news & analysisweb1.amchouston.com/flexshare/001/cfa/moody's/mco 2016 05 23… · of...
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MOODYS.COM
23 MAY 2016
NEWS & ANALYSIS Corporates 2 » Pfizer's Pricey Deal for Anacor Is Credit Negative » Bayer Takeover Offer Confirms Monsanto’s Elevated Event Risk » NXP's Upsized Senior Notes Offering Is Credit Positive » Gerdau Will Benefit from Sale of Its Spanish Subsidiary » Midea's Offer to Buy Out KUKA's Shareholders Is Credit
Positive for KUKA
Infrastructure 7 » Public Service of New Mexico's Rate Case Delay Is Credit Negative » GenOn Energy's Asset Sale Is Credit Positive » Emera Sells Ownership Interest in Algonquin Power & Utilities
for CAD544 Million
Banks 11 » Re-Proposed and Strengthened Pay Rules for US Banks Are
Credit Positive » Raymond James Is Fined for Anti-Money Laundering Failures » For TMX, Consumer Board's Focus on Single-Payment Auto
Title Loans Is Credit Negative » Weaker Related-Party Lending Limits for Russian Banks Would
Be Credit Negative » Vnesheconombank Benefits from Conversion of Central Bank
Loans to Subordinated Debt
Sovereigns 19 » Iraq's Stand-By Arrangement with the IMF Will Help Liquidity » For Nigeria, Niger Delta Oil Pipeline Sabotage Is Credit Negative
Sub-sovereigns 23 » Austrian Pact with HETA Creditors Is Credit Positive for State
of Carinthia
US Public Finance 24 » New York State Property Tax Cap Squeezes School Budgets » Arizona's Prop 123 Increases State Education Funding over 10
Years, a Credit Positive for School Districts » Arizona Voters Approve Public Safety Pension Changes, a
Credit Positive for State and Local Governments
Covered Bonds 30 » Hypothekenbank’s Pfandbrief Holders Benefit from Cover
Pool Merger
RECENTLY IN CREDIT OUTLOOK
» Articles in Last Thursday’s Credit Outlook 32 » Go to Last Thursday’s Credit Outlook
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NEWS & ANALYSIS Credit implications of current events
2 MOODY’S CREDIT OUTLOOK 23 MAY 2016
Corporates
Pfizer’s Pricey Deal for Anacor Is Credit Negative Last Monday, Pfizer Inc. (A1 negative) announced plans to buy Anacor Inc. (unrated), a publicly traded pharmaceutical company focused on dermatology, for approximately $5.2 billion in cash. The announcement comes five weeks after Pfizer terminated its deal with Allergan Plc (subsidiary debt rated Baa3 stable).
The acquisition is credit negative for Pfizer because it is paying a high price – the deal is valued at a 55% premium to Anacor’s closing share price on 13 May – for a company whose key product has not yet been approved by the US Food and Drug Administration (FDA). Still, the deal’s size is relatively modest given Pfizer’s revenue of more than $50 billion. Following the transaction’s announcement, we affirmed Pfizer’s ratings but changed the outlook to negative from stable, reflecting Pfizer’s reduced ability to make acquisitions at its current rating level.
Pfizer’s debt/EBITDA was 2.1x as of 3 April 2016 and remains unchanged for the Anacor acquisition because Pfizer will fund the deal with existing cash. We expect that any future significant acquisitions would involve debt funding. Our quantitative leverage guidance for Pfizer’s A1 rating is 1.5x-2.0x.
Anacor, which is not yet profitable, makes a toenail fungus treatment called Kerydin and is awaiting approval for a new dermatology drug that has blockbuster potential. Anacor splits 50% of Kerydin’s gross profits with Sandoz, a unit of Novartis AG (Aa3 stable), which sells the product in the US. In 2015, Anacor recognized $60.5 million of gross profit sharing revenue related to Kerydin.
But Anacor’s key asset is crisaborole topical ointment 2%, a novel, non-steroidal topical anti-inflammatory phosphodiesterase-4 inhibitor that it is developing for the potential treatment of mild to moderate atopic dermatitis, a type of eczema. The FDA accepted Anacor’s filing for approval in March and we expect the FDA’s decision in January 2017.
Pfizer believes crisabole’s peak sales can reach or exceed $2 billion. Most atopic dermatitis patients are currently treated with older drugs that include antibiotics, antihistamines, topical corticosteroids or topical immuno-modulators. These have varying degrees of effectiveness, and some have warnings of serious side effects. For example, Astellas Pharma Inc.’s (A1 stable) Protopic (tacrolimus) ointment and Valeant Pharmaceuticals International Inc.’s (B2 negative) Elidel (pimecrolimus) cream have warnings related to skin cancer risk. No new drugs have been approved to treat atopic dermatitis in more than 15 years.
Anacor will boost Pfizer’s presence in dermatology, while complementing its immunology drugs Enbrel and Xeljanz. But Kerydin and crisabarole are topical dermatology products. Many drugs in this category will face increasing pricing pressure from payers, in part related to Valeant’s price hikes in the space and subsequent regulatory scrutiny on pricing. In addition, the deal will leave Pfizer with less cash to spend on other opportunities and treatment categories in a rapidly consolidating sector. We expect that Pfizer will evaluate a range of acquisition opportunities to bolster its innovative products business, which is increasingly focused on oncology and other specialized disease areas.
Michael Levesque, CFA Senior Vice President +1.212.553.4093 [email protected]
This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on www.moodys.com for the most updated credit rating action information and rating history.
NEWS & ANALYSIS Credit implications of current events
3 MOODY’S CREDIT OUTLOOK 23 MAY 2016
Bayer Takeover Offer Confirms Monsanto’s Elevated Event Risk US agribusiness giant Monsanto Company (A3 negative) on Wednesday said that it was reviewing a takeover offer from Bayer AG (A3 stable) of Germany. The parties have not disclosed the price, which we estimate at more than $50 billion. A bid from Bayer would be credit negative for Monsanto’s bondholders because the acquisition price would greatly increase leverage at the combined company since Bayer already has roughly $25 billion of debt and a market capitalization of only $115 billion.
Unless structured as a merger, the transaction would likely increase Monsanto’s debt significantly, even if the deal contains an equity component. Additionally, Monsanto’s financial performance is already under strain from low crop prices and its strategy to expand its agricultural chemicals business significantly.
The unsolicited bid makes strategic sense for both companies. Agricultural chemical and seed companies are all under pressure to consolidate after several years of low crop prices, plus the need to develop chemical “cocktails” to complement specific biological traits in seeds. Traits that Monsanto and other agribusiness groups have bioengineered into newer, more profitable seeds require specific chemicals to avoid degrading over time. Farmers using Monsanto’s own RoundUp Ready seeds, which are resistant to RoundUp herbicide, are now battling RoundUp-resistant weeds. Bioengineered seeds will increasingly require close associations with herbicides and insecticides to maximize their yields and prevent the development of resistant weeds or pests.
The pressure to consolidate has led to a number of large agricultural chemical transactions at unusually high valuation multiples – more than 15x annual EBITDA – since early 2015. The Dow Chemical Company’s (Baa2 stable) effort to merge with E.I. du Pont de Nemours and Company (A3 negative) to create the largest global agriculture business prompted Bayer to look for a takeover opportunity.
Regardless of whether the Bayer offer succeeds, we expect that there will be a large transaction in Monsanto’s future. Although Monsanto would probably rather acquire another company or form a joint venture than be taken over – its recent attempt to buy Syngenta AG (A2 review for downgrade) fell through – some large transaction with a chemicals producer would be Monsanto’s quickest way to substantially improve its market position. But Monsanto cannot easily finance a takeover at today’s 15x multiples without sacrificing credit quality.
Growing its own chemical business organically, meanwhile, would be a painstaking process: Monsanto would have to register new chemical products in any country where it hoped to operate, which would delay its entry for selling products often similar to goods already for sale in those markets in the first place. Any delays in the registration process would make it more difficult for Monsanto to gain enough market share to be profitable in chemicals despite its established market share in seeds.
In the meantime, Monsanto’s profitability remains under stress. Lower farmer incomes have reduced demand for premium seeds and chemicals. Profits have improved for private-label and generic crop-chemical producers despite lower prices, but makers of most premium agricultural chemicals have seen reduced volumes and unusually high inventories.
