FRED chart below shows Federal funds, Treasury 2s and 10s. Imagine Fed funds at 2% and Treasury 10s still shy of 3.5 percent yields. The alarm bells in Washington will be ringing.
As we note in an upcoming conversation with Dennis Santiago, banks are constrained by the dual impact of restrictions on lending due to regulation and a dearth of duration due to the Fed, ECB, BOJ and “quantitative easing.” In an already difficult market environment, the less well managed institutions get into trouble more readily. We’ve already described the comic behavior of HNA in previous comments, but needless to say there is always more grist for the mill.
Most recently, Lucy Hornby in Beijing and Hudson Lockett of the Financial Times described some of the structural aspects of the HNA investment in DB, including a suggestion of a rather complex leverage structure above the investment in the bank. “The sharp fall in the bank’s share price has forced HNA either to sell part of its stake, or pay cash to cover a derivatives arrangement that was used to acquire the shares,” they report.
Although it is very common for financial investors to apply leverage high up the capital stack, bank regulators tend to frown on double leverage – especially when it is not adequately disclosed. Double digit ownership of voting shares certainly is a threshold most competent regulators set as requiring active assent for any bank investment.
Ultimately, diligent bank regulators generally need to know who is investing in a bank in a significant way. And a key requirement in that approval process is the ability to be a stable investor and potentially a source of strength to the bank should more capital be required.
Readers of The IRA will recall that DB searched for years and in vain for a new shareholder prior to the arrival of HNA. When the shadowy Chinese group started to accumulate DB shares in February 2017, the situation at the bank was grave – and had been for years.
The board and management of DB has been unable to articulate a strategy for the business going back a decade. While much attention has been focused on the procession of CEOs that have moved through the DB CSUITE, the blame ultimately rests with the board and chairman Paul Achleitner. Like most supervisory bodies in Europe, the board of DB has proven remarkably inert in recent years, basically a reflection of the lax governance of banks more generally in the EU.
For example, the FT reported on April 19, 2018, “Deutsche Bank, HNA, and the GAR chase” that their investigation into the provenance of the HNA investment in DB suggests the possibility “of an additional undisclosed shareholder behind one of the HNA entities.” This is a remarkable revelation (kudos to Cynthia O'Murchu and Robert Smith at FT), yet note that prudential regulators on both sides of the Atlantic have taken no action – at least in public – for fear or toppling over the sagging Deutsche Bank.
Normally when you hide the identity of the beneficial owner of a US bank, the primary regulator begins an enforcement action and sends out cheery referrals to the US Attorney and other law enforcement agencies. The parties involved start thinking about jail time.
Yet in the strange case of DB and HNA, exactly nothing is happening. The regulatory community has been caught completely off base over the past year and more, but can do nothing for fear of ragin contagion. Indeed, the festering mess at DB shows that “took big to fail” is alive and well and global regulators are powerless.
The key issue for investors is to understand that precisely no one is in charge when it comes to the twin systemic risks posed by DB and HNA. If as seems likely HNA is forced to unwind its leveraged investment in DB, then the German bank will be worse off than before. DB will have wasted more than a year engaged with a surreal investor who has disappeared into the mist like a character in a bad Chinese martial arts film. Who then will step forward to rescue DB?
After a $50 billion deal spree, much of it fueled with leverage, HNA has cut a wide swath of value destruction through the world of banking, aviation, lodging, real estate and other sectors. Just how did HNA get the approval of EU regulators for this investment? Nobody knows and nobody is talking. But the aftermath of this celebration of global incompetence could create significant dangers for the financial markets.
When the government of New Zealand shot-down an HNA Group investment in a bank, this provided an indication of big problems. The Overseas Investment Office (OIO) blocked an attempt by China’s HNA Group to buy a vehicle finance firm in part due to doubts about the debt-saddled conglomerate’s financial stability, Reuters reports. The OIO apparently disliked the HNA practice of pledging equity investments in group companies as collateral on loans.
“The information provided about ownership and control interests was not sufficient or adequate for the OIO to determine who the relevant overseas persons are for [HNA’s] application to acquire UDC,” said Lisa Barrett, the office’s deputy chief executive for policy and overseas investment. “We were therefore not satisfied that the investor test in section 18 of the Overseas Investment Act 2005 was met.”
Were US regulators consulted or even aware of the HNA share purchases in DB last year? DB operates a mostly securities business in the US, but the German bank does have a $55 billion trust company in New York. Deutsche Bank Trust Corporation is regulated by the Fed and the State of New York, and is a significant player in the market for commercial mortgage backed securities (CMBS).
Of note, one possible permutation of the DB saga back in Germany is the sale of the US banking business. JP Morgan weighed in on the DB debate several weeks back with the publication of a research report for clients that said Deutsche should shrink its U.S. business “to create shareholder value.” But since German Chancellor Angela Merkel threw the German bank under the bus several years ago, the remaining value of DB is questionable.
Reports that former Merrill Lynch CEO John Thain is being nominated to the supervisory board of DB is certainly good news. Thain is a veteran operator, but sadly he is not CEO. More than anything else, DB needs to tell investors and regulators why this bank should continue to exist. If in fact DB moves forward with the sale of its US unit, then the entire business could be in play.
But should the bank stumble in a way that surprises Europe’s distracted politicians, look for a very hastily planned merger. Our candidate for the first zombie merger of the 21st Century: DB plus Citigroup (C). Neither bank has a particularly strong domestic banking business or funding base, but there are some interesting asymmetries. Financially it would be a disaster for shareholders, but politically it makes all the sense in the world -- especially if you are Angela Merkel or Donald Trump.
