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MOODYS.COM
5 DECEMBER 2016
NEWS & ANALYSIS Corporates 2 » Petrobras’ Exploration Block Sale Reduces Debt by $1.25
Billion, a Credit Positive » Odebrecht Engenharia e Construção’s Signing of Leniency
Agreement Is Credit Positive » Tata Steel UK’s Potential Sale of Specialty Steel Business Is
Credit Positive
Infrastructure 5 » KEPCO’s Long-Term Fixed-Price Contracts for Renewable-
Generated Power Are Credit Positive
Banks 7 » Privatizing Fannie Mae and Freddie Mac Would Be Credit
Negative for Bondholders » Italy’s Imposition of a Systemic Capital Buffer for Large Banks Is
Credit Positive » Greek Banks Aim to Cut Nonperforming Loans to 20% of Gross
Loans by Year-End 2019, a Credit Positive » Review of Swedish Banks’ Synthetic Securitisations Is
Credit Positive » New Czech Mortgage Prepayment Rules Are Credit Negative
for Banks » Georgia’s Plan to Convert Dollar-Denominated Mortgage Loans
into Local Currency Is Credit Positive for Banks » Lebanese Banks Will Benefit from Central Bank’s Higher
Capital Requirements
Exchanges X » Proposed EU Rules for Central Counterparties Are
Credit Positive
Insurers X » Allstate’s Acquisition of Warranty Service Provider SquareTrade
Is Credit Negative
RECENTLY IN CREDIT OUTLOOK
» Articles in Last Thursday’s Credit Outlook 22 » Go to Last Thursday’s Credit Outlook
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NEWS & ANALYSIS Credit implications of current events
2 MOODY’S CREDIT OUTLOOK 5 DECEMBER 2016
Corporates
Petrobras’ Exploration Block Sale Reduces Debt by $1.25 Billion, a Credit Positive Last Monday, Brazil’s national oil company Petroleo Brasileiro S.A. - Petrobras (B2 stable) said that it will reduce debt using $1.25 billion of proceeds from the sale of an exploration block to the Brazilian subsidiary of Norway’s state-owned oil company Statoil ASA (Aa3 stable). The sale and debt reduction are credit positive for Petrobras, which has been struggling with a high debt burden of $123 billion.
When Petrobras announced a new business plan for 2017-21 that called for asset sales to supplement its liquidity, it committed to reducing its reported net debt/EBITDA ratio to 2.5x by the end of 2018 from 4.07x as of September 2016. The sale marks another small step in Petrobras’ effort to sell $19.5 billion in assets during 2017-18. The company today has roughly $247 billion in assets following more than $10 billion in asset sales during 2016.
The asset-sale goal appears feasible, and efforts to divest assets and manage liabilities have already improved Petrobras’ liquidity. From May to October 2016, Petrobras issued around $10 billion in new notes, using proceeds primarily to repay notes maturing 2017-19. But the uncertain final outcomes of two US federal investigations – a Department of Justice criminal investigation of bribery and corruption and a Securities and Exchange Commission civil investigation of accounting accuracy, both begun in 2014 – leave unclear whether Petrobras could easily pay any fines. Because Petrobras aims to keep $18-$20 billion of cash at all times, disbursing cash to pay even moderate fines would probably compel the company to borrow or sell more assets to help boost its cash and address its nearly $10 billion in maturities due in 2017.
The company’s ability to reduce leverage by the end of 2018 will hinge not only on asset sales, operational efficiencies and production increases, but also on global oil prices. Our current view of oil prices at $40-$60 per barrel through 2019 makes Petrobras’ leverage plans feasible but precarious, with little room for error to service its debt and make the capital investments on which oil producers rely. Still, the Statoil deal shows that Petrobras remains intent on raising cash however possible to reduce its debt burden and improve its liquidity.
Nymia Almeida Vice President - Senior Credit Officer +52.55.1253.5707 [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 5 DECEMBER 2016
Odebrecht Engenharia e Construção’s Signing of Leniency Agreement Is Credit Positive Odebrecht S.A. (unrated) on Thursday signed a leniency agreement with Brazilian federal prosecutors over certain corruption charges, accepting BRL6.8 billion ($2 billion) in fines that the company will have to pay over the next 23 years, according to media reports. Despite the size of the fine, the agreement is credit positive for Odebrecht subsidiary Odebrecht Engenharia e Construção S.A. (OEC, Caa1 negative) because it allows Latin America’s largest engineering and construction (E&C) firm to resume signing contracts with public companies. It also lifts restrictions on Odebrecht seeking financing from banks, most notably Brazil’s government-owned development bank, Banco Nacional de Desenvolvimento Econômico e Social. It is not clear yet which of Odebrecht’s subsidiaries will be responsible for the fine payments.
Authorities from the US Department of Justice and Switzerland’s state prosecutor’s office also signed the agreement, clearing up much, if not all, of Odebrecht’s legal uncertainty overseas. The US and Switzerland also had been pursuing investor complaints related to Brazil’s sweeping Lava Jato corruption investigations, which embroiled numerous E&C companies in Brazil and weakened its economy.
The agreement allows OEC to resume bidding for big public E&C contracts that are paramount for the company’s operating sustainability. Without the ability to bid on E&C contracts, OEC’s revenue and EBITDA would continue to suffer significantly, as it has since March 2015, when Brazilian authorities first began investigating the company. The prolonged investigations also limited funding availability for OEC’s projects, making it all the more difficult for OEC to pursue ongoing and future infrastructure developments in its key markets.
The 23-year time frame within which to pay the fines (BRL300 million per year) seems manageable despite Odebrecht’s tight liquidity. As of June 2016, Odebrecht reported consolidated cash availability of around BRL17.5 billion and approximately BRL23.8 billion in short-term debt maturities.