The risks of a corporate takeover, a fading market for premium seeds and chemicals and trouble obtaining royalties in Argentina, India and Brazil all make it more likely that Monsanto’s leverage will remain above its target for longer than it had expected. The company targets a 1.5x debt/EBITDA ratio, but as of 29 February 2016, had an adjusted net leverage of 2.0x, or 2.5x including our adjustments.
John Rogers Senior Vice President +1.212.553.4481 [email protected]
NEWS & ANALYSIS Credit implications of current events
4 MOODY’S CREDIT OUTLOOK 23 MAY 2016
NXP’s Upsized Senior Notes Offering Is Credit Positive Last Wednesday, NXP B.V. (Ba1 stable) said it raised $1.75 billion through a senior notes offering, up from an initially planned $1 billion. The upsized notes offering is credit positive because it will result in a senior secured debt repayment that is $750 million larger than the company previously expected.
The steeper-than-expected reduction in senior secured debt will reduce the expected loss given default (LGD) on NXP’s senior unsecured debt. This is because there will be less secured debt ranking ahead of the unsecured debt. The senior unsecured LGD assessment will improve to LGD4 from LGD5. A greater proportion of unsecured debt in the capital structure improves the company’s capacity to add secured debt as needed. Moreover, the redemption and repayment also improves NXP’s debt maturity profile because debt maturing in 2020 ($1.25 billion of the senior secured term loan B) will be replaced with debt maturing in 2021 and 2023.
NXP is a leading manufacturer of automotive semiconductors and its fab-lite manufacturing model enables it to generate consistent free cash flow. We expect debt/EBITDA as adjusted by us to remain above 3x over the next 12-18 months, which is high for its Ba1 rating given the significant execution risks involved in the integration of its December acquisition of Freescale Semiconductor Inc. (senior secured Baa2 no outlook). Nevertheless, we expect NXP to use most of its free cash flow to reduce debt, enabling the combined company, through a combination of debt reduction and EBITDA growth, to lower adjusted debt/EBITDA to below 3x in 2017.
NXP’s Baa2 (LGD2) senior secured rating reflects the collateral, the guarantees from operating subsidiaries, and the significant cushion of unsecured liabilities. Freescale’s senior secured notes and NXP’s senior secured debt share in each other’s collateral and guarantees. NXP’s Ba2 (LGD4) senior unsecured rating reflects the significant quantity of secured debt, which is structurally senior to the senior unsecured debt, and the guarantees from operating subsidiaries.
The Ba2 (LGD6) rating of the cash convertible notes of NXP Semiconductors N.V. (Ba2 stable) reflects both the absence of collateral and the absence of upstream guarantees from operating subsidiaries, which renders the cash convertible notes structurally subordinated to the debt of NXP. Although we expect the cash convertible notes to have lower recovery in a default scenario than the guaranteed unsecured notes, the expected recovery differential is not sufficient to lead to a notching differential.
Terrence Dennehy Vice President - Senior Analyst +1.212.553.1015 [email protected]
NEWS & ANALYSIS Credit implications of current events
5 MOODY’S CREDIT OUTLOOK 23 MAY 2016
Gerdau Will Benefit from Sale of Its Spanish Subsidiary On Friday, Brazilian steelmaker Gerdau S.A. (Ba3 negative) said that it would sell its Spanish specialty steel subsidiary to Clerbil SL (unrated) for €155 million (BRL620 million). Pending the approval of regulators in Spain, the sale would be credit positive because it is part of Gerdau’s strategy to divest smaller, non-core assets and use proceeds to reduce debt, despite having no significant effect on future operations or capital structure. Using all the sale proceeds for debt reduction would reduce Gerdau’s adjusted debt/EBITDA ratio to 6.0x from 6.2x at the end of 2015. The transaction includes a five-year, €45 million earn-out clause.
Even with the sale, Gerdau, one of the world’s largest suppliers of specialty long steel, faces pending tax liabilities in Brazil’s administrative council of tax appeals. In an unfavorable outcome, Gerdau could be required to provide collateral and guarantees, and eventually pay BRL1.5 billion in taxes, plus interest and penalties. A penalty of that size could jeopardize Gerdau’s medium- to long-term liquidity. Furthermore, some of the company’s executives, including current CEO André Gerdau Johannpeter, allegedly received favorable rulings to tax appeals in return for paying a percentage of the tax relieved to government officials.
For now, the sale offers a small leverage benefit without denting Gerdau’s future operations. The Spanish subsidiary has an annual production capacity of 1 million tons, less than 4% of Gerdau’s total capacity, and its EBITDA margin is smaller than that of Gerdau’s operations in Brazil (9.2% EBITDA margin in the first quarter of 2016), North America (8.3%), South America excluding Brazil (14.8%), and its overall specialty steel business segment (8.0%). The consolidated specialty steel segment, which includes operations in Brazil, the US, Spain and India, generated about 18% of Gerdau’s 12-month EBITDA in March 2016.
Gerdau is seeking relief for a balance sheet that deteriorated significantly in 2015. Along with the asset sale in Spain, Gerdau is looking at cost-saving measures and capital spending cuts to increase its free cash flow generation. But the severity of the ongoing downturn in Brazil’s steel industry will probably keep Gerdau’s leverage and debt-protection metrics strained through at least mid-2017.
Lower sales volumes and profitability, particularly in Brazil and the US, reduced the company’s absolute EBITDA by 20% from a year earlier. Meanwhile, the Brazilian real’s depreciation against the US dollar increased the nominal value of Gerdau’s foreign currency debt – 88% of Gerdau’s debt is denominated in foreign currency – raising the company’s adjusted leverage metrics to 6.2x in 2015 from just 3.6x in 2014.
Barbara Mattos Vice President - Senior Credit Officer +55.11.3043.7357 [email protected]
Carolina Chimenti Associate Analyst +55.11.3043.7318 [email protected]
NEWS & ANALYSIS Credit implications of current events
6 MOODY’S CREDIT OUTLOOK 23 MAY 2016
Midea’s Offer to Buy Out KUKA’s Shareholders Is Credit Positive for KUKA On Wednesday, MECCA International (BVI) Limited, a wholly owned subsidiary of Midea Group Co., Ltd. (A3 stable), announced an offer to acquire for €115 per share all outstanding shares of KUKA AG (Ba2 positive) that it does not currently own.
The offer is credit positive for KUKA because Midea’s increased ownership – up from its current 10.2% stake – will cement KUKA’s strategic position in China and also support its strategy to diversify beyond the supply of robotics to the automotive sector. Additionally, given Midea’s higher rating, if it were to gain significant majority ownership of KUKA, we would consider incorporating shareholder support into our analysis of KUKA’s credit quality and rating.
The more KUKA shares MECCA buys, the closer KUKA will be tied to Midea’s strategy and support. Midea is one of the largest electronic appliance products and maintenance manufacturers in China. Headquartered in Augsburg, Germany, KUKA AG focuses on robot-supported automation of manufacturing processes and is active in the mechanical and plant engineering sector. The group operates under three divisions: KUKA Robotics (approximately 30% of group revenue), KUKA Systems (approximately 50%) and Swisslog (roughly 20%). We expect KUKA to generate revenue of around €3 billion in 2016. Its market capitalization was around €4.4 billion as of 17 May 2016. Midea’s key products are air conditioners (57% of 2014 revenue), refrigerators (7%), washing machines (8%) and small household appliance (24%). MECCA’s buyout offer is in line with its strategy to enhance the automation of its manufacturing process.
KUKA in 2015 had China-related revenue of €425.1 million, or 14.3% of group revenue. Nearly 50% of its revenue was generated with customers from the automotive industry. We believe that Midea’s more material ownership will increase KUKA’s exposure to the Chinese market and increase its exposure to the general industry segment, which is growing faster than the automotive industry. KUKA’s management expects revenue growth of 5%-10% this year from general industry customers versus 0%-5% from the automotive customers.
Besides Midea, KUKA has two German anchor shareholders with Voith GmbH (Ba1 stable) the largest since April 2015, followed by the Friedhelm Loh Group (through Swoctem), as shown below.
KUKA’s Current Shareholders
Source: KUKA AG
Midea’s offer of €115 per share is a premium of around 36% to KUKA’s share price at closing on 17 May.
