Sunday, 20 November 2011

Markets update - Credit - Goodwill Hunting Redux

"Errors of opinion may be tolerated where reason is left free to combat it."
Thomas Jefferson

Dwindling liquidity has been leading to significant market volatility, in most asset classes. Credit hasn't been spared and while CDS single names and indices are still experiencing important intraday spread movements, Cash bonds in the European markets are not spared either. Thursday and Friday were very interesting, namely because we saw an important acceleration of bond tenders in the financial space (triggered by the Santander bond tender we mentioned in our "Mind the Gap" on the 15th), something we have been expecting to happen from our many previous conversations("Subordinated debt - Love me tender", "Crash Test for Dummies"). In fact in a more recent conversation ("Complacency") we argued:
"Something has gotta give" - subordinated bondholders or shareholders, or both.
Well, it looks like subordinated bondholders are the first in line, and are going to give some back, to help European banks shore up their Core Tier 1 capital as they rebuild/shrink their balance sheet in order to meet the June 2012 European Banking Association threshold of a core Tier 1 of 9%.

In today's long credit conversation, as we go through the latest price action and bond tenders, we will revisit Goodwill impairment, which is definitely back on the agenda, a subject which we already approached in December 2010 ("Goodwill Hunting - The rise in Goodwill impairments on Banks Balance Sheet").

But first it is time for a market overview:

The Credit Indices Itraxx overview - Source Bloomberg:
So, three weeks after a supposedly historic agreement on the 26th of October,  we are still near records levels CDS indices wise (Financial indices, and SOVx - European CDS sovereign risk gauge). Itraxx Crossover 5 year CDS index (High Yield gauge) is at around 760 bps, while Investment Grade Europe represented by Itraxx Europe Main 5 year CDS index is around 188 bps.

Itraxx credit indices for Financial Senior 5 year CDS and Financial Subordinate 5 year CDS, remain stubbornly high (300 bps and 538 bps respectively, close to September records level) - source Bloomberg:

Some respite in the Sovereign European CDS Space - source CMA:
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In relation to the bond picture, contagion has been spreading to core Europe last week with some respite as well for France and Austria, as well as a pause in the flight to quality with German 10 year yield increasing, but for how long?- source Bloomberg:

In relation to our CPDO/EFSF relationship with French 10 year Government bond and German 10 year bund yields, while French OAT yields have receded, EFSF bonds yields are still rising towards 4%, currently at 3.87% - source Bloomberg:

Another indicator worth tracking is the relationship between 10 year Swedish Government yields and German 10 year Government yields, which, so far have been moving in lockstep, but recently spread between both are moving towards their highest level of 25 bps (contagion to Germany? Not yet) - source Bloomberg:

As far as the liquidity picture is concern, it is clearly deteriorating. The new reserve period for deposits at the ECB which started on the 9th of November will last this time around 35 days:

In relation to the liquidity update, please find an additional point made by Goldman Sachs Sales/Trading teams on EUR FRA/OIS Basis:
"FRA/OIS Basis shows the difference between the overnight and the 3 month interbank borrowing rate and shows the confidence of banks to lend to each other. Current levels show that the confidence is very low as the premium to borrow long term is very high despite recent unlimited LTRO (long term refinancing operation) by the ECB."
In our last conversation on the 15th, we discussed the latest bond tender by Santander in Europe, which in fact triggered a flurry of bond tenders in the market according to Bloomberg article by Esteban Duarte on the 18th of November:
"Societe Generale SA and Banco Santander SA are among banks offering to buy back or exchange part of about $30 billion of junior debt issuance to boost capital and raise money as borrowing costs rise.
The bond tenders that started in Europe this week allow the banks to repurchase subordinated notes at a discount, booking a capital gain, or swap the securities to raise senior debt. Others pursuing the strategy include BNP Paribas SA, France’s biggest bank, and Northern Rock Asset Management Plc, the so- called bad bank spun off from the lender being purchased by Richard Branson’s Virgin Money Holdings U.K."
And the article to detail the flurry of bonds tenders we have been expecting for a while:
"SocGen offered to repurchase as much as 900 million euros of a total $8.2 billion of Tier 1 notes today, at prices starting at 56 percent of face value. Banco Santander, the biggest Spanish lender, asked holders of 6.8 billion euros of subordinated bonds to swap their securities for new senior notes on Nov. 15.
BNP Paribas, France’s largest bank, offered to exchange or repurchase part of about $10 billion of subordinated bond issuance yesterday for as little as 72.5 cents on the dollar, according to a series of statements. SNS Bank BV of the Netherlands announced a tender of Lower Tier 2 notes yesterday, while nationalized U.K. bank Bradford and Bingley Plc is also tendering for debt."
Love me tender?

