ECB Financial Stability Review
Point Break - November 2022 Report - Our Takeaways
"Johnny has his own demons. Don't you, Johnny? "(Point Break 1991). Everyone has demons. Everyone has a breaking point.
In this Blog Post, we will take a closer look at the ECB November 2022 Financial Stability Report and will summarize our main takeaways. The Financial Stability Report (in short FSR) has the objective of promoting awareness among policymakers, the financial industry, and the public at large of potential systemic risks.
I must admit it: the risks highlighted belong to the category of known unknowns, and more often than not the biggest financial tsunamis develop from vulnerabilities that are neglected by investors and unattended by policymakers. Those are the real tail risks, the unknown unknowns. However, the reason why this time around it is worthwhile to take a closer look at the buildup of breaking points in the realm of the known unknowns is that while central banks are today fully dedicated to reining in the inflationary shock, they have very limited flexibility in preventing macroeconomic errors.
We will draw our attention to four areas highlighted in the report: 1. Sovereign debt vulnerabilities, 2. Leverage and liquidity mismatches in the Shadow-Banking 3. The risk of a sharp contraction in the Real Estate sector, and 4. The deteriorating quality of Banks' Assets. To better systematize our main takeaways, I will employ an analysis framework similar to the Johari Window.
Originally the Johari window is a technique employed in psychology as a graphic model of interpersonal awareness. It is represented like this, as a window of four "panes":
It was created by psychologists Joseph Luft and Harrington Ingham in the 1950s and is used primarily in self-help groups and corporate settings as a heuristic exercise. The philosopher Charles Handy calls this concept the Johari House with four rooms. Room one is the part of the that we and others see. Room two contains aspects that others see but we are unaware of. Room three is the private space we know but hide from others. Room four is the unconscious part of us that neither ourselves nor others see.
We like to employ this approach when analyzing the financial stability report. The two viewpoints are from one side the perspective of the policy maker (The ECB) and from the other the point of view of the financial markets (Asset pricing). In reviewing the latest FSR by the ECB, we will focus in particular on Room 2 and Room 3. In other words, we will try to assess if there are significant discrepancies between perceived fragilities in the assessment of policymakers and market pricing. Room 4 represents instead the blind spots! The demons nobody is aware of.
Sovereign Debt Vulnerabilities
High inflation, low growth, and tightening financial conditions are putting the more-indebted issuers in a tight spot. Higher interest rates hurt the profitability of the most leveraged firms, but the same is also true for the fiscal position of the most indebted governments. No difference - so far - apart from one. And a big one. Governments (not all) can PRINT!
What about the Debt Size?
As we can see in the chart, risk premia for sovereign credit have risen as rates have increased. Additionally, credit spreads are particularly sensitive to rates for those countries with a high Debt to GDP ratio. In other words: yes the debt size matters.
I would like to point out that there are two reasons why sovereign credit spreads - and more generally credit spreads - tend to widen almost mechanically when risk-free rates rise. First of all, interest rate expenses grow, and second, there is a rebalancing dynamic. Higher "risk-free" rates prompt investors to rebalance their portfolios away from risky assets. The spread-widening often becomes self-reinforcing, especially in an environment where market participants take leverage. That's why the ECB pays particular attention to it.
The Debt Maturity Profile
What also adds oil to the flames is that some of the most indebted countries have an Achilles' heel in their debt maturity structure. In the chart below on the Y-axis, we can see what is the share of debt securities maturing in the next two years. The bubble size, instead, reflects the ratio of outstanding debt securities to GDP. For example, in the case of Italy, over 25% of the outstanding debt will have to be rolled over. Spain, Greece, and Portugal find themselves in a better spot, but that's only by a small margin. These countries also need to roll over 20% of their debt in the next two years. It becomes clear that the Rollover Risk exposes several countries more directly to higher rates, higher spreads, and higher inflation.
The following chart is very telling.
