Facts, background, prospects

The mortgage market has experienced a real boom in the United States during the last few years, driven by extremely attractive mortgage loan terms. Interest rates were low, and rising house prices led many people to believe they could buy a home with little or actually no capital of their own. Investor demand for structured, higher-yield securities in a phase of high liquidity surpluses and low returns further encouraged this trend, with the result that the subprime market mushroomed by an unprecedented 800% between 2000 and 2005. Highly complex securitisation structures put risk in the hands of institutions which no longer had any idea of the original exposure and employed totally inadequate resources to analyse the remaining risk.

When conditions changed, interest rates rose and house prices fell, more and more financially weak borrowers were no longer able to service their loans. Loan loss rates climbed. There were also further-reaching implications due to the fact that subprime loans were funded via structured investment vehicles on the capital market.

The roots of the problem

This was the start of a chain reaction: in the US alone, loan losses amount to around $ 400 billion, with investment banks, credit institutions and hedge funds accounting for fully half of these and insurance firms taking around 23%. Yet the subprime debacle is not - as it is so often made out to be - the triggering factor in the present crisis, but rather a symptom of it. The roots of the problem are to be found in the systematic failure to measure and price risk properly over the years that affected virtually all riskier asset classes in the financial markets.

To put it more simply: financial institutions depend on financial innovations, and these create value for all. At the same time, it must be ensured that complex products which make ever-higher demands on institutions' risk management skills are understood and priced properly. That goes particularly for highly-structured, securitised products whose underlying assets many have no longer really understood lately.

The availability and cost of funding via the interbank market led in the decade up to mid-2007 to the strength of a bank being assessed more in terms of the bank's ability to attract solvent borrowers than the quality of its funding. This made it more important for banks to expand their lending business than to ensure optimal funding.

The deposit gap and its consequences

Since 1997, total lendings have increased by an average of 8% annually in the eurozone, whereas deposits have grown by only 6.6%. Though the difference between these two figures of 140 basis points does not appear unusually large, the compound interest effect meant that the deposit gap, i.e. the difference between deposits and loans, widened from € 44 billion in 1997 to € 1.3 trillion last year. This deposit gap was funded by the many different new instruments in the interbank market. Until mid-2007 that was not a problem - the cost of funding via the interbank market was often only slightly higher than that of funding via customer deposits.

So banks found themselves in a situation in which investors were hungry for outside capital. The cost of funding via the interbank market and funding via deposits converged somewhat and as a consequence banks' lending-dominated business model flourished. There was plenty of liquidity available until it became evident in 2007 that funding was becoming much more difficult and for some banks actually impossible.

The result was a general crisis of confidence. Securitisation and syndication markets, and thus also the $ 2.2 trillion asset-backed commercial paper market, virtually came to a standstill. Financial institutions were reluctant to lend each other money any more. Money market paper could hardly be placed any longer, while transactions regarded as safe became unviable. The outcome of all this was that the demand for liquidity and capital increased. Market participants sold assets in still liquid, healthy markets, which then suffered as well.

Sovereign wealth funds as a new source of capital

Although it is still unclear what far-reaching implications the crisis will have for world growth, we see some stabilisation of markets.

Through their investments, new capital providers such as sovereign wealth funds (SWFs) have been a stabilising factor and showed their presence in difficult times when many European banks were unable or unwilling to make such investments. To name but a few examples, the Government of Singapore Investment Corporation (GIC) invested € 6.77 billion to acquire a 9% stake in UBS, China's SWF invested € 0.67 billion in Bear Sterns, and Singapore's Temasek Holdings made a € 4.3 billion investment in Merrill Lynch.

SWFs will have a growing influence on the financial markets in the coming years. To illustrate this: if SWFs stick to their current investment policy and continue to make 40% of their investments in equities, they could buy up almost 10% of the global stock market over the next four years and thus have a major effect on it.

What does the financial crisis mean for banks' existing business and what conclusions can be drawn today for the future evolution of banking? The current financial crisis undoubtedly poses great challenges to banks' business model, particularly to that of capital-market-oriented institutions, whose present “buy and distribute” model is increasingly being questioned. It remains to be seen whether this model will be replaced or whether it will be retained in a modified and improved form.

We anticipate that the profitability of capital-market-oriented European banks will decline in the short to medium term. As regards capital, profit margins and funding facilities, we believe that the results will remain under pressure.