Voith Group25.1%
Midea Group10.2%
Swoctem 10.0%
Other54.7%
Wen Li Associate Analyst +49.69.70730.742 [email protected]
Martin Kohlhase Vice President - Senior Credit Officer +49.69.70730.719 [email protected]
NEWS & ANALYSIS Credit implications of current events
7 MOODY’S CREDIT OUTLOOK 23 MAY 2016
Infrastructure
Public Service of New Mexico’s Rate Case Delay Is Credit Negative Last Wednesday, the New Mexico Public Regulation Commission (NMPRC) ordered a 30-day extension to the procedural schedule for the Public Service Company of New Mexico (PNM, Baa2 stable) general rate case filing submitted 27 August 2015. The extension postpones PNM’s implementation of new customer rates to 1 September 2016, at the earliest, and is credit negative because it delays recovery of the utility’s prudently incurred costs and investments.
This is the New Mexico regulator’s second extension on PNM’s rate case. PNM, the principal operating utility of PNM Resources, Inc. (Baa3 stable), had to re-submit its rate case filing in August 2015 after the NMPRC rejected the utility’s initial application in December 2014. If new rates are implemented in September, the time between a final NMPRC order and PNM’s initial application would be almost 21 months, much longer than the typical state rate case proceeding of about 12 months.
In its current rate case filing, PNM is requesting an electric rate increase of $123.5 million, reflecting a $655 million increase in the rate base since its last case filing in 2010. For the 12 months that ended 31 March 2016, PNM’s ratio of cash flow from operations pre-working capital (CFO pre-W/C) to debt was 15.8%, which is considerably lower than its three-year average CFO pre-W/C to debt of about 20%.
Because of the delays in its pending rate case filing and the associated rate-recovery lag, we expect that PNM will continue to earn below its authorized return on equity. In 2016, we expect PNM’s CFO pre-W/C to debt to be in the mid-teens range, with recovery to the high teens in 2017 once new rates are implemented later this year.
Jeffrey Cassella Vice President - Senior Analyst +1.212.553.1665 [email protected]
NEWS & ANALYSIS Credit implications of current events
8 MOODY’S CREDIT OUTLOOK 23 MAY 2016
GenOn Energy’s Asset Sale Is Credit Positive Last Tuesday, GenOn Energy, Inc. (Gen, Caa2 negative) announced the sale of its 878 megawatt (MW) Aurora natural gas-fired power plant to RA Generation LLC (unrated) for $365 million, subject to certain adjustments. This sale is credit positive for GEN because the additional cash will allow the company to reduce its debt, alleviating GEN’s future financial burden. Proceeds from the asset sale will reduce an expected funding shortfall to $880 million by December 2018, considering the company’s estimate of a negative $450 million operating cash flow, which excludes cash flows from subsidiaries with dividend restrictions.
As planned, it is unlikely that the sale proceeds are sufficient to pay off Gen’s $691 million of maturing debt in 2017, and its $650 million of maturing debt in 2018, as shown below.
GenOn's Liquidity after Aurora Plant Sale Sources of Liquidity 1Q2016-2018 Amount $ Millions
Cash as of March 2016 $319
Revolver Availability 224
Sale of Aurora Power Station 365
Total $908
Uses of liquidity 1Q2016-18
Estimated negative cash flow 2016-18* $450
2017 Bond maturity 691
2018 Bond Maturity 650
Total $1,791
Funding Shortfall -$883
* Excludes cash flows from subsidiaries with dividend restrictions.
Sources: GenOn and Moody’s Investors Service
Aurora’s power station sale is consistent with the company’s publicly stated intent to reduce debt through asset sales and it follows the sale of its Seward Waste Coal Plant and Shelby GT for $138 million. The company has retired $274 million of bonds across several maturities at a cost of $232 million since November 2015.
As of 31 March 2016, GEN without GenOn Mid-Atlantic, LLC (GenMA, B2 negative) and GenOn REMA, LLC (REMA, B2 negative) had a cash balance of $319 million and $224 million available under its revolving credit facility with its parent NRG Energy, Inc. (NRG, Ba3 stable), which we expect is enough to support on-going operating costs and interest expenses. It is noteworthy that GenMA and REMA cannot distribute any of their $599 million of cash, as of 31 March 2016, because they do not satisfy the restricted payment tests under their agreements. An additional source of liquidity for GenOn is a potential reduction of the service agreement fee with NRG, which was $193 million in 2015.
However, it is likely that some sort of debt restructuring is necessary to bring the debt burden down to a sustainable level. This also considers that GEN’s remaining assets are relatively unattractive under current market conditions, which in our view limits GEN’s potential to raise additional cash from future asset sales. GEN’s portfolio is composed mainly of peaking facilities and struggling coal plants. The only exception is Hunterstown (810 MW), a combined cycle gas plant that recorded a capacity factor of 55% 2014 and 72% in 2015.
Toby Shea Vice President - Senior Credit Officer +1.212.553.1779 [email protected]
Christian Hermann Associate Analyst +1.212.553.2912 [email protected]
NEWS & ANALYSIS Credit implications of current events
9 MOODY’S CREDIT OUTLOOK 23 MAY 2016
GEN is a major player in the US merchant power industry with total generating capacity of about 17 gigawatts (GW). GEN is a wholly owned subsidiary of NRG, which is itself the largest merchant power company in the US with about 51 GW of generating capacity, including the 17 GW at GEN.
NEWS & ANALYSIS Credit implications of current events
10 MOODY’S CREDIT OUTLOOK 23 MAY 2016
Emera Sells Ownership Interest in Algonquin Power & Utilities for CAD544 Million Last Tuesday, Emera Inc. (unrated) announced that it had agreed to sell 50.1 million common shares of its ownership interest in Algonquin Power & Utilities Corp. (unrated) in a secondary sale at CAD10.85 per share, which totals CAD544 million. The sale is credit positive for Canada-based Emera if, as we expect, the company uses the proceeds to finance a portion of its pending acquisition of US-based TECO Energy, Inc. (Baa1 stable). At the completion of the sale, Emera will maintain an approximate 5% equity interest in Algonquin.
We expect that proceeds from the sale of the Algonquin stake will be used to reduce the amount of new debt Emera will need to finance the TECO acquisition. In September 2015, Emera announced that it had agreed to acquire TECO for an aggregate purchase price of $10.4 billion, which includes the assumption of $3.9 billion of existing TECO debt. Emera said that it would finance the transaction with a mix of equity and debt in a manner that would maintain its current credit quality. In September 2015, Emera sold approximately $1.7 billion of convertible debentures, which fulfilled the common equity component to finance the TECO acquisition. To finance the remaining portion of the TECO acquisition, Emera plans to issue $800 million to $1.2 billion of preferred equity and hybrid securities and up to $3.8 billion of new debt.
The planned acquisition of TECO will increase Emera’s proportion of regulated earnings to about 85% from 70%. Approximately 92% of TECO’s 2015 operating earnings from continued operations were derived from its principal operating company, Tampa Electric Company (A2 stable), a regulated electric and gas utility operating in Florida. We consider the regulatory framework in Florida to be credit supportive because the utility is allowed to use a group of cost-recovery mechanisms that provide timely recovery of prudently incurred costs and investments.
Peter Giannuzzi Associate Analyst +1.212.553.2917 [email protected]
Jeffrey Cassella Vice President - Senior Analyst +1.212.553.1665 [email protected]
NEWS & ANALYSIS Credit implications of current events
11 MOODY’S CREDIT OUTLOOK 23 MAY 2016
Banks
Re-Proposed and Strengthened Pay Rules for US Banks Are Credit Positive Last Monday, six US federal regulators1 proposed rules to prohibit financial institutions from offering incentive-based compensation that could encourage excessive risk-taking by senior executive officers and other so-called significant risk takers. The rules, mandated by the Dodd Frank Act, will apply to a broader range of employees than the regulators’ 2011 joint proposal, which was never implemented. The new proposal introduces more stringent requirements for incentive compensation deferral and compensation recoupment (i.e., clawback).
As proposed, the rules would be credit positive for banks, in particular large banks such as The Goldman Sachs Group, Inc. (A3 stable) and JPMorgan Chase & Co. (A3 stable) since executives’ and other key risk takers’ compensation would be aligned with sound risk-taking. A bank’s risk profile and the quality of its governance and risk management are key drivers of credit quality within our bank rating methodology.
