European Banks: Value Play or Value Trap? Check out this chart of Deutsche Bank. As you can tell, no one can actually figure out what the price should be. For while there it looked like it was going to zero, but now in the past month the stock is rallying at some 25 percent. But, I mean, the long-term chart does not look great. What's going on here? Could there be a case for buying European banks at this point? Well, that's exactly what we're going to talk about on this week's episode of Real Visions, The One Thing. What's going on investors? AK here. So last week Real Vision took a look at the European banking system. There's a lot to talk about here considering the slow moving European politics, the ECB's not so effective monetary policy and then of course, the fractured banking system. Now I've already mentioned Deutsche Bank share price but that's not the whole story because most of these banks debt far outweigh their market caps. Deutsche Bank, for example, has almost 16.5 billion worth of equity compared to 611 billion worth of debt. Let's start with Thomas Meyer explaining what the core problem is. First of all, we have a sluggish economic performance. Compare the US growths to the European growths, we are less dynamic. That's always a problem. Secondly, we have a fragmented banking market. The idea initially was once we created the Euro, Europe Area banking market would consolidate. It hasn't. There are too many banks around. We have seen very little, hardly any cross-border consolidation. So they are basically eating each other up. Third point, we have already for years here in Germany a very flat yield curve. The banks rely on what they call their interest rate margin. I call it senior reach for money creation. So you basically use your credit, charge the creditor and put it on deposit and don't give any interest to the depositor. The banks call it interest margin. If the yield curve is flat, gone. All right. So slow growth combined with a fractured banking system and a flat yield curve. It's all in the context of a low equity flow versus debt which makes a company's share price way more volatile. So what are you supposed to do as an investor? Could this possibly be value plays at this point? Whitney Tilson, a value investor and former hedge fund manager had this to say. Well, generally banks, particularly investment banks which have big derivative books. Because I think you have to differentiate between just your standard retail banking franchises versus investment banks like a Deutsche Bank or something. Generally speaking, they make me nervous. Insurance companies I'd throw in there as well in that there's black swan risk out there because there's leverage and because they have big either derivative books or loan books where it's very difficult to often, they're sort of black boxes. So you don't know what's in there. So you just have to have a lot of confidence in management generally which is why Berkshire Hathaway certainly is something I felt comfortable owning just because I've studied Buffett and Munger so closely and understand their fundamental conservatism. But there aren't very many other financials. I mean, the financial sector, the history of financials is just littered with boom and bust and management teams that are out there trying to deliver steady earnings growth in a sector that often doesn't lend itself to that. Okay, so an American investor is scared of the big risks of Deutsche Bank's balance sheets especially in an industry where it's difficult to deliver steady earnings growth. Tilson doesn't think the risk is worth the reward. But what do European investors think? Well, here's Philipp Vorndran with his opinion. Why is it that you've decided to take a hard pass on the banking sector? Yeah, the decision was taken in 2007 when the first real informations that the mortgage crisis could be more relevant appear to us, we looked into some of the German banks and realized there are some special purpose vehicles. Nobody could give us a clear information what the value of them was. Both the risk involved was we had the feeling the CFOs of the banks had no clue about what was going on and then we made a very easy decision. If you don't understand the corporation, if you don't have a sound feeling for the quality and the profitability of a business model, then we can't justify investments like that to our clients. So a successful German investment firm has stayed far away from these European banks because they don't think management actually understand the deep problems that they're in. But it doesn't just stop at management problems. Simon White from Variant Perception explains that a secular change in interest rates or inflation expectations could destroy the whole industry. I think banks they are going to struggle because of this tail risk essentially shifting because in the last 30 or 40 years, you could basically be relying on the fact that although rates might go higher, the general trend was lower. We just had a series of lower lows. In an environment where the tail risks shift to higher inflation, the risk is always going to be, we're going to have burst higher in shorter term rates. That, I think, makes the pipe business model extremely difficult because not only is it difficult for them, as I say they're borrowing short term assets, essentially they're borrowing them at shorter term period and lending longer-term. They also provide leverage to other people and if there's less demand for leverage they are really unable to provide that in the same way that they would like to. So the whole last 30 or 40 years, if you like the dominating times of banking, will be very difficult under those circumstances. So it's really not about what instantly happens as I don't think it instantly get higher inflation or instantly see short-term rates rise but the risk profile will change and that will really challenge that business model. So White sees some existential threats on the horizon for the European banks. Whether you believe him or Vorndran, Europe is in for an interesting future. Andreas Steno sums it up by explaining how the ECB is in between a rock and a hard place with the banks and exporters. He says that the ECB may have to choose one to save but in doing that, they're probably going to have to let the other one fail. The ECB has a choice but what's really the end game here? Well, Andreas has an idea for that and how to play it too. It could be an issue for the European banks but I would expect European banks to struggle more due to the flat yield cut in Europe basically. I would have said after these would-be meeting yesterday that it was success if they managed to steepen the yield curve. They did not. Actually the opposite happened. They flattened it due to a very very poorly designed tiering system in my view. So I actually they only did matters worse for the European banks. The struggles will continue in my view, given that the yield curve did nothing but flattening yesterday. The tiering. What was the tiering they announced? How is that going to work for these banks? Well, they announced an exemption for all banks in the Euro zone six times their marginal reserve requirement. So that's basically the bottom that a bank needs to hold at the ECB. So six times that amount will be exempted from the negative deposit rate at the ECB. The issue is that all of the deposits they are packed in German, French, Dutch and Finnish banks. So when Italian banks are exempted six times their marginal reserve requirements, they basically allow the Italian banks to place all of their excess liquidity at zero at the ECB because they don't have a lot of excess liquidity and that could lead to a spike in [inaudible] in southern Europe. So maybe there is actually a risk of an unintentional tightening of financial conditions in Southern Europe due to this tiering system. One size doesn't fit all. My base case is that we will get a rebound in the global economy by April next year. So before that, we're going south still. I have a base case of a cell open equity markets in Q4. For some reason, it's always in Q4. I think the withdrawal of dollar liquidity due to the US Treasury building up its [inaudible] again will be the trigger of that sell off. So a dollar liquidity removal will be bad news for risk appetite in general. So therefore, my base case is to just stay long at safe haven assets for the next four or five months. Then that could be the trigger of that self QE4. Maybe it's too early to expect it by late this year but maybe in Q1 next year, after we've seen this risk of environment. Then the Fed could inject liquidity again and maybe we are back to Hallelujah at least for some time maybe. So he thinks that were in for a equity sell-off in Q4 because of a dollar swing, and then the central bank will respond with more easing which will send equities higher once again. So over the next six months he sees safe haven assets like treasuries or precious metals outperform but as soon as the central banks start QE up again, it should be time to get back into equity. Whichever way you want to play, make sure you hang out with us at Real Vision. I'll talk to you next week. Let's play a game. I'm going to read out three sentences, you've to get to what they have in common. All right? Here we go. 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