It visualizes the size of short positions on euro area Sovereign Debt. A large increase in short positions, in the most indebted countries, already started in 2021 and it continued in the first half of 2022. This dynamic could not go unnoticed and that's why the ECB introduced the Transmission Protection Instrument (TPI) to deal with undesired and potentially uncontrolled spread widening.
Regarding the sovereign debt risk, we find ourselves in Room 1 of the Johari window. The fragility is obvious and it is material, but it is well understood by market participants and by policy-makers. It will be crucial to monitor any possible change in policy stance but in the current regime, I would implement a directional short on peripheral spreads only after a significant tightening. And it will be hard to make money with it!
Non-Bank Financial Institutions - A Game of Shadows
This is an area that requires close attention. Vulnerabilities in the non-banking sector have been persistent and are probably well-known. Nonetheless, very little progress has been made so far by the relevant supervisors. It is now absolutely crucial to enhance the resilience of the shadow-banking sector, especially to address liquidity mismatches and leverage. But until concrete steps are taken, we find ourselves swimming in dangerous waters. The UK Pension Fund shock rang a very alarming bell. On this topic, a few questions remain murky, but what seems clear is that a series of margin calls to post collateral on derivatives trades ignited a chain reaction of forced sales on government bonds which brought to the debacle of the UK Gilts market. I do not buy into the narrative that this was an isolated case. The issue is widespread. My conclusion is that the normalization of interest rates will be very difficult without the potential backstop of the central bank of some form of quantitative easing. Call it TPI or however you like.
The Chart below highlights a few important points. I will summarize the key takeaways in a few bullet points.
Source: Helgi Library
First of all, the size of the euro area non-bank financial sector is 80% of the size of the banking sector. Almost the same.
Funds represent roughly half of it.
The two charts under panel a) display quarterly transactions in debt securities and listed shares by Pension Funds, Insurance Corporations, and Investment Funds. I find it interesting that while funds have been mostly buying sovereign debt and selling credit, Insurance Companies and Pension Funds have been selling both.
In particular, for investment funds, risks arise from a mismatch between the liquidity of their assets and their redemption terms. That's something to pay attention to.
The potential liquidity needs of relatively illiquid funds can amplify negative market dynamics.
The other important aspect to consider is market liquidity in bond markets. See the Chart below.
While liquidity in sovereign debt seems to have remained decent, liquidity in credit significantly deteriorated and it has been heading toward worrying levels. The potential liquidity needs of relatively illiquid funds are something to keep an eye on.
Liquidity risk in the non-bank financial sector and the associated risks of forced asset sales are significant concerns. In particular, for investment funds, risks arise from a mismatch between the liquidity of their assets and their redemption terms. Vis-a-vis the Johari window, we find ourselves in a sort of blind spot. Policymakers are indeed aware of the issue, but it is also true that little progress has been made so far and there is no quick fix. From the markets' perspective, these are risks that are hard to price, and most of the time they just keep floating around. My point of view on this subject is that barbell strategies - those which hold a decent cushion of very liquid assets -, and also liquid investment strategies have a clear advantage in muddling through these volatile times. Less risk of becoming forced sellers possibly at the worst time.
House of Cards? Is the price correction coming?
I am far from being an expert in real estate but will try to put together the pieces of the puzzle from a macro perspective. I will attempt to identify those countries where the real estate sector poses greater stability risk, by looking at 1. The size of residential real estate debt 2. The type of funding of the real estate sector (fixed vs variable rates) 3. Valuations and 4. The most recent price action. Cracks in the system are starting to be visible and, let's face it, the real estate sector is the elephant in the crystal shop. Therefore Central Banks while trying to contain the inflationary shock, should try to avoid collateral damage bigger of the issue they are trying to resolve. But let's go on step by step.
Size of Debt
I will start by noting this: Switzerland, The Nordics, the Netherlands, the UK, Canada, and New Zealand are standing out in terms of the accumulation of residential real estate debt.