We already know the liquidity is poor and we discussed previously how issuance under current market conditions is difficult to say the least, it isn't really a surprise to read in the same article:
"“Banks are currently taking advantage of poor liquidity in the market to buy back, or more often exchange, redundant capital instruments on very attractive terms for the issuer,” said Mark Harmer, an analyst at ING Groep NV in Amsterdam.
It’s definitely a growing trend, especially where traditional access to senior funding channels is limited.”
Given we already know 2012 is going to be a significant year for term issuance for banks ("Mind the Gap..."), you can expect more of the same. First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process.

It was interesting to see as well Deustche Bank increasing the size of a previous 2 year Senior Unsecured FRN (Floating Rate Note) issue by 250 million euros (previous issue size was 1.75 billion Euros, maturity October 2013), at 3month Euribor +75bps.

So yes there is worrying liquidity and funding stress in the European financial system, and according to Bloomberg Liz Capo and Gavin Finch in their article - "Bank Stress Gauges Show Pain Lasting Through ’11: Credit Markets":
"Spanish banks borrowings from the ECB rose 10 percent to 76 billion euros in October, the highest level in more than a year, while Italian firms reliance increased 6 percent to 111.3 billion euros."
And added:
"Italian banks may be forced to increase their reliance on emergency funding from the ECB as their liquidity levels have fallen to levels not seen since January 2009 after the value of the government securities they held tumbled, the central bank wrote in its Financial Stability Report published on Nov. 3.
The ECB announced in October it would reintroduce year-long loans for the regions’ banks as the sovereign debt crisis threatens to lock local money markets. It had previously coordinated with the Federal Reserve to provide euro-area banks with dollars. The central bank offered 12-month loans last month and will off a 13-month loan in December."
According to Radi Khasawneh in the article published on the 18th of November - Italian Banks May Need $8.2 Billion as Government Bonds Slump:
"Italy’s five biggest banks, including Intesa Sanpaolo SpA, may need to raise a combined 6.1 billion euros ($8.2 billion) of additional capital as the Italian government bonds they own deteriorate in value.
Two-year Italian debt, which the banks valued at 97 cents on the euro or better on Sept. 30, trades at about 92.7 cents.
That suggests Intesa, UniCredit SpA, Unione di Banche Italiani
SCPA, Banco Popolare and Monte Dei Paschi di Siena SpA need more capital, today’s Bloomberg Risk newsletter reports."
Given the issue of circularity discussed in our previous post, the more pressure we get on Italian sovereign spreads, the more capital, they will need to raise.

All of the above lead us to revisit a subject we approached already in December 2010 as indicated above, and my good credit friend to comment:
"In term of credit market, following Santander, SNS bank and BNP…Here comes SocGen announcing a tender offer on $1.2 billion of subordinated debt! Hooray! The haircut is 44 %, the tender price is 56%…. I guess the bank will do better next time, if there is a “next time” and will offer tender prices below 50 %.

Tip for “banks’ friends”: First came dividends cuts, then bonds haircuts. Next, we will see some massive write-off (Goodwill ?). UniCredit started, others will follow. The path will be very painful for both shareholders and bondholders."
"Goodwill is an accounting convention that represents the amount paid for an acquisition over and above its book value. Under the accounting rules European banks use, the International Financial Reporting Standards, companies have to write down goodwill on their balance sheets if the underlying assets have permanently deteriorated in value."

