Monday, December 13, 2010

Financial 2011 Outlook

We stick to our marketweight
recommendation for financials,
despite the recent underperformance

In the aftermath of the European bank stress test in July of this year, we changed our
opinion about the state of the European financial system and moved to marketweight
from underweight, while we kept our underweight recommendation for non-financials.
Although our more positive stance regarding financials came under pressure recently,
as financials spreads underperformed non-financials, we stick to our view in respect to
a fundamental stabilization of financial credits. However, although we consider the
systemic fears in respect to the eurozone stability that are currently priced in as
exaggerated, the high spread volatility will persist and the pressure will likely intensify
further in the near term, given that there is no easy short-term solution at hand. Hence,
we refrain from moving to overweight for financials. Nevertheless, we think that the
macro-economic implications from the systemic crisis, which are discounted in
sovereign and financials spreads, are not properly reflected in non-financials. Hence,
we also stick to our underweight recommendation for non-financials.

Uncertainty was a main driver
during the crisis…

The main motivation for our recommendation change to marketweight for financials (in the
aftermath of the European bank stress test) was that we were convinced that the worst for
European banks would lie behind us. Throughout the crisis, one of the major drivers for the
jump-like behavior in spreads was uncertainty.  However, over the last three years of the
crisis, most of the risks and uncertainties that brought the global financial system to the edge
of a collapse in late 2008 / early 2009 are either resolved, in the process of resolution or the
exposures at stake are at least known and therefore do not pose the risk of uncertainty. The
sovereign debt crisis belongs in the last category – unresolved but at least known in respect
to the exposures at stake.

…and uncertainty keeps

During the summer, we saw our hypothesis confirmed, as the spread between financials and
non-financials narrowed further. However, in hindsight, our view missed the crucial remaining
"uncertainty" that drove credit fears over the last couple of weeks: systemic fears regarding
the stability of the eurozone and implications from a potential restructuring of sovereign debt
or bank senior debt. (For more insight into arguments for and against sovereign and bank
debt restructuring, please refer also to our “debating club” section). In the wake of the Irish
crisis, the Armageddon trade – i.e. fears regarding a potential breakup of the eurozone and
the related adverse consequences – resurfaced. The rationale of this Armageddon trade can
be summarized as the “the big elephant in the room” is too big to bail out (to use some of the

recent phrases that circulated in the market) coupled with the crisis experience that debt woes
contain an element of self-fulfilling prophecy. Both parts of the argument – the too-big-to-bail
out and the self-fulfilling aspect– cannot be  easily dismissed. However, while doomsday
aficionados typically leave the discussion here, adding that the provided bailout does not
resolve the underlying source of the trouble and  that the whole system is set to collapse, we
like to dig a little deeper as we think that this view might be wrong because of underestimating
the ability of market economies to change and to adapt to new scenarios.

A politically incorrect excursus on the sovereign debt crisis

Clearly, providing bailout loans
does not resolve the economic
problem, but that’s not the point

Admittedly, it is completely true that providing loans to debt-stricken borrowers does not
resolve the underlying problem, but this argument misses the crucial point. The bailout loans
are not meant to resolve the crisis’ fundamentals. They are just intended to enable the
countries to borrow more to address the underlying problem. A comparison to the drug scene
might help to get more insight: the dispensation of methadone should not be confused with
therapy. It just enables the addict to enter into therapy. Addressing the problems of an addict
is a four-stage process. 1) Convincing the addict that there is a problem, which the person will
deny vehemently (Greece and Ireland already passed this stage).  2) Focusing the addict’s
mind on the resolution of the cause, by taking  him/her off the street and at the same time
avoid going “cold turkey” (i.e. a sudden detoxification with severe medical implications; in the credit
world, this would be called “bankruptcy”). 3) Working on the resolution of the underlying problem,
which is the longest and most painful part of the whole resolution scheme. 4) Find ways to
prevent a relapse. Interestingly, all four stages can be diagnosed during the European
sovereign debt crisis. Starting with the government initially being in a denial mode, but then
surrendering to the inevitable, over the methadone (rescue financing) and the therapy
(austerity measures and structural reforms), until preventing a relapse (Mrs. Merkel’s plan to
enforce the no-bailout clause). At this point, the analogy (hopefully) ends, as in case of drugs
the relapse rate is disappointingly high.