The legal resolution will give OEC considerable financial relief, halting its rapid cash consumption and allowing it to resume its pursuit of more projects. OEC’s cash balance has dropped sharply amid the Lava Jato restrictions, falling to just $1.7 billion as of 30 June 2016, from $2.5 billion at the end of 2015 and $4.4 billion at the end of 2014. As of 30 June 2016, its available cash equaled 52% of total debt outstanding (unaudited), including off-balance-sheet debt guarantees. OEC’s shrinking project backlog has forced it to step up its cash consumption amid delays in its collection of receivables, a lower book-to-bill ratio reducing its cash advances, and foreign-exchange losses, all of which have jeopardized the company’s liquidity.
OEC had nearly BRL50 billion in net revenues during the 12 months through June 2016, and has a $22.9 billion project backlog with 146 large-scale transportation, energy and sewage E&C projects, mostly in Latin America, including buildings and industrial facilities. But this backlog marked a 19% reduction in OEC’s business portfolio from the end of 2015 and a 33% accumulated reduction since 2014.
OEC’s parent Odebrecht is a conglomerate that also owns a controlling stake in chemicals giant Braskem S.A. (Ba1 negative). During the 12 months through June 2016, Odebrecht had BRL118 billion in revenues and BRL17.5 billion in cash on hand, along with about BRL23.8 billion in short-term debt maturities.
Separately, 77 former Odebrecht executives signed plea bargains based on the government’s Lava Jato corruption investigations.
Marcos Schmidt Vice President - Senior Analyst +55.11.3043.7310 [email protected]
NEWS & ANALYSIS Credit implications of current events
4 MOODY’S CREDIT OUTLOOK 5 DECEMBER 2016
Tata Steel UK’s Potential Sale of Specialty Steel Business Is Credit Positive On 28 November, Tata Steel UK Holdings Limited’s (TSUKH, B3 negative) wholly owned subsidiary Tata Steel UK Ltd. (TSUK, unrated) announced that it had signed a letter of intent with Liberty House Group (unrated) to enter into exclusive negotiations on the potential sale of its specialty steel business for an enterprise value of £100 million. The sale, which would be subject to due diligence and corporate approvals, would be credit positive for TSUKH because it would dispose of loss-making assets at a time when the company faces challenging conditions in Europe. Although the sale is for a nominal consideration and will not materially improve leverage, we expect that it will improve TSUKH’s operating performance and marks another step in the company’s restructuring efforts.
As part of the deal, Liberty House would take on several South Yorkshire, England-based assets, notably the Rotherdam electric arc steelworks, the steel purifying facility in Stocksbridge, a mill in Brinsworth, and a few service centres in the UK and China.
The announcement follows the sale of the long products business to Greybull Capital (unrated) in May this year. With the divestment of the specialty steel business, the company’s operations will comprise a number of manufacturing locations for downstream steel production and distribution centres in Europe.
The potential sale of the specialty steel business and the restructuring and/or divestment of the remaining UK operations will reduce the drag on TSUKH’s profitability given that these segments are loss-making, while the remaining Dutch operations are profitable.
The company is also exploring other measures to boost the performance of its entire European business. In July, it initiated discussions with strategic players in the steel industry including thyssenkrupp AG (Ba2 stable) to explore the feasibility of a potential joint venture for its European business.
Carole Herve Associate Analyst +852.3758.1505 [email protected]
Kaustubh Chaubal Vice President - Senior Analyst +65.6398.8332 [email protected]
NEWS & ANALYSIS Credit implications of current events
5 MOODY’S CREDIT OUTLOOK 5 DECEMBER 2016
Infrastructure
KEPCO’s Long-Term Fixed-Price Contracts for Renewable-Generated Power Are Credit Positive Last Wednesday, the Korean government said that Korea Electric Power Corporation’s (KEPCO, Aa2 stable) generation subsidiaries will be required to enter into 20-year, fixed-price contracts when they purchase electricity generated from solar and wind projects starting in the first quarter of 2017. The requirement is credit positive for KEPCO because it will guarantee a certain fixed amount of cash flows for renewable projects, which should boost private investors’ investment in renewable development and help KEPCO curb increases in capital expenditures to develop renewables.
Increased private-sector investment will help KEPCO keep its ratio of funds from operations (FFO) to debt on a consolidated basis in the 28%-32% range over the next one to two years, up slightly from 28% in 2015, absent an unexpected steep rise in fuel costs from 2016 levels. KEPCO’s FFO/debt would slip to 24%-28% if private-sector investment does not increase and KEPCO, as a government-owned entity that implements Korea’s electricity policies, develops almost all of the government’s renewable-power targets on its own.
The government requires a portion of the power that the subsidiaries supply to come from renewable sources: 4.0% for 2017 and 5.0% for 2018, with one-percentage-point increases in 2019 and 2020. If the subsidiaries cannot generate the required amount, they must purchase it.
The government aims to build new renewable capacity of 13 gigawatts in 2016-20, mainly through expansion of solar and wind generation. Based on its latest electricity supply-demand plan, the government plans to expand solar capacity to around 7.0 gigawatts in 2020 and 16.6 gigawatts in 2029 from 2.3 gigawatts in 2015, and wind capacity to 3.6 gigawatts in 2020 and 8.1 gigawatts in 2029 from 732 megawatts in 2015 (see Exhibit 1). The government estimates the planned renewables expansion will require an investment of around KRW30 trillion in 2016-20.
EXHIBIT 1
Korean Government’s Plan for Renewable Energy Development
Source: Korean Ministry of Trade, Industry and Energy
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Hydro Wind Solar Byproduct Gas Other Renewables
Mic Kang Vice President - Senior Analyst +852.3758.1373 [email protected]
NEWS & ANALYSIS Credit implications of current events
6 MOODY’S CREDIT OUTLOOK 5 DECEMBER 2016
The unpredictability of cash inflows relative to fixed operating and debt-servicing costs has been one of the difficulties in renewable projects obtaining necessary long-term funding. Renewable energy prices are volatile, reflecting supply and demand and the system marginal price, which is a key component of the wholesale power price.