Indeed, it will be painful. According to Liam Vaughan and Charles Penty, "EU Banks Face $270 Billion Goodwill Hangover for Past Purchases":
"European banks may have to write down some of the $270 billion of goodwill from their purchases in the run up to the financial crisis before they can sell assets, or new stock, to bolster capital.
UniCredit SpA, Italy’s biggest lender, this week opted to take an 8.7 billion-euro ($10 billion) impairment charge following a series of acquisitions at home and in eastern Europe. Other European banks are yet to follow, analysts said.
Credit Agricole SA, Banco Santander SA and Intesa Sanpaolo SA are among European banks with the most goodwill remaining on their balance sheets, according to data compiled by Bloomberg.
Banks that paid a premium for businesses when the outlook was better will need to reassess the goodwill on their balance sheets,” said Andrew Spooner, an accounting partner at Deloitte LLP in London. “Previous acquisitions which are exposed to peripheral Europe are most vulnerable to impairments.”
We already discussed Austria's exposure to Eastern Europe ("Long hope - Short faith"). Erste Bank in fact, wrote down the value of its Hungarian and Romanian units by a combined 939 million euros in October.

Liam Vaughan and Charles Penty also commented in their article:
"UniCredit wrote down goodwill on assets in its home market, eastern Europe and former Soviet Union countries in its third-quarter earnings report this week, though it didn’t tie the charge to any specific deals among the $60 billion of acquisitions it made from 2005 to 2008."
In December 2010 ("Goodwill Hunting - The rise in Goodwill impairments on Banks Balance Sheet"), this is what we discussed as a reminder:
"When a bank acquires another one, goodwill as intangible asset goes on its balance sheet. When a medium bank acquires a smaller one, goodwill is created onto the balance sheet. But, when the medium bank is acquired by a larger one, there is a compounding effect given that the larger bank will also create some more goodwill of its own and therefore inflates its balance sheet.
As the process goes on and on, for banks on the acquisition war path, you find more and more goodwill making up the capital."

On June 29, 2001, The Financial Accounting Standards Board (FASB) unanimously voted in favor of Statement 142, Goodwill and Other Intangible Assets. Prior to this statement, goodwill was amortized over its useful life not to exceed forty years. Under FASB 142, goodwill will still be recognized as an asset, however, amortization of goodwill will no longer be permitted. Instead, goodwill and other intangibles will be subjected to an annual test for impairment of value. This will not only affect goodwill arising from acquisitions completed after the effective date, but will also affect any unamortized balance of goodwill."
We also indicated at the time:
"Looking at non-cash intangible assets (i.e., goodwill) can be a good indicator and used as a proxy to determine the health of banks.

The significance of the write-downs on Goodwill is often presaged as rough waters ahead. These losses often take a real bite out of corporate earnings. It is therefore very important to track the level of these write-downs to gauge the risk in earnings reported for banks."
And we concluded back then:
"Large Goodwill Impairments increase the debt to equity ratio.
It is therefore paramount to track goodwill impairments in relation to future banks earnings."
For more on the subject, Bloomberg Columnist Jonathan Weil had an interesting column relating to Goodwill impairments - "UniCredit Bombshell Shouldn’t Be the Last One".

Time has come once again to become "Goodwill hunters" in relation to bank earnings!

On a final note I leave you with Bloomberg Chart of the Day from the 18th of November relating to debt collection in Spain (the hunt for bad loans...):
"The CHART OF THE DAY shows the proportion of staff in Bankia SA, Banco Popular Espanol SA and the Spanish unit of Banco Bilbao Vizcaya Argentaria SA working in the banks’ collections teams. The second panel shows the amount of bad loans being chased by each of the collection units’ employees. “I’d say it’s more crucial than ever for the Spanish banks to show they’re trying as hard as they can to recover bad loans,” John Raymond, a southern European banking analyst at CreditSights Inc. in London, said in a phone interview.
As the country’s property crash and a stalling economy drive up defaults, the bad-loans ratio of Spanish banks rose to 7.16 percent in September, the highest level since November 1994, according to Bank of Spain data."

"I believe that banking institutions are more dangerous to our liberties than standing armies."
Thomas Jefferson

Stay tuned!

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