    What can we learn from this excursus? Bailout loans are not a resolution. It is just buying
time. But this is not positive news because it means that, by providing a bailout, the painful
part of the resolution process did not end – it just began. However, whether this strategy can
help to avoid debt restructurings remains to be seen (a risk that will hang over markets for
quite a while). Nevertheless, although even some unorthodox drug therapists would probably
recommend to pursue the “cold turkey” strategy, it remains clear that neither can the “cold turkey”
method replace therapy, nor can a debt restructuring (or leaving the eurozone) avoid addressing the
underlying economic problems. So why opt for the more painful path of immediate debt
restructuring, if the painful economic restructuring cannot be avoided anyway?

Admittedly, moral hazard
is an issue

Moral hazard on the investors’ side might be one answer. The above-mentioned analogy to a
drug addict should not be exaggerated. In particular, it should not imply that there is no moral
issue involved with a bailout. In contrast to the drug case, in which providing methadone does
not bail out the drug dealer, providing rescue loans to enable the borrower to refinance
maturing debt bails out some bondholders (which were part of the problem because they
provided the addictive substance too cheaply, amplifying the problem). Even when the bailout
would just be of a temporary nature and the economic restructuring would be followed by a
subsequent debt restructuring in order to address the legacy problems, some investors (the
ones with shorter-term debt) would be able to escape their share of the burden. This does not
necessarily mean that the bailout comes at the expense of taxpayers who provided the bailout
loans, as bailout loans could be provided under a preferred creditor status (recall that rating
agencies put Greece's rating on watch negative because of one important element of the
revised Franco-German proposal for post-2013 European Stability Mechanism: the preferred
creditor status of government loans). In this case, the bailout of investors in shorter- term debt
would come at the expense of the investors in longer-term debt, as the recovery rate for the
remaining investors would become lower and lower the more pari passu debt will be replaced

by preferred debt from governments. This  fact undermines a troubled country’s ability to
return to bond markets in order to refinance maturing debt by issuing new bonds that are
subordinated to government loans before an anticipated restructuring event.

Risk factors and drivers for financials in 2011 

The European sovereign debt
crisis is the most important
risk factor directly (spread
contagion) and indirectly
(austerity measures can result
in asset quality deterioration)

We have already discussed the most important risk factor for financials above, the European
sovereign debt crisis. Our best guess for the development is that the topic will flare up and die
down every now and then and will therefore result in heavy volatility in spreads. Hence, the
first and foremost implication from this crisis  is ongoing pressure on refinancing costs, which
will influence senior unsecured refinancing activity of banks in 2011 (see below). The second
implication for banks is that austerity measures will result in a soft patch economic
environment in the troubled regions that will weigh on asset quality. This, in turn, could start a
vicious cycle as a deterioration in banks' asset quality may cause more bailout activity for the
respective sovereign, which will weigh on public finances (directly due to required spending or
indirectly due to rising refinancing costs). This could then lead to rising pressure for
governments, and another round of austerity measures, and so forth. This explains why belttightening measures need to be carefully calibrated and should be – in the best case,
designed to foster growth. For Spain and Portugal, the housing market will be in the focus in
this respect. The Spanish house price index rose by almost 45% from 2004 to the peak level
mid-2008, at a 9% annual growth rate. Since  then, house prices declined by 12% in Spain
(5.6% annual rate of losses), which means that the current house prices index is at 2005
levels. In Ireland, the dynamics were faster: from 2000 to the peak in 2006, the housing
market grew at an 11.5% annual growth rate and has been shrinking at the same rate since
then, totaling a loss of 36%. Current house prices are comparable to 2002 levels. The
dynamics in Ireland were similar to the US housing market (measured by the Case-Shiller
index), with a one-year delay, while in Spain the contraction is at a slower pace. However,
some important differences between the European and the US housing crisis are noteworthy.
First of all, loan documentation in Europe experience similar excesses as subprime
documentation in the US. And second, the housing crisis in the US was aggravated by socalled non-recourse loans, where over-indebted borrowers (i.e. the ones with a negative
equity stake in the house) can simply walk away from their loans by handing over the key to
the banks. This created selling pressure as banks tried to get rid of the houses. European
legislation, however, does not allow such non-recourse loans. Another factor that could weigh
on the troubled European housing markets is  the exit of the ECB from its exceptional
measures. The short-term interest rates increased substantially in the second half of 2010,
with the 3M-Euribor rising from a low of 0.65% to a current level above 1%. As many home
buyers in Spain, for example, were using variable rate loans, a surge in the Euribor translates
into higher borrowing costs. This could pose serious problems, in particular for unemployed
borrowers that have only limited income to meet their scheduled payments. While the ECB
has normalized conditions in the money market, with the refi rate being again the decisive
parameter, its bank funding activity is still exceptional. Recently, the full-allotment LTROs
were prolonged again. Nevertheless, any changes on this side will increase the pressure on
banks in the periphery.