The system marginal price ranged from KRW92 per kilowatt-hour to KRW166 per kilowatt-hour in 2012-15, subject to crude oil prices and power supply from low-cost baseload power plants. The price of renewable energy certificates (REC) – which electricity generators purchase from renewables – also varied from KRW177,000 per REC to KRW209,000 per REC during the same period (see Exhibit 2).
EXHIBIT 2
Korea’s Wholesale Price for Electricity Generated from Renewables and Cost of Renewable Energy Certificates Have Been Volatile
Source: Korean Ministry of Trade, Industry and Energy
The long-term, fixed-prices will also increase the predictability of KEPCO’s purchase costs for electricity generated from renewables, because its purchase prices will be fixed for 20 years. We believe that long-term contract prices will be reasonable because they will be determined through competitive bidding from renewable projects.
Additionally, we expect that private investors’ investments in renewable developments will reduce the execution risk associated with KEPCO’s development of renewable energy sources, particularly given the limited availability of land on which to develop massive renewable projects. Execution risk includes delays in the startup of new projects and cost overruns.
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System Marginal Price - left axis Renewable Energy Certificates - right axis
NEWS & ANALYSIS Credit implications of current events
7 MOODY’S CREDIT OUTLOOK 5 DECEMBER 2016
Banks
Privatizing Fannie Mae and Freddie Mac Would Be Credit Negative for Bondholders Last Wednesday, US President-elect Donald Trump’s likely Treasury secretary, Steve Mnuchin, stated that the Trump administration would look to privatize government-sponsored enterprises (GSEs) Fannie Mae (Aaa stable) and Freddie Mac (Aaa stable). Privatization would be credit negative for the GSEs because it increases the risk of funding disruptions owing to the many questions about how privatization would occur given the amount of debt the GSEs must refinance.
In order to privatize the GSEs, they must emerge from conservatorship with sufficient capital to provide enough confidence in their future performance that the debt markets will continue fund them. Today, the GSEs have just $1.2 billion in capital, but are supported by their access to committed capital from the US Treasury.
In September 2008, when the GSEs were placed into conservatorship by their regulator, the Federal Housing Finance Agency (FHFA), the GSEs entered into a senior preferred stock purchase agreement (PSPA) with the US Treasury. Under this agreement, Fannie Mae has access to $117.6 billion (originally $200 billion) in capital, while Freddie Mac has access $140.5 billion (originally $200 billion). These amounts will decline with any future draws. Under the agreements, the Treasury will contribute capital to Fannie Mae or Freddie Mac should the FHFA determine that either of their net worth is negative. Additionally, the GSEs cannot build capital on their own given the requirement that they pay any excess earnings to the Treasury over their permitted capital base.1
According to the PSPAs, the FHFA and US Treasury can end conservatorship at any time. Based on Mr. Mnuchin’s comments, the US Treasury is (or soon will be) ready to end conservatorship. However, the FHFA’s views are less clear, and we believe that FHFA Director Melvin Watt would resist taking these actions. Mr. Watt has given no indication that he believes the GSEs are healthy enough to end conservatorship. Plus, it is unclear how affordable housing mandates would work under privatized GSEs. Mr. Watt’s five-year term as FHFA director is not subject to affirmation by the incoming administration and runs through 2019, which would allow him to slow down any privatization effort.
In order for privatization to work, and assuming the GSEs would continue to participate in the mortgage market as they do today, they would need a strong capital base that likely totals in the hundreds of billions of dollars. And, confidence in their financial standing would be critical given the need to refinance their debts during any transition to becoming a private company.
Fannie Mae’s outstanding debt totaled $351.6 billion as of third-quarter 2016, while Freddie Mac’s was $378.1 billion. Furthermore, Fannie Mae had $51.4 billion of discount notes outstanding as of the end of the third-quarter 2016, while Freddie Mac had $69.3 billion outstanding. In addition, the GSEs in aggregate have $4.6 trillion (close to 25% of GDP) of mortgage-backed securities outstanding. Disruptions in their ability to issue debt, materially higher debt issuing costs or a decline in mortgage-backed securities pricing would negatively affect US housing and the US economy.
1 Under the terms of the amended PSPA, Fannie Mae and Freddie Mac are permitted to retain $1.2 billion in capital during 2016,
declining to $600 million in 2017 and $0 in 2018.
Brian Harris, CPA Senior Vice President +1.212.553.4705 [email protected]
NEWS & ANALYSIS Credit implications of current events
8 MOODY’S CREDIT OUTLOOK 5 DECEMBER 2016
Our Aaa ratings on the GSEs’ debt obligations are based on our assumption of support by the US government. Although GSE reform could take many directions, we believe the likely path will include government support for the senior debt issued by the companies before the implementation of reform through final maturity, and expect the effective substitution of the US sovereign rating for these obligations to continue. Nevertheless, there are alternative reform outcomes that would be less creditor friendly, as well as many variables that could change the path of reform, making the ultimate outcome highly uncertain. Although we recognize this overall uncertainty, we also believe that any change in the GSEs’ current setup is unlikely to occur during our rating outlook horizon of the next 12-18 months, and thus we have a stable rating outlook. Despite Mr. Mnuchin’s comments, we believe that there is a very low probability that the GSEs will be privatized over the next few years given their capital needs and complexities of privatization.
