2023-03-17 02:58:29 ET
Summary
- European banks are facing similar strains to their US counterparts, with more focus on the economy and inflation and less on unrealized bond losses.
- The UK's NatWest has fared well in recent years despite massive declines in 2020, seeing its core equity ratio stabilize at solid levels.
- NatWest has immense exposure to the UK's precarious mortgage market.
- Many UK borrowers will need to refinance at much higher rates this year and fail to obtain approval due to the massive rise in interest rates.
- With UK home prices falling, real wages collapsing, and mortgage defaults growing, NatWest may soon be on the hook for an immense increase in nonperforming loans.
The recent crash in Credit Suisse ( CS ) has raised alarms of a new European banking crisis. Credit Suisse is a "systemically important bank" and appears to be at considerable risk of failing, given its 70%+ decline over the past year. On the one hand, Europe's banking issues are similar to that of the US because the two systems are extremely interconnected. However, European banks are, on the whole, a bit larger than US banks and are more globally interlinked toward the rest of Eurasia. Many European banks are still strained by Europe's more-prolonged banking crisis, exacerbated by huge financial stability discrepancies across EU countries. The UK Pound and the Euro are extremely low compared to the US dollar today, with the Pound hitting a record low late last year .
Financial issues facing US banks are pretty significant, but I would argue Europe's financial system (including the UK) has a more substantial set of challenges ahead of it. In the US, smaller banks appear to be impaired while many larger banks, like JPMorgan ( JPM ), appear more healthy, allowing them to play a role in de-stressing the system. Comparatively, Europe's largest banks, such as HSBC ( HSBC ), Banco Santander ( SAN ), Deutsche Bank ( DB ), and numerous others, have been struggling to survive since 2008, consistently requiring significant government aid to remain afloat. European banks in the ETF ( EUFN ) have had almost no net positive returns (after dividends) since 2010, while the US Financials ETF ( XLF ) has risen 224%. See below:
Given the chronic underperformance of European banks, investors may wonder if the recent wave of financial and economic strains may be their "final nail in the coffin." Of course, large European banks also usually trade at a lower valuation and higher dividend yields than large US counterparts. It may be possible that, due to their weak performance over the past decade, some are seen as "cleaner" than their US counterparts due to potentially more extensive government oversight since 2010.
One interesting example is Scotland's NatWest Group ( NWG ), formerly known as the Royal Bank of Scotland. I was bullish on the stock when it hit its lows in March of 2020 due to my view that its government ownership would "guarantee" a bailout "or the similar, but different word" due to the lockdown situation. The stock has delivered a 170% return since; however, it has lost nearly 20% of its value since its February peak due to concerns regarding the international contagion effect of US regional banks and Credit Suisse. On the one hand, NWG trades at an attractive forward "P/E" of 6X with a high yield of 7.5%. On the other, it may face significant challenges due to bond valuation declines, economic loan losses, and rising deposit rates in Europe.
NatWest's Largest Risk is UK Mortgages
There are material differences between NatWest's asset and liability book and those typically seen in US banks. For one, the UK government debt-to-GDP is much lower than that of the US at ~95% and has not risen much since 2010 . As such, British banks typically carry less sovereign debt than US banks. NatWest currently has £720B in assets and £683B in liabilities, of which just around £12B are US and UK government bonds not held for trading ( see report pg. 84 ). Further, most of those assets are valued at fair value, not amortized cost, so NatWest's total potential unrealized bond losses appears to be very low. This issue is the most considerable systemic risk in US banks but is seemingly a lower issue in UK banks as a whole. Comparatively, UK pensions are the primary owners of long-dated gilts, giving them the most significant exposure to that systemic risk factor.
In recent years NatWest has gained a very strong capitalization ratio. Its "CET1" in 2021 was a stellar 18%, though it fell to 14.2% last year as economic risks began to create issues in the lending market. NatWest also has a disproportionately large cash position compared to its assets at ~20%, vs. average US banks at 13%. See below:
NatWest has a comparatively extensive loan portfolio, totaling £373B compared to £470B in total deposits. Its total loan-to-deposit ratio is just below 80%. Historically, that is a relatively standard figure but is a bit higher than typical US bank levels of ~60% . Over half of the bank's loans are mortgages, with the rest diversified between corporate and personal loans. Accordingly, UK mortgage market issues are the greatest threat to NatWest.
UK home prices have risen very quickly since 2020 amid low mortgage rates. As in the US, the UK's average mortgage rates have increased from ~2.5% to 4.9% for a 10-year fixed-rate loan since last year. Recently, this sharp decline in affordability appears to be causing a slowdown in UK home price growth:
UK home price-to-income ratios are generally much higher at around 9X compared to 7X in the US . More importantly, UK home price-to-income ratios have been consistently elevated for the past decade due to low mortgage rates, while the figure has risen more recently in the US. Accordingly, many UK home borrowers may be overleveraged if they had to refinance today. Problematically, it is far more common for British borrowers to use short-term fixed-rate mortgages and variable-rate loans. In fact, a quarter of all UK mortgages are variable, and over a third are set to expire within the next two years.
