Bank Risk Report: After Underperformance in 2011, Bank Market Signals Show Investors Still Cautious

Bank Risk Report: After Underperformance in 2011, Bank Market Signals Show Investors Still Cautious

US Banks: CDS-implied ratings of the largest US banks underperformed in 2011; numerous concerns linger
CDS spreads for US banks remained very wide versus comparably rated companies throughout 2011. At the beginning of the year the average CDS-implied rating for the 19 US banks on which we have data was Baa2, or four notches lower than their A1 average Moody’s rating. The average rating declined through the year to A2 due to numerous ratings revisions in 2011 (primarily to reduce uplift from systemic support considerations), but the CDS-implied rating remained at Baa2, or three notches below the average rating.

While the aggregate of companies’ CDS-implied ratings are within three notches of their Moody’s rating about 80% of the time, banks have had greater disagreements between their Moody’s and CDS-implied ratings than any other sector for several years, as their exposure to numerous issues remains elevated in investors’ minds. These disagreements are most profound for the largest banking franchises (Figure 1). The average CDS spread for US banks widened by 75 bp (or 58%) from 130 bp to 201 bp over the 2011 year. The figure below shows how dramatically CDS spreads worsened for the largest banks starting with the most significant European exposures last summer.

US banks’ large ratings gaps reflect concern that Moody’s ratings may decline further as systemic support continues to be reduced, diminishing its uplift in ratings.Each of the US-based Systemically Important Financial Institutions (SIFI Banks) has a negative rating outlook at present. In addition core profits remain quite weak as revenue growth has been sluggish, credit costs high, and expenses difficult to reduce. Many non-recurring items populate bank income statements, such as debt valuation adjustment (DVA) gains and reserve releases, which in the aggregate accounted for over half of third-quarter earnings at US-based SIFI banks. The levels of economic activity and interest rates will also play an important role in the recovery of net-interest income; investment banking revenues (which were disappointing in 2011) remain important for the largest franchises. As Basel III is implemented, the level of capital and liquidity to be maintained by the SIFI banks as buffer against uncertainty remains an ongoing debate.

The potential for the unintended consequences from new rules to strengthen balance sheets and from regulatory reform in general looms large to investors. Revenues were reduced significantly by some reforms, such as the Durbin Amendment (limiting debit card interchange fees) and the Volker Rule (limiting prop trading and derivatives activities). Reported bank earnings fell in 2011 by about 20% from the prior year. The Dodd-Frank legislation directed different banking regulatory bodies to implement about 400 new rulemaking requirements; less than one third have been completed. Regulatory compliance costs are sure to rise. And how the new rules constrain heretofore profitable businesses remains a wild card.

Legal liabilities in the mortgage mess are still an important issue. Faulty mortgage put-backs from investors and GSEs have mounted at some banks, and legal penalties and/or settlements loom unresolved.
European contagion risk remains heightened for the largest US banking institutions, which have had the largest cross-border exposures to the GIIPS nations and their banks. Their market-implied ratings (CDS, bond, and equity) have all remained far worse than the less exposed regional banks. Causes of enormous volatility — past, current, and likely future — in both debt and equity markets include potential developments along the path towards liquidity mechanisms for the GIIPs nations’ banks, the unknown prospect of agreement among the euro nations on a concerted solution to their debt problems, the need to restructure the balance between spending and taxation, and the adoption of real fiscal discipline.

Reflecting the concerns cited above, since the start of 2011, the net decline in CDS-implied ratings of five of the largest US banks was at least one notch. Bank of America declined from Ba1 to Ba2, Citigroup from Baa3 to Ba1, Goldman Sachs from Baa2 to Ba1, JP Morgan Chase from A2 to Baa1, and Morgan Stanley from Ba1 to Ba2. In November 2011, MS and GS suffered declines in their CDS-implied ratings to Ba3, from which they have since modestly recovered. Among the largest banks only the CDS-implied rating of Wells Fargo & Co. remained unchanged from the beginning of the year, at Baa1. The only banks to show improvement in CDS-implied ratings were the super-regional peer group (however, we note their CDS are less liquid than the larger banks): Fifth Third showed a three notch rise in its CDS-implied rating to Ba1, Discover Financial services also showed a three notch rise to Baa3, and Capital One Financial showed a one notch rise to Baa1. Readers will recall that a rise in the CDS-implied rating shows that the CDS of the company have outperformed the broad market.

European Financial Institutions

News-driven credit spread fluctuations
Optimism on incremental steps to provide liquidity to euro banks reversed recent spread widening trends. As we wrote last month,spreads don’t go one way forever. And market participants had gotten so comfortable with the notion that Europe was in insoluble crisis that they had forgotten that there was a price at which some investors would accept that risk. Market prices on bank debt that had been most damaged were generally those that did best in the month. CDS spread improvements of 10% or more were seen at two of the Austrian banks, NordLB, Unicredit AG, and at Deutsche Bank in Germany, at Bank of Ireland, UBI, La Caixa, Banco Pastor, and Credit Suisse. These market moves resulted in CDS-implied rating improvements of nearly one notch in every case — a rarity in the last several years.