NEWS & ANALYSIS Credit implications of current events
9 MOODY’S CREDIT OUTLOOK 5 DECEMBER 2016
Italy’s Imposition of a Systemic Capital Buffer for Large Banks Is Credit Positive On 30 November, the Bank of Italy (BOI) introduced a systemic capital buffer for the country’s other systemically important institutions (O-SIIs), namely UniCredit SpA (Baa1/Baa1 stable, ba12), Intesa Sanpaolo SpA (A3/Baa1 stable, baa3) and Banca Monte dei Paschi di Siena S.p.A. (Montepaschi, B2/B3 review direction uncertain, ca review direction uncertain). The introduction of the buffers, which begins in 2017, is credit positive because it will force the banks to hold more common equity Tier 1 (CET1) capital relative to their risk-weighted assets, therefore strengthening their loss-absorption capacity. Exhibit 1 provides phase-in details of the buffers for each bank.
EXHIBIT 1
Systemic Buffers for Italy’s Other Systemically Important Institutions Bank Starting in 2018 Starting in 2019 Starting in 2020 Starting in 2021
UniCredit 0.25% 0.50% 0.75% 1.00%
Intesa Sanpaolo 0.19% 0.38% 0.56% 0.75%
Montepaschi 0.06% 0.13% 0.19% 0.25%
Source: Bank of Italy
Increasing capital requirements will also send a positive signal to the market because it shows that regulators have acknowledged the challenges that Italian banks currently face, including supervisory pressure to reduce their large stock of problem loans and increase provisions, which may necessitate more capital. Italian banks are having difficulty disposing of problem loans without incurring losses because market prices are significantly lower than book values.
Euro area banks must comply with a prudential capital ratio that the European Central Bank sets as part of the supervisory review and evaluation process (SREP). The SREP requirement is composed of three elements: a minimum CET1 ratio of 4.5%, a capital conservation buffer and potentially additional capital (Pillar II). Other buffers on top of the SREP compose the capital requirement, including the buffer for O-SIIs, and are set by member countries, which tailor the buffer individually and aim to address the “too big to fail” issue. Its calibration is based on a methodology set by the European Banking Authority and whose factors include size, complexity and interconnectedness.
Pending communication of new SREP levels, Intesa easily meets its 10.25% requirement for 2021, with a fully loaded CET1 of 13% as of September 2016 (Exhibit 2). UniCredit’s fully loaded CET1 of 10.82% as of September 2016 is close to the 10.75% requirement that the bank must meet in 2019.3 We expect UniCredit to announce a significant strengthening of its cushion over requirements as part of its strategic review this month. Montepaschi’s fully loaded CET1 ratio of 10.7% as of September 2016 is below its 11% requirement for 2021 and the bank had negative capital in the European Banking Authority’s stress test. The bank is undertaking a debt exchange and capital raise4 that, if successful, will allow it to meet its current and future capital requirements.
2 The bank ratings shown in this report are the deposit rating, senior unsecured debt rating and baseline credit assessment. 3 UniCredit is also designated as a global systemically important institution, meaning that although its 1% requirement is the same as
its O-SII requirement, and not additive, its phase-in period is shorter. 4 See Monte dei Paschi’s Debt Exchange Offer Is Credit Positive for Senior Creditors, 21 November 2016.
London +44.20.7772.5454
NEWS & ANALYSIS Credit implications of current events
10 MOODY’S CREDIT OUTLOOK 5 DECEMBER 2016
EXHIBIT 2
Italy’s Other Systemically Important Institutions’ Fully Loaded Common Equity Tier 1 Ratios as of September 2016 versus Capital Requirements
Sources: The banks and Moody’s Investors Service
The phase-in period will avoid adverse effects on credit supply and the country’s economic recovery (we expect Italy’s GDP to grow by 0.8% in 2017 and by 1% in 2018), even though investors are likely to expect banks to have the buffers fully in place ahead of schedule. The systemic buffers, together with the recent phased-in approach applied for the capital conservation buffer,5 will bring Italian banks more in line with most countries in Europe.
5 See Italy Lowers Capital Conservation Buffer for Banks, Reducing Coupon-Suspension Risk for Additional Tier 1 Instruments, 22
September 2016.
10.82%
13.00%
10.70%10.75% 10.25% 11.00%
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UniCredit Intesa Sanpaolo Montepaschi
Fully Loaded CET1 Fully Loaded Capital Requirement
NEWS & ANALYSIS Credit implications of current events
11 MOODY’S CREDIT OUTLOOK 5 DECEMBER 2016
Greek Banks Aim to Cut Nonperforming Loans to 20% of Gross Loans by Year-End 2019, a Credit Positive Last Wednesday, Bank of Greece published its first report on operational targets for banks, which indicates a reduction in nonperforming loans (NPLs) to around 20% of gross loans by the end of 2019 from 37% as of September 2016, and a reduction in nonperforming exposures (NPEs)6 to around 34% of gross loans from 51% over the same period. The targeted decreases are quite ambitious and will likely prove challenging for Greek banks, but will partly alleviate banks’ sizable burden of nonperforming loans and exposures that currently weigh on balance sheets.
Reducing NPLs and ultimately NPEs is the banks’ most significant challenge, and will require sustainable economic growth over the next three years. NPEs were approximately €107 billion, or 57% of GDP, as of September 2016. These reductions are also a prerequisite to improve Greek banks’ financial soundness and to free up capital to redirect to more productive economic sectors. The Bank of Greece, in cooperation with the European Central Bank’s banking supervision arm, set targets for both NPLs and NPEs, and both regulators will closely monitor these targets, which will inevitably encourage banks to dedicate sufficient resources to tackle the economy’s NPE problem.
The Bank of Greece’s report provides the first glimpse of the targets (see Exhibit 1), in addition to technical background and potential drivers behind the evolution of problem loans in Greece. The Bank of Greece will publish a similar quarterly report with a summary of progress toward meeting the targets. The central bank is mandated to request additional corrective measures from a bank that does not meet the targets.
EXHIBIT 1
Greek Banks’ Nonperforming Loan/Nonperforming Exposure Operational Targets 2016-19
Note: Exposures refer only to on-balance-sheet items of all commercial and cooperative banks in Greece on an individual basis and not on a consolidated group basis. Source: Bank of Greece
6 NPLs are loans that are 90 days past due, while NPEs include NPLs and other restructured loans that are not 90 days past due but
which the debtor is assessed as unlikely to pay its credit obligations in full, as per the European Banking Authority’s guidelines.