The threat of restructuring
remains a Damocles sword

The ultimate risk for investors in bank debt, however, is the threat of restructuring. With the
exposures at stake being very large (aggregated bank debt can easily be a multiple of
domestic GDP), the risk is that governments might choose not to bail out their banking system
in case the resulting default risk for the sovereign would be too high (please refer to our
debating club section for details and arguments). Last but not least, the downturn in European
commercial real estate also poses a risk for financials. The CRE downturn produced negative
headlines with respect to respective mutual funds. So far, mortgage exposure of banks has
not been in the focus. In case of a further deterioration, this might change however.

Supply Forecast

In the following articles, we expand our supply forecast for 2011. Note that we already
published our supply forecast for non-financials and the securitization market in the November
edition of the Euro Credit Pilot. We start with a brief overview of topics for bank senior debt,
which is notoriously difficult to forecast.  We will then discuss the supply for eurozone
government bonds, for sub-sovereigns & agencies and for covered bonds in more detail.

Supply for financials 

Supply forecast for financials
is a notoriously difficult task

A supply forecast for financials, in particular for banks, is a notoriously difficult task, as banks
have many different funding channels. Note that in contrast to non-financials, the liability side
of financials is not necessarily driven by refinancing of the business, but is itself part of the
active business. Hence, typical banks rely on a funding mix involving a vast range of funding
sources. Besides the "capital products" (i.e. subordinated bonds), this can include deposits,
senior unsecured bonds, covered bonds, securitization, private placements and interbank
loans, money market borrowing, commercial paper funding and central bank liquidity
measures, as well as government guaranteed bonds. Banks typically use all refinancing
sources and aim at a funding mix that minimizes funding costs. In addition, the funding
requirements also depend on the changes in  the balance sheet. Hence,  the use of specific
refinancing tools, such as senior unsecured bonds, covered bonds or securitization depends
on several factors, like the structure of the balance sheet  (corporate loans, for example,
cannot be used for cover pools), the cost of funding and the availability of potential alternative
funding sources (i.e. central bank). Nevertheless, one important factor that links non-financials
issuance activity with bank funding requirements is the so-called “Wall of Refinancing”. This
buzzword describes a substantial surge in debt maturities for non-financials in 2013/14. Since
this not only stems from bond maturities but also syndicated and leveraged loans, it will also
impact the banking sector. In particular, the  “Wall of Refinancing” coincides with the new
Basel III rules regarding common equity requirements. According to the new regulations,
banks will have to increase their common equity ratio to RWA from 2% to 4.5% until 2015
(and thereafter they will have to add another 2.5% of common equity due to the so-called
capital conservation buffer). This will force banks to offload some of the loan exposure into the
bond market already in 2011/12; this, in turn, will depend on the absorption capacity for new
corporate bonds, which will probably be skewed towards the sub-investment grade credit
qualities. The higher the volume that can be securitized, the smaller the refinancing needs for
banks, which would otherwise increase, as many loans were refinanced via CLOs, which
have also face a Wall of Refinancing in 2013/14, but won't be available as a funding source.