The rule would apply to banks, asset managers, broker-dealers and other financial institutions with total consolidated assets of more than $1 billion. Larger institutions would have more stringent requirements in the new tiered approach, which classifies institutions into Level 1, those with $250 billion or more in assets, which would have the most stringent standards; Level 2 institutions with $50-$250 billion would have less stringent standards; and Level 3 institutions with $1-$50 billion (Level 3) would have easier requirements.
The revised rules apply to a larger swath of employees than the 2011 proposal. For example, the definition of “senior executive officers” has been expanded to cover roles including chief compliance officer, chief credit officer and the heads of control functions. The definition of “significant risk takers” such as loan officers and underwriters would also include employees who receive at least one-third of their pay from incentive compensation (excluding senior executive officers) and meet certain compensation tests, such as being among the top 5% of highest-compensated employees.
At Level 1 banks, the largest banks, senior executives would be required to defer at least 60% and other key risk takers at least 50% of their annual incentive compensation for at least four years. At Level 2 institutions, senior executives would defer 50% and other key risk takers 40%, for at least three years. Most large banks that require deferrals defer at least half of senior executives’ incentive compensation for three years, but few use a four-year period. During the deferral period, the awards would be subject to reduction and forfeiture in various adverse outcomes, including poor financial performance. Reducing compensation before it has vested is easier than clawing it backing it after it has been paid out.
To cover compensation that has already been paid out, tough clawback policies apply to 100% of incentive-based compensation for up to seven years after the awards have vested in cases of misconduct, including fraud, intentional misrepresentation of information used to determine the individual’s bonus compensation, and misconduct that resulted in significant financial or reputational harm to the bank. Most banks already have clawback polices in place, but clawback periods rarely extend beyond three years, and then only at the largest banks.
Most aspects of the proposal are credit positive, but the mandatory deferral and vesting periods may be too short to cover risks that only become apparent over say seven to ten years, as with fines and litigation.
1 National Credit Union Administration, Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Federal
Housing Financing Agency, the Board of Governors of the Federal Reserve System, and the Securities and Exchange Commission.
Christian Plath Vice President - Senior Credit Officer +1.212.553.7182 [email protected]
Ram Sri-Saravanapavaan Associate Analyst +1.212.553.4927 [email protected]
NEWS & ANALYSIS Credit implications of current events
12 MOODY’S CREDIT OUTLOOK 23 MAY 2016
Other jurisdictions, including the UK and Switzerland, require longer minimum deferral, vesting, and clawback periods, which we view favorably.
Because the proposal is largely consistent with current practice and interagency guidance, we expect larger banks will have little difficulty implementing the rules, with the possible exception of strengthening clawback polices and expanding the scope of covered employees. Smaller banks may face more difficulty adapting to the changes since their compensation practices vary more widely.
NEWS & ANALYSIS Credit implications of current events
13 MOODY’S CREDIT OUTLOOK 23 MAY 2016
Raymond James Is Fined for Anti-Money Laundering Failures Last Wednesday, the Financial Industry Regulatory Authority (FINRA) announced that it fined two broker-dealer subsidiaries of Raymond James Financial, Inc. (Baa2 positive) $17 million for failures to implement adequate anti-money laundering (AML) programs.
The fine is credit negative for Raymond James because it reveals that operational shortfalls at the firm are continuing after a 2012 FINRA sanction for inadequate AML procedures. The recent investigation concluded that Raymond James failed to commit enough resources to its AML program and assigned too few individuals with the extensive responsibilities the program entails. Earlier this month, the firm announced that it had increased its investment in technology and expanded the AML team to around 50 hires, from just seven.
FINRA also found a lack of systems and written procedures for monitoring potentially suspicious transactions. Examples of high-risk activities that would normally raise a red flag include the transfer of funds from multiple accounts to the same third-party account without an apparent business purpose, or movement of cash from a customer’s account to the account of an employee at the firm. Raymond James’ increase of financial advisors, which is driven by the 2012 Morgan Keegan acquisition, surpassed the firm’s investment in technology and people within the AML compliance function.
In April 2016, the company agreed to sell its ownership interest in two entities that serve the Latin American market, one based in British Virgin Islands and the other in Uruguay. These operations did not affect the company’s overall results. The cost of operating these entities would have been higher than the benefit after incorporating AML controls, because they are located in jurisdictions vulnerable to money laundering.
Our positive outlook on Raymond James rating reflects the firm’s franchise strength, its diversified revenue base and disciplined share buybacks and dividend policies.
Fadi Abdel Massih Analyst +1.212.553.0441 [email protected]
NEWS & ANALYSIS Credit implications of current events
14 MOODY’S CREDIT OUTLOOK 23 MAY 2016
For TMX, Consumer Board’s Focus on Single-Payment Auto Title Loans Is Credit Negative Last Wednesday, the Consumer Financial Protection Board (CFPB) issued a study and comments on single-payment auto title lending, which is critical of the industry’s method of underwriting loans and willingness to renew or extend loan maturity. These are short-term loans backed by the borrower’s vehicle, intended to be repaid with a single payment. The CFPB will likely propose new rules for the sector as early as this quarter addressing these issues. New rules are likely to reduce TMX Finance LLC (B3 stable) origination volume and profitability, a credit negative. Further, the CFPB’s proposals increase refinancing risk for TMX, which has $603 million of its senior secured notes maturing in September 2018.
TMX is an auto title lender with the majority of its operations in these single-payment loans. Underwriting for much of the industry is primarily focused on the value of the vehicle that serves as collateral, as opposed to the borrowers’ ability to repay. The results of the CFPB’s industry-wide study revealed very high default rates and borrowers’ propensity to roll-over their loans several months beyond initial maturity dates and pay significant additional fees. The CFPB characterized this lending as having the potential to create long-term debt traps for borrowers. The CFPB further indicated that these loans pose a danger to consumers, especially for borrowers whose vehicles are repossessed, costing them ready access to their jobs or doctors. These views raise the probability of changes to the underwriting and/or pricing of single-payment auto title lending.
TMX will likely need to change underwriting practices to assess the borrower’s ability to repay, which is a significant change from the company’s practices for most of its portfolio. Required underwriting changes could, at least temporarily, reduce loan volumes and loan sizes, and negatively affect earnings.
In addition to origination and profit challenges, TMX faces elevated refinancing risk for its 2018 maturity. The proposed rules are likely as early as this quarter. After a probable comment period for industry participants and subsequent implementation period, the rules are apt to take effect in either late 2017 or early 2018. The timing will provide a short time frame before TMX’s September 2018 senior secured notes mature for the company to make necessary changes and demonstrate its performance to attract bondholders to a new issue. We expect TMX to refinance these bonds because it does not have the internal liquidity capacity to pay them off.
Jason Grohotolski Vice President - Senior Credit Officer +1.212.553.1067 [email protected]
NEWS & ANALYSIS Credit implications of current events
15 MOODY’S CREDIT OUTLOOK 23 MAY 2016
Weaker Related-Party Lending Limits for Russian Banks Would Be Credit Negative On 17 May, the First Deputy Chairman of the Central Bank of Russia (CBR) Alexey Simanovsky said that the CBR may loosen the related-party lending limit scheduled to take effect 1 January 2017.2 According to Mr. Simanovsky, the CBR may phase-in implementation of the limit by partially excluding from its calculation the related-party loans to entities that “conduct real economic activity,” a CBR definition,3 while entities that “do not conduct real economic activity” will be included in full.
We think that loosening banks’ related-party lending limit will undermine the rule’s substance and remove incentives for banks making related-parties loans to resolve the long-lasting deficiencies in their corporate governance and risk underwriting. We expect that banks will be able to prove that the majority of their related-party borrowers conduct real economic activity and should be subject to reduced requirements.
The new proposal is another step toward softening the effect of the so-called N25 ratio, which caps banks’ loans to related-parties at 20% of their total regulatory capital – a limit twice postponed because many local banks would have failed to comply with the requirement. The regulator has not provided any details of the newly proposed computation approach, nor has it specified how long the transition period for this temporary easing measure could last or when the full-scale requirement would be phased-in for all types of related-party borrowers.