78.3 78.1 76.3 74.7 72.4 70.5 65.9 53 40.2106.9 106.9 105.8 105.2 103.4 102 98.2 83.3 66.7
38% 37% 36% 36% 35% 34%32%
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Nondas Nicolaides Vice President - Senior Credit Officer +357.25.693.006 [email protected]
NEWS & ANALYSIS Credit implications of current events
12 MOODY’S CREDIT OUTLOOK 5 DECEMBER 2016
Banks will reduce their NPEs predominantly by identifying viable businesses and implementing sustainable long-term restructuring solutions. According to Bank of Greece projections, loan restructuring will drive around 29% of the NPE reduction, while the majority of the reduction will be effective during 2018-19. In addition, write-offs of up to €14 billion, liquidations of around €11.5 billion, sales of loans to licensed NPE management platforms of approximately €7.4 billion, and collections of €6 billion will also improve banks’ asset quality (see Exhibit 2). However, banks also expect around €30.4 billion of new NPEs during 2017-19 amid still-difficult economic conditions in Greece.
EXHIBIT 2
Greek Banks’ Nonperforming Exposure Reduction Plan
Source: Bank of Greece
The concerted effort by banks and regulators to improve the system’s asset quality is vital so that banks can contribute more effectively to productivity and growth in Greece. However, even if the target of 20% NPLs to gross loans is achieved by the end of 2019, Greek banks will continue to have one of the highest level of problem loans in the European Union, limiting the upside potential of their credit quality and ratings.
€ 106.9
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NEWS & ANALYSIS Credit implications of current events
13 MOODY’S CREDIT OUTLOOK 5 DECEMBER 2016
Review of Swedish Banks’ Synthetic Securitisations Is Credit Positive Last Friday, Sweden’s financial supervisory authority Finansinspektionen (SFSA) announced that it will review synthetic securitisation transactions undertaken by domestic banks, with a view to reducing the capital benefit the transactions provide to banks. This will apply to the banks’ supervisory review and evaluation process starting in 2017. The resulting higher capital requirements would be credit positive for Swedish banks.
Synthetic securitisations transfer part of the credit risk of a bank’s loan portfolio to an investor, reducing risk-weighted assets and required regulatory capital. The underlying loan portfolio remains on the balance sheet of the bank, which is also responsible for servicing the loans.
The SFSA believes that Swedish banks may be incentivised to use this technique to meet more stringent capital requirements in the coming years, which could give rise to a large securitisation market. However, banks would face the need to enter into new transactions as previous transactions expire. This would be difficult in a time of market stress, and if unsuccessful the credit risk would flow back to the banks. This could cause banks to reduce their lending, a pro cyclical hit to the economy.
The SFSA is proposing to increase banks’ Pillar II capital requirements for synthetic securitisation transactions that do not meet two criteria. The first relates to the estimated flow-back risk on individual transactions that would lead to an increase in a bank’s total capital requirement of more than 25 basis points for systemically important banks and 50 basis points for non-systemically important banks. The second criteria is that the nominal value of securitised credit volumes must be lower than 15% of a systemically important bank’s total lending to a sector in which it has a large domestic presence.
In August 2016, Nordea Bank AB (Aa3/Aa3 stable, a37) completed an €8.4 billion synthetic securitisation of a portfolio of corporate and small and midsize enterprise loans, the first in many years in Sweden and which resulted in an approximately 30-basis-point increase the bank’s common equity Tier 1 ratio. We expect Nordea and other Swedish banks to pursue similar capital-accretive transactions over the next 12-18 months. However, the prospects of the SFSA’s proposed higher capital requirements will likely curtail such transactions because the associated capital benefits could fade.
7 The bank ratings shown in this report are Nordea Bank’s deposit rating, senior unsecured debt rating and baseline credit assessment.
Andrea Usai Senior Vice President +44.20.7772.1058 [email protected]
Niclas Boheman Assistant Vice President - Analyst +44.20.7772.1643 [email protected]
NEWS & ANALYSIS Credit implications of current events
14 MOODY’S CREDIT OUTLOOK 5 DECEMBER 2016
New Czech Mortgage Prepayment Rules Are Credit Negative for Banks Last Thursday, the Czech Republic amended laws to ease mortgage prepayment penalties for borrowers, a credit negative for Czech banks. Under the new law, borrowers with loans originated or refinanced on or after 1 December 2016 will be allowed to repay without fee or penalty up to 25% of the loan value annually. The loans can be prepaid penalty free one year or more after origination during the initial fixed interest rate period, which varies between three and five years and averages around 52 months for mortgages originated in 2015, according to the Czech National Bank. The law also caps the early prepayment fee on mortgage loans during the fixed interest rate period at 1%, or CZK50,000, if the client sells the property after two years.8
The more accommodative prepayment regulations during the initial fixed interest rate period is credit negative for banks because the cap diminishes their ability to generate fee income and interest revenue. The most affected entities are Ceskoslovenska Obchodni Banka, a.s. (A2 stable, baa19), Raiffeisenbank, a.s. - Mortgage Covered Bonds (A1), Komercni Banka a.s. (A2 stable, baa1) and Ceska Sporitelna a.s. (A2 stable, baa1), whose mortgage portfolios constitute 34%-40% of their loan books (see Exhibit 1).
EXHIBIT 1
Top Five Czech Banks’ Exposure to Mortgage Loans
Sources: The banks, Czech National Bank and Moody’s Investors Service
Czech banks have a loan-to-deposit ratio of 78% and are able to finance their credit growth by applying short-term deposit funding to long-term mortgage loans utilising interest rate swaps (see Exhibit 2). Prepayments without fees or penalties raises the uncertainty of the mortgage portfolio’s duration and the cash flows, which may raise the cost of the swaps that banks use to hedge their interest rate risk.