Higher capital needs

We expect banks' total subprime losses to amount to around $ 103 billion. The banks monitored by GS Research have, on their own, made approximately $ 88 billion worth of subprime-related write-downs and value adjustments to date. History teaches us that a banking crisis is not over until the sector has been recapitalised on a large scale. Consequently, during the past few weeks European banks have announced capital increases of some € 45 billion - most of these in the form of capital increases with subscription rights which first have to be digested in the coming weeks and months and will probably absorb a large part of investors' liquidity.

Potentially higher capital requirements will also be a burden.

Profit margins

While the currently higher asset spreads for banks are quite positive, it is not clear in our view - given the negative trend in lending - how they will affect profits. The adverse effects of competitive pressure on margins in corporate lending have been offset in recent years by less risk provisioning, with the result that risk-adjusted margins have remained largely unchanged.

During the upturn in 2001, loan loss provisions were on average 64 basis points of risk-weighted loans. We expect risk provisioning for potential losses of capital at the German banks monitored by GS Research to rise above the value of risk-weighted loans, from 23 basis points last year to 30 basis points this year.

Funding: pressure on profitability

The average five-year credit default swap (CDS) spreads for capital-market-oriented European banks were still over 90 basis points a month ago. In comparison, these spreads were six basis points at the end of 2006 and around 40 basis points at the end of 2007. These higher spreads make it likely that cost of funding will continue to rise and thus put pressure on profitability.

Yet - perhaps more importantly - this means that banks and European investment grade corporates are moving closer to each other on the cost of funding. This naturally raises the question of how banks as intermediaries are supposed to earn margin if their funding costs are not any lower than that of corporates. Corporates are now switching increasingly to approaching investors directly. As a result, funding via the capital markets is probably the biggest challenge facing banks at present. For example, the big European banks' bond issues and securitisations dropped from € 330 billion in the first quarter of 2007 to € 86 billion in the fourth quarter.

The current financial crisis naturally also affects a sector which has played a leading role in mergers and acquisitions (M&As) in recent years. While financial sponsors were involved in over 25% of all M&A deals in 2006 and 2007, this figure has fallen since August 2007 to less than 16% - and is still declining. The growing credit spreads are making funding more difficult and producing more conservative financing structures.

Opportunities for strategic investors

However, this means more opportunities for strategic investors, since they face less competition from private equity firms at a time when many institutions are concentrating on their core business and shedding fringe activities. 390 transactions were initiated by strategic investors in 2006, with the number rising to 439 in 2007. Funding is no problem for them, as most have a well-filled “war chest”.

The financial industry itself is highly active at the moment. Contrary to what is often assumed, the global banking sector is not heavily concentrated: the Top 20 banks represent less than 40% of worldwide market capitalisation - in industry this figure is 67%. Following JPMorgan's takeover of Bear Sterns, the mood in Germany at present is also upbeat and we can expect big changes to the landscape for both the private banks and the Landesbanks in the medium term as a result of consolidation. The capital is there. Many investors are just waiting for the right opportunity.

Despite the high capital overhang, another important market segment is in poor shape: we have seen hardly any initial public offerings (IPOs) to date in Europe. According to Dow Jones Venture Source 2007, only 38 companies went public in Europe last year, with an issuance volume of around $ 1.3 billion, which was only half that of 2006. At the moment, some companies in Germany are tentatively trying to place an issue in a somewhat calmer market environment. The resounding success of Visa's IPO in the US in the midst of the financial crisis shows that sound companies with a convincing business model can be successful even in a difficult market environment.

The planned partial privatisation of Deutsche Bahn (German Railways) will undoubtedly also send a signal, and it is already likely that the market will see a number of capital increases, especially in the banking sector.

At the same time, we cannot rule out a further sharp increase in the number of insolvencies due to the financial crisis. Credit insurer Atradius, for example, believes that the number of insolvencies in Germany should jump by 15 - 20% in the coming eighteen months. It bases this forecast on a survey of 2,500 companies worldwide. But things will not stay like this in the long term.

Today, we can tentatively say that we are probably seeing the beginning of the end of the financial crisis, although the fall-out from it will be around for a long time. Analysing how such a crisis could happen in the first place and what lessons we should learn from it are questions that will continue to occupy us for some time to come.