Markets update - Credit - Subordinated debt - Love me tender?

"Junk bonds prove there's nothing magical in a Aaa bond rating."

Merton Miller

Debt tender offer:
"When a firm retires all or a portion of its debt securities by making an offer to its debtholders to repurchase a predetermined number of bonds at a specified price and during a set period of time. Firms may use a debt tender offer as a mechanism for capital restructuring or refinancing."

In our post "The European issue of circularity", we discussed recapitalization issues in general, and subordinated Tier 1 bond tender in particular.

As a reminder:
"We know that "access to capital is depending on growth outlooks", a cheaper way for a bank to beef up its Core Tier 1 capital is to buy back at a discount its Hybrid Subordinated perpetual bonds in the secondary market."
We know that in 2009 "the game was for weakly capitalised banks to quietly retire bonds at distressed levels to create/boost Core Tier 1 capital, which was precious as long as they could finance the purchase with term debt."

We also know from this previous post that French bank BPCE tendered their bonds "to further enhance the quality and efficiency of the Company's capital base".

We expected others to follow suit and given the difficulty for the weaker players in the peripheral space to access capital at a reasonable rate, as well as needing to boost their core Tier 1 capital base, it was of no surprise to see Portuguese bank Banco Espirito Santo following French bank BPCE in tendering some of its subordinated debt on the 18th of October, but this time around, we have a debt to equity swap. So, yes, another long post.

But before we go through the nitty-gritty details, it is time for a quick market overview - Source Bloomberg:

Tighter slightly in the morning as per above picture but wider by the end of the day given concerns related to the cancellation of the meeting of European Union Finance ministers on Wednesday.
Itraxx Financial Senior 5 year CDS index increased by 7.5 bps to around 242 bps.
Itraxx Financial Subordinated 5 year CDS index increased by 6 bps to 474 bps. Overall, this month, the market is tighter by 80 bps since the end of last month, as we have seen a slight improvement in the credit markets so far in October in relation to spreads movements.
Itraxx Crossover 5 year CDS index (High Yield) ended up 7 bps wider as well on the day at around 714 bps.

The liquidity picture - source Bloomberg:

Some improvements but ECB overnight deposits are climbing at a faster pace compared to last month.
Flight to quality mode, on a slight hold pattern as indicated by the relationship between Germany Sovereign 5 year CDS and 10 year German government bonds yield slightly above 2% - source Bloomberg:

We started the day at around 2.13% yield and ended up around 2.05% yield.

EFSF bond versus 10 year German and French government bonds, correlation is still there between French bonds and EFSF bonds - source Bloomberg:

Itraxx Financial Senior 5 year CDS index, Eurostoxx and German Bund 10 year bond yield above 2%, Volatility levels - Source Bloomberg:

So, where do we go from there? It all depends on Wednesday European outcome and the can kicking game.

We all know by now we have moved from convergence to divergence in relation to bonds yields - source Bloomberg:

ECB has been stepping in since the 8th of August to support Italian and Spanish bond yields as they are again moving closer to the dangerous 6% yield threshold.

But back to our Subordinated bond tender story for our Portuguese bank.
The need to raise capital will be acute for peripheral countries due to issue of circularity we previously discussed. Given we know by now that access to capital is only open to better quality issuers in the financial space, the current level of financial spreads for weaker issuers, make it impossible for them to access funding at reasonable rates. Survival of the fittest is still the name of the game with the liquidity support provided by the ECB for these weaker players.

Bloomberg - "Savings Wars From Italy to Portugal Drive Bank Costs Higher"
By Charles Penty and Sonia Sirletti:
"The five largest banks in Italy, Spain and Portugal combined have more than 200 billion euros in medium- and long-term debt maturing before 2013, according to data compiled by Bloomberg.
The last time a Portuguese bank tapped wholesale debt markets was in March 2010, while Banco Santander SA’s 1 billion-euro sale of bonds in June was the most recent by a Spanish lender. UniCredit SpA, Italy’s largest bank, paid a record spread for Italian covered bonds in August when it raised 1 billion euros from a sale of 10-year notes that yielded 215 basis points more than the benchmark mid-swap rate.
Banco Espirito said in August that it trimmed lending by 3.1 percent from a year earlier and boosted customer funds by 23 percent to bring its loan to-deposit ratio down to 155 percent from 198 percent a year earlier. A lower loan-to-deposit ratio is a sign the bank is less reliant on sources of funding such as bond sales to fund its business."