8 In the event of pre-payment, outside the conditions mentioned, the mortgagors will have to pay to the bank the applicable costs on
lost spread, unwinding swaps and administrative expenses. Furthermore, if the client dies or is seriously ill, he or his heirs can repay it free of charge.
9 The bank ratings shown in this report are the banks’ deposit ratings and baseline credit assessment.
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CSOB Raiffeisenbank Ceska Komercni UniCredit Bank CzechRepublic and Slovakia
Mortgage Loans/Total Loan Book - left axis Market Share in Private Mortgage Lending - right axis
Arif Bekiroglu Assistant Vice President - Analyst +44.20.7772.1713 [email protected]
Aleksander Blacha Associate Analyst +44.20.7772.5282 [email protected]
NEWS & ANALYSIS Credit implications of current events
15 MOODY’S CREDIT OUTLOOK 5 DECEMBER 2016
EXHIBIT 2
Czech Banks’ Mortgage Loan Rates
Source: Czech National Bank
Eased regulations could hasten growth in the riskier investment property market because of the lower cost of exiting a mortgage obligation by flipping a property after a few years of ownership. Over past two years, residential real-estate prices have increased by 10% and are gaining momentum. An increasing share of investment properties risks negatively affecting the real estate market, as speculative property owners sell their investments, and banks record losses in a downturn.
On a positive note, potentially faster amortization of mortgage loans from early prepayments during the current low interest rate operating environment will reduce banks’ credit risk and make borrowers saddled with rising household debt more resistant to any future rise in interest rates. For most households, mortgages are the biggest debt obligation. Czech household indebtedness was 65% of disposable income in 2015, up from 60% in 2012, according to Haver Analytics. Historically, the main market participants charged an early repayment fee of either 10% of the outstanding principal or 5% the outstanding principal for each remaining year of the fixed interest rate period.
0
200
400
600
800
1,000
1,200
0%
1%
2%
3%
4%
5%
6%
Q1
2008
Q2
2008
Q3
2008
Q4
2008
Q1
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Q4
2010
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2011
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CZK
Billi
ons
Loans for House Purchase - right axis Interest Rate on New Mortgage Loans - left axis
NEWS & ANALYSIS Credit implications of current events
16 MOODY’S CREDIT OUTLOOK 5 DECEMBER 2016
Georgia’s Plan to Convert Dollar-Denominated Mortgage Loans into Local Currency Is Credit Positive for Banks Last Tuesday, Georgia Prime Minister Giorgi Kvirikashvili announced a plan to subsidise the voluntary conversion of US dollar-denominated mortgages issued before January 2015 into Georgian lari (GEL) at a preferential rate. The conversion is credit positive for Georgia’s banks because it will reduce credit losses.
The program covers dollar-denominated loans by individuals that are collateralised by real estate, up to GEL100,000 (around $39,000), but not more than the value of the real estate collateral. The rate for loan conversion will be the official exchange rate at the conversion date minus 20 tetri (100 tetri equal one lari). If the prevailing exchange rate is GEL2.50 per dollar, the conversion rate would be 2.30. The conversion program begins 1 January 2017 and ends 28 February, and will be administered by the National Bank of Georgia (NBG). The plan implies no costs for banks because the state budget will cover the 20 tetri difference. We estimate that around 5% of banks’ portfolios will be eligible under the program.
Banks in Georgia are exposed to increased credit risk when currency movements adversely affect borrowers’ repayment capacity. Around two thirds of loans in Georgia are denominated in a foreign currency (predominantly US dollars), while about 40% of JSC Bank of Georgia’s (Ba3 stable, ba310) and JSC TBC Bank’s (Ba3 stable, ba3) loan books are denominated in dollars to borrowers that have no dollar income (see Exhibit 1).
EXHIBIT 1
Georgian Rated Banks Loan Book Breakdown in Currencies and Borrower Income as of June 2016
Note: Based on Moody’s estimates from aggregated information. Sources: JSC TBC Bank and BGEO Group PLC
Against these currency-induced credit risks, Georgian banks maintain substantial balance-sheet buffers driven by NBG’s 175% risk weight for foreign-currency-denominated loans to unhedged borrowers. Banks also assume a 10%-20% domestic currency depreciation when they assess a borrower’s ability to afford debt repayments for foreign-currency loans. However, the latter buffers have been exhausted for loans issued before 2015 because of the lari’s 27% depreciation against the dollar since January 2015, together with the currencies of Georgia’s main trading partners (see Exhibit 2). Last week, the lari fell to a record low of 2.56 per US dollar (the previous low of 2.49 was in January).
10 The bank ratings shown in this report are the banks’ local deposit rating and baseline credit assessment.
26%
41%
33%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Mortgages Consumer SME & Micro Corporate Total
USD Loans - Some USD Income USD Loans - No USD Income Local & Other Currency Loans
Alexios Philippides Assistant Vice President – Analyst +357.25.693.031 [email protected]
NEWS & ANALYSIS Credit implications of current events
17 MOODY’S CREDIT OUTLOOK 5 DECEMBER 2016
EXHIBIT 2
Georgian Lari and Major Trading Partners’ Currencies versus US Dollar Indexed to 100 at 1 January 2015.
Key: AZN = Azerbaijani manat; TRY= Turkish lira; RUB = Russian ruble. Sources: Factset and Moody’s Investors Service
The depreciation also has a negative effect on banks’ capital ratios because most risk assets are denominated in appreciating dollars, while capital is held in lari.11 The conversion of mortgages into local currency with lower risk weights will also partly mitigate this negative effect.
Businesses, especially small and midsize enterprises, also have dollar-denominated loans without any dollar income and face a sharp increase in leverage. Therefore, we expect that any further material depreciation of the lari will lead to asset-quality deterioration on banks’ foreign-currency business loans to unhedged borrowers.