The current version already includes some materially looser provisions to facilitate banks’ compliance with N25 limit. For instance, the 20% cap will be applied separately for exposures to each group of related-party borrowers, such as for groups related to different shareholders of the same bank. Also, for the purpose of the ratio computation, banks will be allowed to reduce the related-party exposure by the amount of high-quality liquid collateral pledged against the loan. We estimate that as a result of these relaxed provisions, Moody’s-rated banks reporting very high related-party lending under International Financial Reporting Standards (IFRS), as shown in Exhibit 1, will have their N25 ratio standing just slightly above the 20% regulatory threshold, while some of them may even meet the requirement, for instance, through securing the collateral (such as in the case of Bank Otkritie Financial Corporation, Ba3/Ba3 negative, b14).
2 The definition of a bank’s “related party” includes 1) any legal entity that controls or exercises influence over the bank, or is under control
or influence of the bank; 2) any individual who controls or exercises influence over the bank; 3) any board director or manager with influence over key decisions; 4) entities that constitute a single group with related parties listed above.
3 We understand that the definition of borrowers “potentially conducting no real economic activity” will be harmonised with the CBR’s other regulations currently in effect, including (but not limited to) the 1) absence of fixed assets and/or other manufacturing capacities; 2) a loan more than 10x the borrower’s average quarterly revenue; 3) a borrower’s no or low tax and payroll payments; and 4) complex and non-transparent transactions lacking obvious economic substance.
4 The bank ratings shown in this report are the bank’s local currency deposit rating, senior unsecured debt rating and baseline credit assessment.
Ilya Pestryakov Associate Analyst +7.495.228.6117 [email protected]
Olga Ulyanova Vice President - Senior Analyst +7.495.228.6078 [email protected]
NEWS & ANALYSIS Credit implications of current events
16 MOODY’S CREDIT OUTLOOK 23 MAY 2016
EXHIBIT 1
Rated Russian Banks with the Highest Related-Party Loans as a Percent of Total Capital
Note: Total capital (the denominator of the ratio) includes Tier 2 capital components, such as subordinated debt, to make it a closer proxy to the banks’ regulatory capital applying to N25 computation. Source: the banks’ International Financial Reporting Standards data
We believe that the N25 regulatory limit will not address the fundamental concern about related-party lending because when dealing with related parties, many banks’ lending decisions deviate from standard credit underwriting practices, increasing the banks’ risks. As shown in Exhibit 2, the weighted-average total related-party exposure for Moody’s-rated Russian banks has trended up in recent years and was 39% of total capital at year-end 2015.
EXHIBIT 2
Rated Russian Banks’ Weighted-Average Related-Party Loans as Percent of Total Capital
Sources: Moody’s-rated banks’ International Financial Reporting Standards data and Moody’s Investors Service
281%
72% 68%
36% 24% 21% 20% 18% 10%
92%
51%69%
36% 26% 21% 20% 17% 28%
0%
50%
100%
150%
200%
250%
300%
Bank OtkritieFinancial
CorporationPJSC
Tatfondbank Joint StockCommercial
Bank Avangard
RGS Bank RussianInternational
Bank
Finprombank Far Eastern Bank Promsvyazbank MetallinvestbankJSCB
2015 2014
23%22%
31%
24%20% 19%
19%
13%
25%
39%
0%
5%
10%
15%
20%
25%
30%
35%
40%
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
NEWS & ANALYSIS Credit implications of current events
17 MOODY’S CREDIT OUTLOOK 23 MAY 2016
Vnesheconombank Benefits from Conversion of Central Bank Loans to Subordinated Debt On 17 May, Russia’s State Duma, the lower chamber of the national parliament, approved amendments to the Law on Investment Funds that allow the Central Bank of Russia (CBR) to convert RUB212.6 billion of loans it provided to Vnesheconombank (VEB, Ba1 negative) into the same amount of subordinated debt. The credit-positive conversion will alleviate capital pressures on VEB, a government-related issuer (GRI).
Although VEB is a non-banking financial institution and is fully owned by the Russian government, it must adhere to the total capital adequacy ratio (CAR) of 10%, which is calculated according to the CBR’s requirements, and a covenant of its eurobonds. According to our estimates, converting the CBR loans to subordinated debt will increase VEB’s total CAR to above 13% from 12.1% as of 31 March 2016. The loan conversion is designed to boost the bank’s capital and funding amid weak earnings and anticipated losses this year and is a part of a wider government and CBR support package following VEB’s restructuring and the government’s capital support amid losses in the first-quarter, which resulted in marginal CAR growth (see Exhibit 1).
EXHIBIT 1
Vnesheconombank’s Total Capital Adequacy Ratio Dynamics
Note: Calculated on unconsolidated basis (only for VEB) and as per the CBR’s statutory requirements. Source: Vnesheconombank
VEB’s anticipated loss this year as a result of additional provisioning charges and weak core profitability, make the loan conversion and total CAR boost especially important. VEB will likely require new provisioning charges to cover its substantial problem loans (all individually impaired and overdue loans as per our classification), which accounted for around 39% of gross loans as of year-end 2015. The high proportion of nonperforming loans will also keep core profitability modest: VEB’s net interest margin was only 1.5% at year-end 2015.
The high number and amount of problem loans, particularly related to infrastructure projects for the 2014 Winter Olympics and to Ukrainian credit exposures, largely reflect the government’s strong influence over VEB’s lending and investment decisions. However, VEB’s issuer ratings incorporate very high probability of the government’s support, while its standalone credit quality is weak. Substantial growth in VEB’s problem loans in 2014 (see Exhibit 2) largely reflects government-directed lending.
0%
2%
4%
6%
8%
10%
12%
14%
16%
2012 2013 2014 2015 Q1 2016
Alexander Proklov Vice President - Senior Analyst +7.495.228.6072 [email protected]
NEWS & ANALYSIS Credit implications of current events
18 MOODY’S CREDIT OUTLOOK 23 MAY 2016
EXHIBIT 2
Vnesheconombank’s Problem Loans
Sources: VEB Group, Moody’s Banking Financial Metrics, and Moody's Investors Service estimates
0%
5%
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25%
30%
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40%
2010 2011 2012 2013 2014 2015
NEWS & ANALYSIS Credit implications of current events
19 MOODY’S CREDIT OUTLOOK 23 MAY 2016
Sovereigns
Iraq’s Stand-By Arrangement with the IMF Will Help Liquidity Last Thursday, the International Monetary Fund (IMF) announced that it had reached a staff- level agreement on a three-year Stand-By Arrangement with Iraq (unrated), under which, pending approval by the IMF executive board, Iraq will have access to up to $5.4 billion in loans at interest rates of 1.0%-1.3%. The agreement is credit positive for Iraq because it will improve liquidity. The Stand-By Arrangement follows a prerequisite Staff-Monitored Program in November, in which Iraqi authorities agreed to undertake measures to enhance public financial management.
Iraq’s economy and government finances have been hit by the twin shocks of the rise of the Islamic State of Iraq and Syria (ISIS) and falling oil prices. ISIS has destroyed infrastructure, reduced economic activity in occupied areas, and strained government resources, with expenditures now more heavily tilted toward wages for operations against ISIS (see Exhibit 1). Meanwhile, lower oil prices since mid-2014 have taken a toll on government revenues and the country’s external current account balance: oil revenues account for more than 90% of total government revenues and almost 100% of goods exports.
EXHIBIT 1
Iraq’s General Government Expenditures 2014
2015
Note: SOE = state-owned enterprise. Source: International Monetary Fund
The Stand-By-Arrangement will help the government finance its large twin fiscal and current account deficits, which stood at 15% of GDP and 6.4% of GDP respectively in 2015 and will likely widen further this year. The fiscal deficit has largely been financed by domestic banks either via loans to the government or by buying government debt securities (see Exhibit 2). To fund the balance-of-payments shortfall, the authorities resorted to drawing on foreign exchange reserves, which fell to around $50 billion at the end of 2015 (equivalent to about nine months of imports), from a high of about $74 billion in 2013.