Volatility persisted , though. One day monthly spread improvement for the best performers in global banks appeared to be nearly 20%, the next day it was closer to 10%, and the former was more consistently large banks. We read this as a measure of the further degree of uncertainty that persists. Large one-day swings are common around the turn of a year, but clearly 2012.didn’t start as well as 2011 ended.

The average CDS-implied rating for the European region didn’t change at all, remaining at Ba2. The average CDS spread narrowed only 47 bp to 507 bp (that high level itself says how meaningless “average” is in Europe). Alpha Bank’s spreads widened 17% (to nearly 3000 bp), and in general Greece’s banks didn’t participate in the good month, although it is hard to imagine that very much trading is occurring in Greek bank CDS. Caisse Centrale du Credit Immobilier’s (C3IF) spreads widened 44% to 476 bp. That is a small financial institution, but one sending a fairly notable signal. Wholesale-financed models are not in vogue.

Italian bond-implied ratings improve
The one and two notch rises in the bond-implied ratings of some Italian banks were helped by the Italian Ministry of Finance, which guaranteed all Italian bank bonds.

The more tempered results in bond-implied ratings around Europe are due, we believe, to the investors’ concern regarding increasing subordination of unsecured debt, which we discuss below.

ECB puts off day of reckoning
The injection of liquidity into the European banking system by the European Central Bank took the threat of a refinancing crisis off the table for the near future. In addition to the €489 billion take up of the ECB’s first longer-term refinancing operation (three-year LTRO) announced December 22, there are other measures — the reduction of the reserve requirement by half and the addition of classes of eligible collateral — that now solidify the ability for substantial take up of a second LTRO in February if it proves necessary or desirable.

Figure 1 shows the maturity structure of the reverse-transactions/liquidity-providing operations of the ECB. Recall that the previous sets of LTROs that were long enough to be used to set up a carry trade — the one-years of 2009 and 2010 (the red-shaded area) — were used that way by many banks. This was not entirely unintended — bank capital was partially restored and some confidence returned to the system.

However, the carry trade arguably led to or accelerated the need for the rescue of the three EFSF countries3
2 “French Bank Market Signals Update: Volatility Reflects Ongoing Risk, but Volatility Is a Two-Way Street”: as the banks of these countries became conduits for government debt issuance and/or buyers of last resort. The banks in these countries only profited from the carry trade for those bonds that have paid at par to date. For the rest, the mark to market losses, as well as the additional capital charges now required, have been devastating. Thus, it seems unlikely that banks will now jump into the highest yielding sovereign bonds with the cheap unlimited liquidity on offer.

What the LTRO has done, however, is to buy the banking system time to deleverage at a more manageable rate than otherwise. The level of long-term liquidity provided after the current six and twelve month operations mature (and not including February’s take up), at about €475 billion, is roughly in line with the level in the system before the unlimited operations began in late 2008. While that period (i.e., before 2008) was characterized by a great deal of wholesale borrowing on top of deposit financing, balance sheets have shrunk since then and will continue to do so over the next three years, so the goal of achieving a largely deposit-funded banking system is not, theoretically, out of reach.

Senior unsecured debt holders’ uncertainty persists
Whether investors can be convinced to lend to banks on an unsecured basis remains to be seen. Option adjusted spreads on senior unsecured bank debt are double what they were at the launch of the first one-year LTRO, and still well above the peak level of the end of 2008 (Figure 2) for good reasons. The most obvious reason is deteriorating asset quality, as concerns over sovereign credit quality have replaced concerns over other assets such as subprime mortgages and other structured credits, and as the region looks to be heading toward recession. The less obvious one is the subordination of unsecured debt by collateralized lending.

The former case is ironic because governments issued debt to guarantee the recapitalization (or at least refinancing) of the banking system, but almost nothing was ever done about resolution of troubled banks (with some notable positive exceptions). Many of them are still borrowing from the ECB or their national central banks.

The latter case is troubling. All the various sovereign “crises” didn’t move the option adjusted spreads of senior unsecured bank debt through 200 bp, and then they moved from 200 bp through 400 bp from August to December, 2011. European sovereign spreads didn’t double in that period of time. But the market’s view of senior unsecured debt changed by that amount. December’s improvement didn’t actually make much headway back toward 200 bp.

Covered bonds and most other asset backed securities guarantee a certain amount of over-collateralization, and as assets deteriorate, cover pools have to be replenished with performing assets. This leaves unsecured borrowers with a worse set of assets. In the case of any other secured lending, every time a loan is made, obviously the collateral has to be performing. As collateralized lending has continued to make up a larger share of bank debt, unsecured bank debt has become less secure. Issuance data (Figure 3) shows covered bonds’ increasing share of issuance. These securities generally have longer maturities than other bank debt, at five to ten years. Other asset backed securities are not included in the chart but are also starting to grow as a proportion of issuance. Year to date issuance patterns confirm the distinct shift toward covered bonds as several large deals came to market in the first several days.

At some point the yields will become enticing for buyers, and that point may be soon, or more likely will come and go. Outside of liquidation, it becomes less relevant how many claims come ahead of you, and with three-year funding guaranteed by the ECB, debt of a shorter maturity starts to seem attractive.

Market-implied ratings tables for global banking regions and companies

Monthly Bank Risk Report key credit metrics