Anabela Reis in a Bloomberg article indicated the following:
"Portuguese banks are being squeezed by demands that they boost capital as the government’s effort to reduce the deficit deepens the recession.
Echoing the struggles of their Greek counterparts, Portuguese lenders are unable to tap the financial markets for funds and hobbled by debt-laden state companies. At the same time, international regulators are forcing them to raise capital as they’re dependent on the European Central Bank for funds."

So austerity measures in conjunction with loan book contractions will lead unfortunately to a credit crunch in peripheral countries, seriously putting in jeopardy their economic growth plan and deficit reduction plans.
We discussed our concerns back in August in the post "It's the liquidity stupid...and why it matters again...":
"Lack of funding means that bank will have no choice but to shrink their loan books. If it happens, you will have another credit crunch in weaker European economies, meaning a huge drag on their economic recovery and therefore major challenges for our already struggling politicians.

As a reminder, 50% of banks earnings for average commercial banks come from the loan book: no funding, no loan; no loan, no growth; and; no growth means no earnings."

In a Bloomberg article by Liam Vaughan and Aaron Kirchfeld on the 25th of October -"Italy, Spain May Bear Brunt of European Bank Capital Plan":

"Banks with large holdings of U.K., German and French bonds may avoid raising additional capital, while those with Greek, Irish, Italian, Portuguese and Spanish debt will have to raise the most, according to London-based analysts at JPMorgan Chase and Co. and MF Global Ltd."

Hence the issue of circularity weighting on banks' capital needs.

Liam Vaughan and Aaron Kirchfeld commented:

"In Portugal, Banco Espirito Santo SA, the country’s largest lender by market value, may require about 3.4 billion euros, and Banco Comercial Portugues about 3.9 billion euros, according to MF Global.
Spain’s two largest banks, Banco Santander SA and BBVA may require about 3.1 billion euros each, Banco Popular SA 2.8 billion euros, Banco de Sabadell SA 2 billion euros and Bankinter SA 914 million euros, according to JPMorgan."

We also learn from the same article an interesting point:
"Banks with large holdings of U.K., German and French bonds may avoid raising additional capital, while those with Greek, Irish, Italian, Portuguese and Spanish debt will have to raise the most, according to London-based analysts at JP Morgan and MF Global Ltd."

Reason behind, another interesting accounting trick according to the same article:

"Lenders may be able to mark up the value of bonds that are trading above face value, allowing them to mitigate the cost of writing down their southern European sovereign debt, the people said."

So we have the direct effect of circularity we discussed at play as indicated again by Bloomberg:
"That may benefit U.K. and German lenders such as Royal Bank of Scotland Group Plc and Deutsche Bank AG, whose biggest holdings of bonds are those issued by their own governments. It may also allow French banks to avoid further fundraisings."

And we know from our conversation "Long hope - Short faith", that:
"Banks have fought bitterly against increasing equity buffers which is the cheapest and easiest way to recapitalize banks.

Why? Because allowing high payouts to shareholders, namely bank employees in many cases, allows financial institutions to raise their leverage."

Liam Vaughan and Aaron Kirchfeld in their Bloomberg article indicated the following:
"Lenders including Deutsche Bank have opposed further capital injections because they risk diluting shareholders without addressing the underlying problem of a potential Greek default. BNP Paribas SA, France’s largest bank, is among financial firms that have said they can meet demands for increased capital without cash injections."

So what will happen now and how will these banks raise money to meet capital ratios before the June 2012 deadline?

They will contract their balance sheets, in effect impacting access to credit and triggering most likely another credit crunch and it is already happening.

Source Bloomberg, Anabela Reis - "Portuguese Banks Pinched With Recession Deepening: Euro Credit"

"Loans to companies dropped to 116.2 billion euros in August, the lowest since March, and loans to individuals declined to 140.8 billion euros, the lowest in a year, according to the Bank of Portugal."

