In our latest corporate bond market outlook, Co-Head of Research Nick Elfner gives his expectations for corporates after a volatile year.
Hello this is Natalie Baker, vice president of Marketing here at Breckinridge and welcome to our special edition Breckinridge podcast. Today, I am joined by Nick Elfner, head of our corporate credit team here at Breckinridge. Nick is also a member of our Investment Committee. Today we will be discussing potential regulatory changes to the Dodd-Frank Act in our podcast, “Is a Dodd-Frank Rollback Good or Bad for Bondholders?” So Nick, what exactly happened this weekend?
Well as you know, the Patriots won their fifth Super Bowl so that was exciting and the Wall Street Journal, Barron's, Bloomberg and other financial journals wrote about the possibility of a Dodd-Frank rewrite or repeal which would impact how the U.S. banking sector is regulated.
So President Trump has described the Dodd-Frank law as a disaster and signed an executive order to potentially roll it back. What is the law and what is President Trump taking issue with?
So the Dodd-Frank act was passed by the U.S. Congress and signed into federal law in July 2010. It represented a major overhaul of the U.S. financial regulatory system. Among the Volcker Rule and other regulations, the act sets standards for moving bank capital requirements higher, reducing proprietary trading activities and strengthening governance. The president and other critics contend that the act has made it harder to get credit, slowed loan growth and by extension the economy.
Well you mention the Volcker Rule. What exactly is that?
The Volcker Rule is part of the act that limited U.S. depository institutions from engaging in certain types of trading and investing activities. Restrictions were placed on proprietary trading and investing in hedge funds and private equity funds. However, full implementation of the Volcker Rule did not take place until July of 2015 after several years of lawsuits and challenges from big banks and other parties.
What has come out of the law since it was put in place?
So large U.S. banks have shuttered proprietary trading desks and have fought implementation of the Volcker Rule over concerns that it would negatively impact capital markets activities, including principal transactions. In reality, U.S. banks still make fairly good returns in their trading operations. Another outcome has been a material reduction in illiquid so-called Level III assets for the industry which proved to be a big problem during the financial crisis. So balance sheets are far more liquid today than they were at that time.
Okay. So what could dismantling the Dodd-Frank act or parts of it mean for investment grade bondholders in the banking sector?
Well in the short term, there could be some benefits to overhauling the act as it may support near-term earnings results for some U.S. banks. In recent years, banks have hired thousands of compliance and risk managers who have added to headcount costs. Some of these positions could be redundant. A rollback may also permit banks to reduce capital which would improve still subpar ROEs. However, over the longer term, a more lightly regulated U.S. banking system would increase credit risk for bank unsecured bondholders by enabling big banks to take greater trading and lending risks and through re-leveraging their balance sheets. History shows us that weak or declining bank capital ratios lead to increase in bank failures over time.
Okay, so it sounds like there is some time horizon issues here and there are similarities to short-termism in other parts of the corporate market.
Yes, I would agree with that. It is also symptomatic of where we are in the credit cycle. After repairing their balance sheets in the immediate aftermath of the great recession, industrial companies have reduced their equity cushion in favor of debt leverage over the last few years. Credit risk is increased along with shareholder rewards and long-term capital expenditures have languished. U.S. banks have really been in balance sheet repair mode since the financial crisis ended and regulators have only begrudgingly allowed increases in shareholder rewards, but rewards are still a fraction of industrial company peers. Now that capital is high, banks may have more inclination to return cash to shareholders at the expense of long-term capital strength.
How have bank credit spreads reacted thus far to the news?
So bank credit spreads are about five basis points tighter since the news broke with the president's executive order to the Treasury. U.S. money center bank stocks rose and credit spreads tightened on the news as market participants priced in higher future earnings and shareholder enhancements on prospects of deregulation.
Okay, but even looking before this announcement financial spreads had been tightening since the election, is that right?
Yes, that is correct. IG financial spreads are about 10 basis points tighter since the election. The prospect of deregulation and higher interest rates has supported bank spreads.
Looking at the sector, what did bank earnings look like and do we think the sector is still in good shape?
So the big U.S. banks reported good Q4 earnings to generally beat expectations. Solid capital markets revenues, good loan growth, improved credit quality and expense discipline supported these results. We did see a slowdown in mortgage banking and that weighed on some larger mortgage lenders. Banks do stand to benefit should interest rates continue to rise from lending activities. Overall, we have a stable outlook for the U.S. banks sector with strong capital liquidity and asset quality indicators, partially offset by volatile earnings, mixed government trends and as we have talked about, some rising shareholder rewards.
Let me just recount some recent comments from Gary Cohn, former Goldman exec and director of the White House National Economic Council, “European banks are at mid- to low single digit tier 1 capital, while the U.S. banks are at double digit tier 1 capital, and we are trying to compete with them. If we all conform to the Basel Capital Rules and we all had the same amount of capital, it would be a much more level playing field which would be really good for the U.S. banks.” Okay, what should we, as bond investors, make of this sort of posture? Is this credit positive or credit negative to have some rollback in regulations given that there is some risk that capital ratios are not as high?
So first of all, the relative capital strength of the big U.S. banks versus global peers is a key positive differentiator. High capital ratios have enabled U.S. banks to utilize balance sheet and gain market share in trading and investment banking activities, mostly at the expense of big European banks over the last few years. Dealer and trading counterparties also care about high capital strength, liquidity and credit ratings. And U.S. banks, despite these thicker capital cushions are also still more profitable than the European counterparts. Now you asked if rolling back regulation would be credit positive or negative if it resulted in lower capital ratios. If that is the case, it would be a credit negative. As I said, history shows us that weak or declining bank capital tends to lead to failures over time.
Let’s go back to some of the specifics in the executive order. What about the fiduciary rule that is also discussed in the order? What is it, and what would it mean to postpone that rule?
So the Department of Labor fiduciary rule is a ruling that is scheduled to be phased-in on April 10, 2017, that expands the investment advice fiduciary definition under the Employee Retirement Income Security Act of 1974 or ERISA. However, last Friday, President Trump signed an executive order delaying the rule’s implementation by 180 days. Postponing the new rule would potentially delay implementation at some brokerage firms. However, others are more likely to move forward given costs already incurred, and assuming an eventual phase-in. This is essentially the experience with delays and implementation of the Volcker Rule.
Okay, well let’s round up with one last question here. What is Breckinridge's perspective on all of this?
Well cutting down Dodd-Frank may support near-term earnings results for some U.S. banks. However, over the longer-term, a more lightly regulated U.S. banking system would increase credit risk for bank unsecured bondholders. Higher minimum capital requirements for large banks are meant to increase credit worthiness and safety and soundness. Clearly, the U.S. banks are operating from a position of strength in terms of capital but regulators and leaders in the industry should remember what a combination of excessive leverage and weak regulatory oversight can do. Since the global financial crisis, U.S. bank management teams have worked hard to rebuild their financial, political, and human capital and make reparations for the loss of public trust in large financial institutions. We should be cautious in undoing robust regulatory frameworks that have compelled improvements in bank credit profiles and spurred U.S. banks to be a source of stability for the United States economy.
All right, thanks so much, Nick. We hope that you in the field have found this informative and please also see our companion blog post that is located on our website under the same title, “Is a Dodd-Frank Rollback Good or Bad for Bank Bondholders?” Thank you for listening and have a great day.
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