Salary and pension46%
Non-oil investment17%
Goods and services6%
Oil investment16%
Other transfers3%
Social safety net transfers5%
War reparations3%
Transfers to SOEs3%
Interest payments1%
Salary and pension60%
Non-oil investment10%
Goods and services5%
Oil investment12%
Other transfers3%
Social safety net transfers6%
Transfers to SOEs2% Interest payments
2%
Shirin Mohammadi Associate Analyst +1.212.553.3256 [email protected]
Steffen Dyck Vice President - Senior Credit Officer +49.69.7073.0942 [email protected]
NEWS & ANALYSIS Credit implications of current events
20 MOODY’S CREDIT OUTLOOK 23 MAY 2016
EXHIBIT 2
Iraqi Sources of Domestic Financing in 2015 Were Insufficient to Prevent Arrears
Note: The 2015 deficit was partly financed by the accumulation of domestic arrears. Source: International Monetary Fund
A key component of the Staff-Monitored Program that led to this Stand-By Arrangement was that Iraqi authorities agreed to aim to reduce the non-oil primary deficit (i.e., the difference between non-oil revenues and non-oil expenditures excluding net interest payments) by 4% of non-oil GDP between 2014 and 2016. According to preliminary estimates by the IMF, Iraq has already exceeded this target, reducing that deficit to 52% of non-oil GDP in 2015 from 60% in 2014.
Despite this progress, fiscal consolidation will remain a challenge. The government’s plan to increase oil output is jeopardized by the tight fiscal situation, which led to the buildup of arrears to international oil companies (although all outstanding arrears to international oil companies have now been cleared), and subsequent downward revisions to investment budgets. To reduce its co-investment obligation, the Iraqi government asked BP p.l.c. (A2 positive), Lukoil, PJSC (Ba1 negative), Exxon Mobil Corporation (Aaa negative) and Royal Dutch Shell Plc (Aa2 negative) to reduce their investment spending to $5.5 billion in 2016, from an originally proposed $8.7 billion. This reduces the government’s spending commitments and allows existing funds to be redirected toward military operations against ISIS, but also leads to lower future revenues, which makes it more difficult for the authorities to fund future military operations should they still be needed a year from now.
Nonetheless, the Stand-By Arrangement, which will be disbursed in 13 tranches over a three-year period through June 2019, will help ease some liquidity pressure and increases incentives for the government to continue its fiscal consolidation efforts. Spending pressures could also be alleviated if the government follows a proposal by international oil companies to switch to production sharing agreements from current services contracts.
T-Bills and Bonds63%
Commercial Bank Loans16%
Arrears15%
IMF Rapid Financing Instrument4%
Special Drawing Right Allocation2%
NEWS & ANALYSIS Credit implications of current events
21 MOODY’S CREDIT OUTLOOK 23 MAY 2016
For Nigeria, Niger Delta Oil Pipeline Sabotage Is Credit Negative Last Monday, Nigerian Oil Minister Emmanuel Ibe Kachikwu acknowledged a recent 40% decline in oil production to 1.4 million barrels per day, versus a monthly average of 2.1 million barrels per day in 2015. The decline is mainly the result of a fresh resurgence of militancy in the Niger Delta and is credit negative for the sovereign.
Attacks on pipelines and key energy infrastructure managed by various international oil companies have slowed the country’s oil production to historic lows, adding to myriad economic challenges facing the Nigerian government (B1 stable) amid persistently low oil prices. Oil and gas constitute more than 90% of Nigeria’s exports, and oil is the main source of foreign currency for Nigeria’s economy and an important share of government revenues.
As the exhibit below shows, past bouts of militancy have triggered extended periods of production shortfalls. In 2009, oil production reached a low of 1.65 million barrels per day. Nigeria’s 2016 budget assumes oil production of 2.2 million barrels per day and an average oil price of $38 per barrel.
Nigeria’s Oil Production in Millions of Barrels
Sources: The Central Bank of Nigeria, Bloomberg and Moody’s Investors Service
Although Nigeria is striving to promote non-oil revenue, the transition is difficult. The country is looking to significantly increase its value-added tax, income tax and appropriate revenue from various government agencies. However, the budget still expects oil revenue to constitute 20% of the federal government’s revenue, and an even larger share for Nigeria’s states and municipalities.
If the decline in oil production persists, it risks jeopardizing Nigeria’s expansionary 2016 budget, which is geared toward critical infrastructure projects. The government’s budgeted deficit of 2.2% of GDP is already close to the statutory limit of 3% imposed by a 2007 fiscal law, but we do not expect the government to breach this limit. Instead, we think it is more likely that authorities will reduce spending if the revenue shortfall is significant, which should be manageable since the budget was only recently signed by President Muhammadu Buhari and took effect at the beginning of this month.
Nevertheless, external pressures continue to mount, with reserves having fallen to $26 billion in April from $28.4 billion at the end of 2015. Lower oil and gas receipts likely mean a larger-than-expected current account deficit. Therefore, if the production shortfall lasts, pressure on the local currency, the naira, is likely to persist. Existing foreign-currency restrictions and soft capital controls have hurt foreign direct investment and real GDP growth in Nigeria. Sabotage of gas pipelines will further delay the increase in electricity production at some gas plants, another factor that will hold back growth.
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Aurelien Mali Vice President - Senior Credit Officer +971.4.237.9537 [email protected]
Jeffrey Christiansen Associate Analyst +971.4.237.9574 [email protected]
NEWS & ANALYSIS Credit implications of current events
22 MOODY’S CREDIT OUTLOOK 23 MAY 2016
An escalation of violence is not out of the question, with the recent deployment of the Nigerian navy as an initial response. The stakes are high given that one of the three priorities of Mr. Buhari’s campaign was fixing the oil sector, alongside fighting corruption and eradicating the terrorist group Boko Haram.
One year into Mr. Buhari’s presidency, there have been some successes that would be jeopardized if an insurgency were to take hold and cause a spike in operating costs for oil companies on top of significantly constrained oil production. Among the successes, transparency has increased with the publication of a newly restructured Nigerian National Petroleum Corporation’s accounts and a reduction in the company’s operating losses; the performance of Nigeria’s refineries is improving, albeit slowly; and the government recently ended oil subsidies that were costly for the budget.
NEWS & ANALYSIS Credit implications of current events
23 MOODY’S CREDIT OUTLOOK 23 MAY 2016
Sub-sovereigns
Austrian Pact with HETA Creditors Is Credit Positive for State of Carinthia Last Wednesday, the Austrian Ministry of Finance announced that a significant number of HETA’s (formerly Hypo Alpe Adria, unrated) creditors and the Austrian government (Aaa negative) had reached a memorandum of understanding, paving the way to avoid triggering the Austrian state of Carinthia’s (B3 negative) guarantees for HETA’s grandfathered debt instrument. The memorandum, which amicably settles a restructuring of HETA’s debt instruments, is credit positive for Carinthia.
As part of the agreement, Carinthia’s special-purpose vehicle Kärntner Ausgleichsfond (KAF) will make a higher purchase offer for HETA’s Carinthia-guaranteed debt after its offer in January failed to garner investors’ required two-thirds approval. We expect that the improved offer of around 90% of nominal value (up from around 80% in the January offer) and the fact that a significant number of creditors participated in negotiating the agreement will lead to a resolution in the coming months.
HETA’s total outstanding Carinthia-guaranteed debt instruments equal €11 billion, of which €10.2 billion are senior unsecured debt and the remainder are subordinated debt instruments. The Austrian government will provide cash to KAF to fund the offer, but Carinthia will bear €1.2 billion of the cost. There are some steps to complete before the offer can officially be submitted; the plan is to make the offer in September and complete the process in October.
We see a strong likelihood that the central government will intervene to avoid a default by Carinthia, resulting in a three-notch uplift in the state’s rating to B3. Wednesday’s announcement is the latest in a number of support actions by the central government over the past several months to ensure that the guarantee is never called. These actions have included passage of a law voiding the guarantee on the sub debt (it was later declared unconstitutional) and providing all the funding to KAF to make the buyback offer to bondholders. It is noteworthy that approximately 70% of Carinthia’s debt is held by the central government.
HETA is a wind-down entity established under federal law and 100%-owned by the Austrian government since 2009. Some of HETA’s outstanding debt instruments benefit from a deficiency guarantee provided by Carinthia, its former owner.