So what's all about your Banco Espirito Santo tender Martin?
Well as Espirito Santo Chief Executive Officer Ricardo Salgado put it nicely:

"Its more interesting for banks to extend their shareholder base, by converting bonds into shares, than having the state as a shareholder."

On October 18 Banco Espirito Santo announced a capital increase in effect via its bond tender:
BESPL 6.625 Perp callable 2012 Exchange at 74 Upper Tier 2 XS0147275829 Amount: 423,561,000

BESPL 4.50 Perp callable 2015 Exchange at 66 Upper Tier 2 XS0207754754 Amount: 474,033,000

BESPL 5.58 Perp callable 2014 Exchange at 61 Tier 1 XS0171467854 Amount: 553,265,000

And my good credit friend to comment:
"First debt to equity swap for a Portuguese bank: Banco Espirito Santo … but I guess not the last one for European banks … as we have been saying for a while…
The total amount of debt to be exchange for equities is euro 1,450,859,000 ! Banco Espirito Santo total market cap is approximately euro 1,743 million…which means 83.5% dilution for the current shareholders!"

This is the recent price action on Banco Espirito Santo share price:

So, in our debt to equity swap, courtesy of the subordinated bond tender, not only the subordinated bond holder is taking a hit, but our shareholder as well. Love me tender?

Subordinated debt - Wikipedia:
"From the perspective of policy-makers and regulators, the potential benefit from having banks issue subordinated debt is that the markets and their information-generating capabilities are enrolled in the "supervision" of the financial condition of the banks. This hopefully creates both an early-warning system, like the so-called "canary in the mine," and also an incentive for bank management to act prudently, thus helping to offset the moral hazard that can otherwise exist, especially if banks have limited equity and deposits are insured. This role of subordinated debt has attracted increasing attention from policy analysts in recent years."

But if you think the credit crunch will only happen in the peripheral countries because of banks shrinking their balance sheets, think again:
According to my good quant friend at Macro Research house RCUBE (Risk - Return - Research), and from the latest “Association Française des Trésoriers d’Entreprise” (French Corporate Treasurers Association), the latest survey confirms the reality of a credit crunch in France, respondents now consider that the cash situation for French corporates is nearly as bad as in late 2008! - "Our readers know that we pay very close attention to bank lending standards, especially in Europe where banks represent around 70% of corporate financing."

Europe Banks Vow $1 Trillion Shrinkage as Recapitalization Looms - Bloomberg by Anne-Sylvaine Chassany and Liam Vaughan - October 19:

"European banks, assuring investors they can weather the sovereign debt crisis by selling assets and reducing lending, may not be able to raise money fast enough to prevent government-forced recapitalizations.
Banks in France, the U.K., Ireland, Germany and Spain have announced plans to shrink by about 775 billion euros ($1.06 trillion) in the next two years to reduce short-term funding needs and comply with tougher regulatory capital requirements, according to data compiled by Bloomberg. Morgan Stanley predicts that amount could reach 2 trillion euros across Europe as banks curb lending and sell loans and entire businesses. A lack of buyers and the losses lenders face on loan sales are making those targets unrealistic."

On a final note I leave you with Bloomberg - Chart of the Day - Euro Area Debt Quality Worsens at Record Pace:

"The CHART OF THE DAY shows the average rating for the bloc, calculated by Bloomberg from the assessments of the three main evaluators, has worsened to 3.14, representing the third-best grade, from 2.12 in May 2010 when the European Financial Stability Facility was designed. The measure fell 0.23 point in the previous 15 months. The average is calculated by giving a numerical grade for each grading, where 1 is the highest, and adjusting it for each country’s share of the EFSF guarantee.
Seven of the 17 euro-sharing nations have had their ratings downgraded since the announcement of the facility, which maintains a top grade from Standard & Poor’s, Moody’s Investors Service and Fitch Ratings. As the contagion has spread to banks, prompting governments to work out recapitalization plans, further cuts, mainly for the top-rated countries, may reduce the strength of the fund."

"How few there are who have courage enough to own their faults, or resolution enough to mend them."
Benjamin Franklin

Stay tuned!