Source: Helgi Library
The Eurozone seems to be in a better spot. Even in Germany, where the real estate sector is often seen as one of the country's main fragilities, total mortgage loans account for 40% of the GDP. As said, I am far from being an expert in the field, but it would seem that in the euro area the problem is much more contained than in other parts of the world.
The second aspect is the EU bank's exposure to loans collateralized by real estate properties.
As of Q1 2022, EU/EEA banks reported EUR 4.1 trillion of outstanding mortgage loans. These loans represent 33.5% of the total loans towards NFCs and households and they are one of the most important loan segments for EU banks. But I would also point out that the level has been very stable in recent years and it does not seem that banks took excessive risks in this area.
Type of Funding (breakdown by interest rate type)
Ay, there's the rub! How's the debt of residential real estate financed? By long-term fixed-rate mortgages or by more short-term or variable rates products?
Source: EMF, Aegon Asset Management
Furthermore, the following chart, taken by a report by Riksbank, also highlights that the % of new loans in variable rates represents - in most cases - a small fraction of the new loans.
Finland, Portugal, and only to some extent Sweden stand out as exceptions with a significant portion of new loans having been stipulated with a variable rate.
What about valuations?
I report here three charts that I found striking. The first one, below, takes into consideration the price-to-income ratio for a broad universe of countries.
The second chart instead, based on The UBS Global Real Estate Bubble Index gauges the risk of a property bubble by looking at excessive lending and construction activity, imbalances in the real economy, etc. across the globe.
The third and last chart is compiled by Bloomberg. The analysis looks globally at some of the largest real estate markets and ranks them in terms of vulnerability according to a few indicators.
It seems that the most vulnerable real estate markets are outside the Eurozone. However, there are a few locations across Central Europe where prices have been running hot for a while. The key message that a few central bankers, including the ECB, have been sending through is that they hope for a smooth and gradual price stabilization. I think this is only possible, if and only if, monetary policy does not become excessively restrictive. Otherwise, Houston we have a problem!
House Price Developments
Here, it is where things seem to start cracking.
House prices are starting to cool down. As we can see from the chart below, this is particularly true for a few countries and in some cases, corrections in prices from the highs have been steep.
In the UK - that's not in the chart - house prices are also weakening. British house prices slid last month by the most since the GFC as the slowdown in the housing market intensified, according to Halifax. House prices fell 2.3% month-on-month in November. That's the biggest drop since October 2008. In the US, as well, where prices are still holding a housing recession is now lingering as affordability is now stretched to the limit. In the US the monthly payment on a new 30Y fixed-rate mortgage at the prevailing average mortgage size is $2,600. That's 43% of the median pre-tax household income. Rates can't go much further. Even at these levels, consumers have very little air left in the diving tank.
Where do we stand? It depends a lot on what asset class we are looking at. This vulnerabily is difficult to classify. To what extent this risk is priced by the market is a big topic and a thorough review goes beyond the scope of this post. The rates market already prices a slowdown by the end of next year - but impossible to disentangle what's the part stemming from the real estate sector -. Many real estate companies have been significantly repriced and although the worst-case scenario is certainly not priced in, it looks like there could be the opportunity for some bottom-up selection capable of picking diamonds out of shattered glass. The broader credit asset class, at least at the time of writing, with XOVER CDS spreads at 460bps, would seem to price little probability of a real estate tail event. There are many different shades of grey in how markets are pricing a real estate recession. This could be the right set-up for attractive relative value trades.
Bank Asset Quality
Overall, the banking system is judged to be well-equipped to address the risks we are facing. Tightened capital and liquidity requirements over many years since the GFC have better-equipped banks across Europe and in many other countries to deal with crises. Profits from rising interest rates create a good buffer for banks. From the ECB's point of view, the big question mark concerns asset quality. But let's go step-by-step.
Widening margins contributed to faster net interest income (NII) growth, reflecting a limited pass-through of higher short-term rates to deposit rates. Against this backdrop, consensus analyst forecasts for listed banks’ 2023 ROE have been revised slightly upwards since May as the positive effect of higher rates is projected to more than offset the negative impact of weak economic activity on loan loss provisions. Overall profitability prospects seem to be now too optimistic.