On the one hand, the UK's mortgage lending "style" insulates NatWest from specific issues that are huge in US banks. Around 22% of NatWest's mortgages expire by the end of 2023 , and the vast majority are shorter-term or variable rates compared to the US standard "fixed 30-year". As such, NatWest's mortgage portfolio has much lower duration risk exposure than other US banks, such as Wells Fargo ( WFC ). That said because UK borrowers are more leveraged than their incomes, and interest costs are twice as high as last year, it seems the UK mortgage market is headed for a non-performance crisis. Today, millions of people in the UK must refinance their mortgages, but approval rates have collapsed, implying many of those near-term mortgages may be hitting default. Further, a likely decline in UK home prices (due to the affordability crisis) may increase LTV ratios and cause many 2020-2021 homebuyers to have significant leftover debt upon refinancing.
Economic Strain Exacerbates Risk
Notably, the UK does not have a considerable mortgage guarantee program like the US, so banks are liable for mortgage losses. That said, UK mortgages are "full recourse" whereas they're "non-recourse" in the US, meaning UK lenders can pursue all assets to recoup losses on mortgages if a foreclosed home does not sell for enough to offset mortgages. While this difference has not significantly impacted UK banks, I suspect it will over the coming three years as home prices decline due to rising borrowing costs while borrowers cannot refinance. Currently, around 9% of UK mortgages are at high risk of default, though this figure will increase if the UK's economic issues continue to mount.
The United Kingdom has a much higher inflation rate of ~10.1% YoY . Producer price input prices rose at a staggering 25% annual pace at last year's peak, signaling most businesses are struggling to maintain profits amid a sharp rise in costs. The UK has a notoriously poor current account deficit of 2-6% of GDP in any given year and is historically an extremely import-sensitive country. While the UK has decent "value-added" industries, it has few natural exportable commodities; for example, 80% of its food is imported if raw ingredients are counted.
Globally, the most significant economic issue appears to be shortages in raw commodities, such as food, energy, and minerals. Countries with substantial net exports of such items are likely much better off than those with immense import dependency. The UK economy is likely the most exposed large European economy to this risk factor due to its geographical position and lack of EU trade protections. Fundamentally, this type of inflation (supply-side) is also less sensitive to economic demand, so the UK may not see inflation decline if its economy slows. Real incomes in the UK are falling toward 2006 levels and may continue to slide if unemployment rises amid a growing business slowdown .
The Bottom Line
On the one hand, NatWest likely has low exposure to the issues in the US banking industry and is somewhat isolated from Europe's other banking issues. NWG also trades an attractive "P/E" valuation with a high dividend yield. Further, based on official measures, NWG has strong capitalization and an excellent cash balance to offset potential challenges.
That said, I am bearish on NWG today due to its immense exposure to the UK mortgage market. In my view, the UK mortgage industry is rapidly heading into its greatest-ever crisis due to the tremendous increase in home valuations and the impending shock as borrowers fail to refinance as their mortgage comes due. If the UK economy were strong, borrowers might manage to offset rising mortgage costs due to a rise in home prices; however, UK home prices appear to be slowing and may rapidly decline as mortgage approval plummets. Rising living costs and falling real wages will likely exacerbate the issue.
Theoretically, NWG has protections from the UK's stricter mortgage laws. Still, I doubt borrowers will have significant other assets to repay the massive debt levels given the increase in home prices. Further, if mass foreclosures occur (as implied by default predictions), then home prices would stumble such that LTVs skyrocket. Since there are no precedents for the UK's current mortgage situation, it isn't easy to model the impact these events would have on the company's valuation. However, while NWGs may have proper capitalization, a significant loan loss in its mortgage portfolio could still wipe out its equity value.
Rising deposit rates should also negatively impact its NIMs this year, and its balance sheet may have secondary challenges due to its vast ~£99B derivative portfolio if Credit Suisse faces closure. The bank's considerable mortgage risk may not negatively impact its equity soon as we're only beginning to see rising defaults in the UK mortgage market; however, I believe this is the most significant overall risk to the bank. Overall, I am slightly bearish on NWG, though I would not short the stock until greater red flags surrounding its mortgage book begins to attract more media attention. It is possible that government interventions could stop or, more likely, delay the crisis; however, as in the US, I suspect the issue is large enough that the UK government cannot fix it - given money-printing is dangerous when inflation is as high as it is.
For further details see:
NatWest Group: U.K. Mortgage Crisis May Greatly Impair Equity