Harald Sperlein Vice President - Senior Analyst +49.69.70730.906 [email protected]
NEWS & ANALYSIS Credit implications of current events
24 MOODY’S CREDIT OUTLOOK 23 MAY 2016
US Public Finance
New York State Property Tax Cap Squeezes School Budgets Last Tuesday, eight school districts requesting overrides of the New York state property tax cap failed to pass their budgets for fiscal 2017, ending 30 June 2017, on the first attempt. The number of districts seeking overrides doubled to 36 from the fiscal 2016 vote, largely the result of a limited 0.12% levy growth factor for fiscal 2017. The relatively high hurdle of 60% voter approval for overrides keeps the number of districts seeking them relatively low. If allowable levy growth remains restricted, school districts will have to increasingly depend on overrides, state aid growth and expenditure cuts to balance their budgets, a credit negative.
Growth in the allowable property tax levy has fallen considerably since the cap was implemented in fiscal 2013, and the nearly 0% growth for fiscal 2017 is credit negative for districts whose property taxes constitute the largest source of revenue. The cap limits annual levy growth to the lesser of 2% or the consumer price index (CPI) unless the district obtains an override of the cap.
The pressure that increasingly limited levy growth puts on districts’ financial operations has compelled more districts to consider overrides. But the 60% voter hurdle heightens the risk of budget failure. Each of the eight school districts seeking an override that failed to pass its budget on 17 May (see Exhibit 1) will have an opportunity to put an amended budget before voters on 21 June. If the budget fails again, the district would have to enact a contingency budget, which would allow the same budget as the prior fiscal year, by 1 July.
EXHFIBIT 1
New York School Districts Failing to Override School Property Tax Limit
School District Rating Property Tax as a Percent of
General Fund Revenue
Waverly Central School District Unrated 25.6%
Canaseraga Central School District A2 29.8%
Jasper-Troupsburg School District A3 23.0%
Florida Union Free School District Unrated 71.7%
Bedford Central School District Aa2 91.4%
Elwood Union Free School District Aa2 76.7%
Highland Central School District Unrated Not Available
Tuckahoe Common School District Unrated 91.3%
Source: New York State Education Department
As Exhibit 2 shows, growth in state aid revenue has outpaced levy growth, which generally benefits districts that are more reliant on state revenues and challenges districts more dependent on property taxes.
Tiphany Lee-Allen Assistant Vice President - Analyst +1.212.553.4772 [email protected]
Chris Salcedo Associate Analyst +1.212.553.3761 [email protected]
NEWS & ANALYSIS Credit implications of current events
25 MOODY’S CREDIT OUTLOOK 23 MAY 2016
EXHIBIT 2
New York State Aid Revenue and Average Annual Property Tax Levy Growth
Source: New York State Education Department
The effect of Canaseraga Central School District’s (A2) defeated budget is mitigated by its dependence on state aid, which constitutes 66% of revenues. Districts that are heavily reliant on property taxes to support operations may be constrained by the limited growth allowable and these challenges could lead to negative rating action. In the case of the Bedford Central School District (Aa2 negative), 91.4% of its revenue comes from property taxes and less than 5% comes from the state. With the narrowing allowable levy growth, the district ran three consecutive deficits through fiscal 2015. State aid growth is likely to be only marginally beneficial given its limited contribution to revenues.
Although school districts more reliant on state aid derive a greater benefit from the current environment of low levy growth and increased state revenues, property taxes have traditionally been a more stable source of revenue than state aid. Continued dependence on state aid growth to enhance revenues and balance budgets exposes districts to state-level budget strain. In 2008, the state instituted the Gap Elimination Adjustment to manage its own financial challenges, reducing education aid across the state. The Gap Elimination Adjustment continued through fiscal 2015 and the state only began to reinstate the funding in fiscal 2016.
2.90% 3.28%2.27%
2.83%1.98% 1.48%
0.69%
-3.7%
-6.7%
3.6%4.5%
5.2%5.9% 5.5%
-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%
FY2011 FY2012 FY2013 FY2014 FY2015 FY2016 FY2017
Average Tax Levy Increase State Aid Increase Change
NEWS & ANALYSIS Credit implications of current events
26 MOODY’S CREDIT OUTLOOK 23 MAY 2016
Arizona’s Prop 123 Increases State Education Funding over 10 Years, a Credit Positive for School Districts On 17 May, Arizona (Aa2 stable) voters passed Proposition 123, which will increase state funding to school districts by $3.5 billion over the next 10 years, increasing per-pupil funding by about $300 million annually. School districts will receive the first installment of Prop 123 monies, approximately $299 million, at the end of fiscal 2016 (30 June 2016).
Moody’s-rated Arizona school districts will see an average increase in revenues equal to 3.5% of each school district’s individual general fund revenues, a credit positive for the school districts (see exhibit). However, Arizona’s per-pupil funding, which was the 48th lowest of the 50 states, or approximately 67% of the US average, according to US Census Bureau 2013 data, will remain one of the lowest ranked states for per-pupil funding. The increase in Prop 123 monies is not enough to move Arizona’s ranking in 2016. Prop 123 resolves a five-year lawsuit. In 2009, Arizona passed Proposition 301 that required the state to provide inflationary adjustments to base level funding. During the recession, the state did not fund for base level inflation, which prompted a lawsuit in 2010.
Districts Receiving the Largest Amount of Prop 123 Funding by Percent of General Fund Revenues
School District Rating Prop 123 Funding
$ Thousands Prop 123 Funding as % of
General Fund Revenues
Somerton Elementary #11, Yuma County Baa1 $592 4.9%
Crane Elementary #13, Yuma County A2 $1,332 4.7%
Laveen Elementary #59, Maricopa County Aa3 $1,334 4.7%
Murphy Elementary #21, Maricopa County A2 $403 4.3%
Thatcher Unified #4, Graham County A2 $363 4.3%
Creighton Elementary #14, Maricopa County A1 $1,350 4.3%
Kingman Unified #20, Mohave County Aa3 $1,400 4.3%
Tolleson Elementary #17, Maricopa County A1 $606 4.1%
Eloy Elementary, Pinal County Baa1 $203 4.1%
Higley Unified, Maricopa County A1 $2,400 4.1%
Source: Arizona Joint Legislative Budget Committee
Prop 123 will amend the Arizona Constitution to increase the annual distributions from the State Land Trust Permanent Endowment Fund to 6.9% from 2.5%. Additionally, $625 million will be appropriated from the state’s general fund for K-12 education – $50 million will be distributed during each of the first five years and $75 million in each of the last five years. The increase in annual funding is less than 1% of the state’s 2016 general fund budget. Prop 123 will provide approximately 72% of the funding the state would have legally owed the districts without a settlement. Because of underfunding between fiscal 2010 and 2013, the state will pay out an additional $625 million that covers roughly 50% of the back payments that the state owes. After fiscal 2025, disbursements from the state land trust will go back down to 2.5% annual distribution, which will likely result in an education funding gap.
Because of the timing of the June distributions, the state is allowing districts to carry over these monies into fiscal 2017, which begins 1 July. However, after fiscal 2016, these monies will be subject to the state’s 4% carryover rule. School districts are legally allowed to carry forward up to 4% of any unused maintenance and operation budget balance. Prop 123 monies are unrestricted revenues and a majority of districts have indicated that this funding will likely be used for compensation, although some have indicated it will be used for a combination of compensation, capital improvements and increasing reserves. Districts will
Brittni Smith Associate Analyst +1 415.274.1725 [email protected]
NEWS & ANALYSIS Credit implications of current events
27 MOODY’S CREDIT OUTLOOK 23 MAY 2016
continue to receive Prop 123 monies through fiscal 2025, although the amount may fluctuate as a result of enrollment because monies will be allocated on a pro-rated basis using the weighted student count.
Prop 123 has several triggers that would suspend inflationary spending. Four key triggers are listed below:
» If growth in state sales tax and employment are each less than 2%
» If the increased distribution decreases the state land trust five-year average balance to below the average balance of the preceding five years, the state legislature could reduce the distribution to a minimum of 2.5% for the next fiscal year. The reduction would only be for one year and the state would not be required to pay back the difference in future years
» The legislature could also reduce per-pupil base-level funding by the same amount of the decreased distribution, which it also would not be required to pay back in future years and base-level funding would grow from the reduced amount
» Beginning in fiscal 2026, if education funding distribution reaches 49% of the general fund, the state would allow the suspension of inflation funding for the next fiscal year
Since 2001, there has been no five-year period where the state land trust balance was lower than the preceding five years. Currently education spending accounts for approximately 42% of the state’s General Fund appropriations.