According to the ECB, banks’ profitability outlook is subject to four sources of downside risk. Let's summarize the key takeaways in what follows:
1. NII growth could be negatively affected by lower loan volume growth in a downturn.
2. Revenues from investment banking and asset management have already declined and stalled in the first half of 2022 and remain vulnerable to larger asset price corrections.
3. Operating costs are expected to remain under pressure in a high inflation environment, while consensus analyst forecasts predict no increase in listed banks’ aggregate operating costs from (expected) 2022 levels.
4. Finally, worse than currently expected macroeconomic outcomes could lead to a higher increase in provisioning than anticipated at this point.
Banks’ solvency and leverage ratios declined in the first half of 2022, but they remained at robust levels. On aggregate, risk-weighted asset (RWA) growth was the largest contributing factor to the decline in the first half of 2022, mainly due to the robust growth of credit risk RWAs. Similar to the RWA ratio, banks’ leverage ratios also fell across the board dropping below their pre-pandemic levels. The decline was mainly due to the expiry of the exemption of central bank reserves from the calculation of the denominator.
A glimpse into asset quality: NPLs
Banks’ non-performing loan (NPL) ratios continued their downward trend in the first half of 2022. A further decrease in the NPL stock and continued credit growth both contributed to the decline of the total NPL ratio. Both aggregate NPL stocks and the NPL ratio reached their lowest levels since supervisory data on significant institutions were first published in 2015. The reduction of NPLs was mainly driven by disposals and securitizations of loan portfolios in a few countries.
NFC stands for non-financial corporates; HH stands for households. More forward-looking metrics of asset quality like the share of Stage 2 loans are approaching a level just above the peak reached during the pandemic. This might pose further risks for banks' cost of risk and profitability ahead, but the bottom line is that banks overall would be able to face a possible economic downturn starting from a position of strength.
"Overall, the euro area banking system is well placed to withstand many risks, in part because of the regulatory and prudential policy reforms of the past decade." This is a narrative picked up by most financial analysts and it seems there is no significant discrepancy between the ECB analysis and analysts' estimates.
This is particularly true for banks' stocks. We see from the chart below as they outperformed the broad stock market.
Following our Johari window approach, an area where it seems there is a significant discrepancy between the regulator's point of view and market pricing is banks' debt.
The market funding costs of euro-area banks have continued to rise, with little dispersion in the bank bond market across euro-area countries. Contrary to banks' equity, banks' debt has significantly repriced. AT1 (CoCos) spreads have widened to levels close to the ones seen at the peak of the pandemic shock, while senior debt in some cases is even wider than it was in March 2020. Financial debt seems to be dislocated and I believe it is an attractive asset to own. I would just be cautious of banks in those countries that rank higher in terms of real estate vulnerability and focus on the rest! For the risk-averse, a possible tail hedge could be represented by puts on banks' stocks as they are in relative terms probably trading at expensive levels.
The real Point Break is the housing market. Liquidity mismatches and over-leverage issues can amplify market volatility and create significant dislocations, but that's something Central Banks are well-equipped to deal with. A real estate recession, instead, is a different ball game. The FED and all major central banks have indeed shown a track record in 2008 to be able to navigate a real estate crisis, but that's something - history teaches - that's not solved overnight and it gets dragged along for years. Housing affordability seems to be stretched almost everywhere and there is little room for mortgage rates to go much further. As the inflationary wave seems to be almost mechanically poised -barred further shocks- for a retreat, central banks have to be careful with their higher for longer and be quick in adjusting real rates to avoid excessive overtightening. Once again, the direction of travel of the FED and the ECB will be highly material for next year's economic and market outlook! I am optimistic central banks will slow down their pace of hiking starting from the next meetings, but let's be aware we are walking on a thin rope!
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