As part of the plan, the NBG will require all new loans below GEL100,000 from January 2017 and below GEL200,000 from January 2018 to be issued in local currency. This will help contain currency-induced credit risk for banks and support the long-term de-dollarisation of the economy.
11 See page 6 of Banks - Georgia: Pressure from Currency Depreciation, but Long-Term Prospects Remain Solid, 3 March 2016.
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Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Oct-16
GEL/USD EUR/USD AZN/USD TRY/USD RUB/USD
NEWS & ANALYSIS Credit implications of current events
18 MOODY’S CREDIT OUTLOOK 5 DECEMBER 2016
Lebanese Banks Will Benefit from Central Bank’s Higher Capital Requirements On Saturday, Riad Salameh, the governor of Banque du Liban (BdL), Lebanon’s central bank, said that the proceeds realised from its financial operations with commercial banks will allow the banks to increase their capital and help them to comply with new higher capital adequacy requirements. Lebanon will phase in higher Basel III capital requirements by the end of 2018 and will require banks to comply with a minimum capital adequacy ratio of 15%, up from 12% previously. This development is credit positive for Lebanese banks because it will help them strengthen their loss-absorption capacity.
Intermediary Circular 436, which amends Basic Circular 44 issued by BdL, requires banks to have higher capital ratios, with a minimum Basel III common equity Tier 1 ratio (CET1) of 10%, up from 8.5% currently, and a Tier 1 ratio of 13%, up from 10% currently. Additionally, the capital conservation buffer will increase to 4.5% from 2.5%, resulting in a minimum capital adequacy ratio of 15%. The increase in the minimum capital adequacy ratios will be gradual until the end of 2018. However, the capital conservation buffer will not apply before the end of 2018 and banks will be required to have a minimum CET1 ratio of 8.5% in 2016 and 9.0% in 2017 (see exhibit). As a result, we expect banks’ capital adequacy ratios to improve in order to meet the new requirements.
Evolution of Lebanese Banks’ Minimum Capital Requirements
Sources: Banque du Liban and Moody’s Investors Service
The new capital requirements, and the measures to help the banks achieve them, will strengthen banks’ loss-absorption capacity. Currently, we view Lebanese banks’ capital buffers as modest given the high and growing exposure to the Lebanese government (B2 negative) and the challenging domestic operating environment. We forecast real GDP growth of 2.0% in 2017, well below the 9% average for 2007-10.
Lebanese banks’ average Basel III Tier 1 capital ratio was 13.7% as of year-end 2015, while their total capital adequacy ratio was 15.0%. However, the regulatory zero risk weight applied to local-currency-denominated government securities understates risk-weighted assets (RWAs), and inflates reported capital adequacy ratios. If we apply a risk weighting of 100% to these securities, which is in line with global standards for a B2-rated sovereign, the average Tier 1 ratio falls to 11.8% as of year-end 2015. Furthermore, we note that although we do not adjust RWAs to reflect banks’ exposures to the central bank, bank capital ratios reflect a 50% risk weight for foreign currency placements and certificates of deposit (CDs) with the BdL (following an amendment in 2014 from 100% previously).
8.5% 9.0%
0%
2%
4%
6%
8%
10%
12%
14%
16%
2015 2016 2017 2018
Minimum CET1 Including Capital Conservation Buffer Minimum Tier 1 Capital Minimum Total Capital
8.0% 10.0%
10.0%
12.0%11.0%
14.0%
12.0%
14.5%15.0%
13.0%
Marina Hadjitsangari Associate Analyst +357.25.693.034 [email protected]
Alexios Philippides Assistant Vice President - Analyst +357.25.693.031 [email protected]
NEWS & ANALYSIS Credit implications of current events
19 MOODY’S CREDIT OUTLOOK 5 DECEMBER 2016
We expect that banks will meet the higher capital requirements because of the significant proceeds they have realised from the BdL’s recent financial operations, which, according Mr. Salameh, will allow banks to increase their buffers by up to $2.4 billion in aggregate. BdL bought Lebanese pound-denominated treasury bills from commercial banks at a premium and sold the banks Lebanese government Eurobonds and BdL CDs.12
Currently, banks are required to keep the gains from the above transaction as Lebanese pound-denominated reserves included in their Tier 2 capital in anticipation of International Financial Reporting Standards 9 and the new capital requirements. Once those requirements are met and upon the approval of BdL and the Banking Control Commission, the banks will then be allowed to release any excess funds realised from the transaction.
12 See Lebanese Banks’ Decline in Foreign Assets Is Credit Negative, 24 October 2016.
NEWS & ANALYSIS Credit implications of current events
20 MOODY’S CREDIT OUTLOOK 5 DECEMBER 2016
Exchanges
Proposed EU Rules for Central Counterparties Are Credit Positive Last Monday, the European Commission published its proposal for European Union rules governing the recovery and resolution of central counterparty clearing houses (CCPs) such as LCH.Clearnet Limited (unrated), Eurex Clearing (unrated) and KDPW_CCP (unrated). The proposals are credit positive because they make the recovery of a distressed CCP more likely. The objective for these measures is to safeguard financial stability from the potentially destabilizing effect of a failing CCP, while ensuring the continuity of critical functions and protecting taxpayers from losses.
CCPs will be required to prepare and regularly update their recovery plans, outlining the steps to take to restore their financial position following a significant deterioration of their financial position. The recovery plan should include both qualitative and quantitative indicators related to the CCP’s financial position that can be regularly monitored. A CCP’s supervisory college would be tasked with assessing this plan to ensure it is comprehensive and can feasibly restore the CCP’s viability. For any deficiencies, the competent authority could seek measures to strengthen the CCP. A key development with this proposal is the improved consistency of the recovery or resolution framework in Europe; current approaches lack uniformity and introduce uncertainty resulting from divergent approaches.