NEWS & ANALYSIS Credit implications of current events
28 MOODY’S CREDIT OUTLOOK 23 MAY 2016
Arizona Voters Approve Public Safety Pension Changes, a Credit Positive for State and Local Governments Last Tuesday, voters in Arizona (Aa2 stable) overwhelmingly approved Proposition 124, modifying the state constitution to allow certain changes to permanent benefit increases (PBIs) for public safety employee pensions. Approval of the amendment is credit positive for Arizona and its local governments because it will replace PBIs, which were unfunded benefit increases, with more predictable cost-of-living adjustments (COLAs) that will be funded as part of ongoing plan costs.
The constitutional amendment is the last step in a series of pension reforms enacted earlier this year by the state. It directly addresses several years of litigation over pension changes, including court rulings that prohibited changes to PBIs. In 2014, the Arizona Supreme Court ruled that changes to PBI formulas for retirees, originally enacted in 2011, were unconstitutional. A lower court went even further in a similar case in 2015, ruling that PBI changes could not be applied to any future retirees who began working before the 2011 changes.
The funding system for the state’s Public Safety Personnel Retirement System (PSPRS) historically did not account for future PBI benefit awards. If PSPRS experienced investment returns above certain targets in a given year, permanent hikes to retiree benefits were granted even though they had not previously been funded. This structure contributed to rising unfunded liabilities that reached $6.4 billion in 2015, versus $1.5 billion in 2006. Our adjusted net pension liability was far higher in 2015 at $13.2 billion. Over the same time period, the average government contribution rate to PSPRS increased sharply to 39% of payroll from 17% (see exhibit).
Arizona Governments’ Average Contribution Rates as a Percent of Payroll and Total Reported PSPRS Unfunded Liabilities
Source: Arizona Public Safety Personnel Retirement System actuarial valuation
The Arizona constitution states that public pension benefits “shall not be diminished or impaired.” Proposition 124 added an exception to this prohibition, allowing a new COLA benefit tied to a consumer price index and capped at 2% to replace PBIs for current employees and retirees. The amendment will not undo PBIs already awarded, but the new COLA structure will increase the cost predictability of benefits.
In addition to placing Proposition 124 on the ballot, the state made other pension changes, including the creation of a new “Tier 3” for employees hired after 1 July 2017. Tier 3 employees will choose between a defined contribution plan or a less expensive defined benefit plan, where employees also share the costs of amortizing any unfunded liabilities. According to plan actuaries, employer normal costs for Tier 3 will be 43% less than for “Tier 2.”
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$0
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2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
$ Bi
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s
Reported Unfunded Liabilities - left axis Contributions as Percent of Pay - right axis
Tom Aaron Vice President - Senior Analyst +1.312.706.9967 [email protected]
Samuel Feldman-Crough Associate Analyst +1.415.274.1706 [email protected]
NEWS & ANALYSIS Credit implications of current events
29 MOODY’S CREDIT OUTLOOK 23 MAY 2016
Despite Arizona’s successful appeal to voters over PBIs and its reduced risk and costs for future employee pensions, certain key legal questions and funding risks remain. Employee contribution requirements were increased in 2011, and a lower court ruled those changes were unconstitutional. The state’s highest court has not yet ruled, and Tuesday’s vote does not address employee contributions. Additionally, government pension costs for PSPRS will continue to increase because accumulated unfunded liabilities must be paid down. Plan actuaries project that contribution rates will reach and stay near 50% of payroll through at least 2030, regardless of legal outcomes over employee contributions.
NEWS & ANALYSIS Credit implications of current events
30 MOODY’S CREDIT OUTLOOK 23 MAY 2016
Covered Bonds
Hypothekenbank’s Pfandbrief Holders Benefit from Cover Pool Merger Last Tuesday, Commerzbank AG (A2/Baa1 stable, baa35), announced that it had completed the process of assuming all Pfandbrief debt issued by Hypothekenbank Frankfurt AG (HF, A2/Baa1 stable, baa3) and merging both banks’ cover pools. Although Commerzbank’s mortgage cover pool primarily consisted of residential mortgages, HF’s mortgage cover pool was substantially composed of commercial real estate loans that have almost all been removed from the merged cover pool, while maintaining at least a comparable level of over-collateralisation. The merged cover pool now primarily consists of residential real estate mortgages. This is credit positive for holders of HF’s mortgage Pfandbrief because residential real estate mortgages are typically better credit quality than commercial real estate mortgages.
As the exhibit below shows, the nominal value of HF’s mortgage cover pool as of 31 December 2015 was €13 billion and comprised 55% residential mortgages, 33% commercial mortgages and 12% supplementary assets (primarily claims against public-sector entities or claims guaranteed by such entities). The nominal value of Commerzbank’s mortgage cover pool was €8.7 billion and comprised 98% residential and 2% supplementary assets. The over-collateralisation level of the merged programme is at least comparable to HF’s former Pfandbrief program because of the previously very high 132% over-collateralisation in Commerzbank’s programme.
Commerzbank’s and Hypothekenbank Frankfurt’s Key Covered Bond Credit Metrics as of 31 December 2015
Hypothekenbank Frankfurt Commerzbank
Covered Bond Rating Aaa Aaa
Counterparty Risk Assessment A2(cr) A2(cr)
Covered Bond Rating Anchor1 Counterparty Risk Assessment + 1 notch
Counterparty Risk Assessment + 1 notch
Total Assets in Cover Pool €13.0 billion €8.7 billion
Total Outstanding Pfandbrief €10.8 billion €4.2 billion
Asset Types in Cover Pool:
Residential Mortgages 55% 98%
Commercial Mortgages, Thereof: 33% -
Retail 47% -
Office 38% -
Other Commercial Mortgages 15% -
Supplementary Assets 12% 2%
Collateral Risk 7.7% 3.3%
Market Risk 10.5% 12.0%
Cover Pool Losses 18.1% 15.3%
Note: 1 The covered bond anchor is the risk, expressed as a rating, that a covered bond issuer ceases to make payments under the covered bonds. For German Pfandbrief we use the issuer’s counterparty risk assessment plus one notch as the covered bond anchor.
Source: Moody’s Investors Service
5 The bank ratings shown in this report are the bank’s deposit rating, senior unsecured debt rating (where available) and baseline
credit assessment.
Patrick Widmayer Vice President - Senior Analyst +49.69.70730.715 [email protected]
NEWS & ANALYSIS Credit implications of current events
31 MOODY’S CREDIT OUTLOOK 23 MAY 2016
By removing the commercial mortgages that had been part of HF’s cover pool, holders of HF’s mortgage Pfandbrief will be less exposed to credit risk than they had been previously. Collateral risk,6 our measure of cover pool credit quality, was 3.3% for Commerzbank’s former cover pool and 7.7% for HF’s former cover pool. The difference in both cover pools’ credit quality was primarily driven by the higher credit risk of the commercial real estate loans in HF’s former cover pool.
Commerzbank is now Germany’s fifth-largest issuer of mortgage Pfandbrief, with outstanding Pfandbrief debt totalling €13.8 billion as of 31 March 2016. HF was established in 2002 following the merger of the mortgage subsidiaries of Commerzbank, Deutsche Bank AG and Dresdner Bank AG. In 2008, HF became a wholly owned subsidiary of Commerzbank and on 13 May 2016, HF’s residential and commercial mortgages as well as its public-sector loans were transferred to Commerzbank.
6 Collateral Risk is the level of losses that our Expected Loss Model assumes will effect covered bondholders following a failure of covered
bond issuer as a result of the credit quality of the cover pool.
RECENTLY IN CREDIT OUTLOOK Select any article below to go to last Thursday’s Credit Outlook on moodys.com
32 MOODY’S CREDIT OUTLOOK 23 MAY 2016
NEWS & ANALYSIS Corporates 2 » Terex's Planned Sale of Material Handling and Port Solutions
Business Is Credit Positive » US Department Store Sales Register More Declines » Topaz Secures New Contract for 15 Vessels in Kazakhstan, a
Credit Positive
Banks 5 » Sberbank Cuts Its Consumer Lending Rates, a Credit Negative
for Competitors » Japanese Megabanks’ Exposure to Energy and Resource-
Related Businesses Is Credit Negative
Securitization 8 » New York Court's Payment Decision in Countrywide
Settlement Will Benefit RMBS Investors
MOODYS.COM
Report: 190041
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