The likely implication of these measures is the strengthening of CCP waterfalls, the order in which resources are used to provide loss absorption in case of a member default. We expect this strengthening to occur through an increase in pre-funded financial resources, incorporating the defaulter’s margin, CCPs’ own capital and a default fund that contains contributions from non-defaulting members. Additionally, given the likelihood that regulatory intervention may be made earlier in the default-management process, a CCP may be more likely to preserve its pre-funded waterfall layers. This makes the recovery of the CCP more likely, minimizing the need for resolution and the possible spread of financial instability to the wider capital markets.
The proposals call for establishing a resolution plan for each CCP. In the event that a CCP is not recoverable, the resolution authority will be tasked with liquidating the CCP through the use of its own resolution tools and powers, while ensuring continuity for the CCP’s critical functions. Although the resolution plans should not assume extraordinary public financial support, the proposal does allow for temporary liquidity support from the central bank to facilitate a resolution process.
Given the aim of limiting taxpayer losses, the potential for public support may decline. Although this may be the case, the proposed regulation and increased incentive placed on the supervisory college to ensure the robustness of the CCP improves CCP risk capabilities and governance which is positive for their credit quality.
Maxwell Price Associate Analyst +44.20.7772.1778 [email protected]
Michael C. Eberhardt, CFA Vice President - Senior Credit Officer +44.20.7772.8611 [email protected]
NEWS & ANALYSIS Credit implications of current events
21 MOODY’S CREDIT OUTLOOK 5 DECEMBER 2016
Insurers
Allstate’s Acquisition of Warranty Service Provider SquareTrade Is Credit Negative On Monday, The Allstate Corporation (A3 stable) announced that it had reached an agreement to acquire privately held SquareTrade, a consumer goods protection plan provider, for approximately $1.43 billion from a group of shareholders including Bain Capital Private Equity and Bain Capital Ventures. The pending acquisition is credit negative because it is a significant investment in a fast-growing, but still unproven, product and customer segment for Allstate, and will incrementally increase financial leverage and intangibles while reducing interest coverage metrics. Allstate expects the acquisition to close in January 2017, subject to regulatory approvals.
Allstate plans to fund the purchase price using holding company cash and proceeds from its newly issued senior debt. Although the financing will incrementally increase leverage while modestly reducing holding company liquidity, which included $2.7 billion in cash and marketable investments at 30 September 2016, the acquisition is manageable given Allstate’s strong financial and liquidity profile. In May 2016, Allstate’s board authorized a new $1.5 billion common share repurchase program, of which $938 million remained available as of 30 September; the acquisition will not affect this program. We expect that the company will continue to actively manage capital, commensurate with its earnings, surplus levels and potential for market volatility of investments.
Founded in 1999, SquareTrade’s largely point-of-sale and e-commerce-based coverage and services ensure the repair or replacement of customer electronics and appliances (e.g., televisions, computers, personal electronics and smartphones). According to Allstate, SquareTrade’s revenue increased fourfold over the past five years, largely because of contracts with retailers such as Amazon, eBay, Costco, Sam’s Club, Target, Staples, Office Depot and Toys “R” Us. SquareTrade currently provides more than 25 million active protection plans, with an average duration of 2.5 years. SquareTrade competes with firms such as Assurant, Inc. (Baa2 stable), Asurion, LLC (B1 stable) and other carriers in the appliance and mobile warranty segment.
Allstate expects the acquisition to be dilutive to shareholders for the first three years, including the amortization of purchased intangibles, and to generate an internal rate of return above its cost of capital in later years. Allstate based its estimate on SquareTrade’s sustained rapid revenue growth and an increase in its margins as the company expands its retail relationships and product offerings. Further margin expansion may be possible if Allstate replaces the retailer’s current outside insurance carriers (thereby saving certain fees, and taking on underwriting risk/profits as well as investment income) and provides analytical and operational support and affiliated branding. SquareTrade currently does not have a significant presence in the vast US wireless mobile phone protection market, which is dominated by a few competitors and could be difficult to grow.
Allstate may seek to expand SquareTrade’s product coverage to its core customer base in property/casualty and life insurance, offering a broader suite of products to meet customers’ needs, similar to other ancillary businesses such as auto warranties. However, the potential for product cross-selling opportunities between Allstate’s and SquareTrade’s existing customers is uncertain, given each firms’ distinct product distribution channels. Although SquareTrade offers the potential to become an incremental source of fee-based non-regulated earnings for the insurer, Allstate expects no material benefit for the foreseeable future.
Alan Murray Senior Vice President +1.212.553.7787 [email protected]
RECENTLY IN CREDIT OUTLOOK Select any article below to go to last Thursday’s Credit Outlook on moodys.com
22 MOODY’S CREDIT OUTLOOK 5 DECEMBER 2016
NEWS & ANALYSIS Corporates 2 » Brazilian Homebuilders Will Benefit from Expansion of Home
Finance Eligibility » NLMK’s Launch of Pellet Plant Is Credit Positive
Infrastructure 5 » Enable Midstream’s Equity Offering Is Credit Positive » Sempra’s Postponement of Peruvian Gas Pipeline Investment
Is Credit Positive » Major UK Integrated Utilities Will Benefit from Shutdown of
Independent Energy Retailer » Shanghai Electric Power’s Asset Purchase from Parent Is
Credit Negative
Banks 10 » Savings Bank of Ukraine’s Reform Agreement Ahead of
Partial Privatization Is Credit Positive » China’s Proposal to Revise Banks’ Off-Balance-Sheet
Exposure Regulations Is Credit Positive
Insurers 14 » Taiwan’s Higher Capital Requirements Are Credit Positive for
Life Insurers
Sovereigns 15 » Kuwait’s Election Results Will Impede Reform Efforts, a
Credit Negative
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