We expect an increase
in senior unsecured
issuance activity

We expect a higher volume of iBoxx-eligible bonds in 2011 than was the case in 2010. YTD
new issues by financials reached EUR 132bn, in line with our forecast of EUR 125bn. With
new issuance probably remaining subdued for the rest of the year, the 2010 volume will be
above 2007 (EUR 116bn), but below 2008 and 2009 (EUR 162bn and EUR 153bn). For 2011,
we expect EUR 150bn in iBoxx-eligible bonds by banks, insurers, and financial services. Our
estimate is based on the assumption of easing tensions once the sovereign situation is
clarified: either more countries will need support (beneficial for the banking system) or, the
candidates can escape in a way that is accepted by the market (also beneficial). Either way, a
solution will be found in 1Q11, with funding markets resuming stronger activity then.
Redemptions in 2011 (EUR 102bn) will be double those in 2010 (EUR 53bn), while
government-guaranteed bonds  redemptions will be 15% higher (EUR 34bn in 2011). The
higher amount of redemptions, which will be lower for normal funding in 2012 and more than
double for GGBs, has led to fears that banks will not be able to meet their funding
requirements. When this was a problem two years ago, GGBs were designed for those
countries whose banking systems are now in trouble. GGBs might not be a solution anymore.
Still, funding-stretched banks can rely on the ECB. For solid banks, other means of funding,
e.g. covered bonds are available in case senior bail-in discussions spoil the party. Deposits
are also an option, but the market is limited and, in some countries, prices are prohibitive
given the ongoing competition. Overall, one should also bear in mind the ongoing
deleveraging process, which reduces funding requirements.

Sovereign borrowing requirements in 2011 

We expect deficits of EMU countries
to be EUR 128bn lower on
aggregate than this year

Next year, the austerity programs put in place by EMU governments will lead to a
decrease in deficit figures compared to this year. We expect the decrease in the deficit at
the EMU level to be in the EUR 128bn area. Note that we refer to the central government
deficit and not to the general government deficit, as government bonds usually finance the
central government deficit.

Borrowing requirements in 2011 

down by EUR 75bn

While we expect deficits to decline by a sizeable amount, we anticipate borrowing
requirements to decrease less due to higher bond redemptions (domestic and, to a
lesser extent, foreign).

Main trends for 2011
We expect gross bond supply to
be in the EUR 825bn area, some
EUR 145bn less than this year

The main trends that emerge from our analysis is that in  2011 borrowing requirements
should decrease due to a projected fall in deficits and despite an increase in bond
redemptions. To recap, we expect gross issuance to be EUR 825bn (EUR 145bn less
than this year) and net issuance of EUR 270bn (EUR 150bn less than this year).

Part of the reduction in gross
supply will be due to some
EMU periphery countries not
issuing next year

Of the EUR 145bn reduction in gross bond issuance, EUR 61bn will be due to the fact
that two countries will not issue next year (Greece and Ireland), while we regard it as
likely that Portugal will also have to ask for financial aid. The reduction in gross supply
would be more moderate if these countries were issuing bonds.

Finally, net supply should
decline next year

After increasing by EUR 50bn from 2009 to 2010, net supply should decrease by EUR 150bn
from 2010 to 2011. EUR 128bn of this decline results from a decrease in the deficit,
while the remaining amount can be attributed to our assumption that Greece, Ireland
and possibly Portugal will be absent from the bond market next year.

Where will demand come
from next year?

An important aspect is how high demand for bonds will be next year. Gross supply has
been quite heavy in the last two years and expansionary monetary policy has driven yields to
record-low levels. With the ECB slowly moving towards exiting liquidity support measures and
supply still abundant, it will be challenging for the EMU countries to refinance in the primary
market. The good news in this respect is that Greece, Ireland and likely Portugal will be absent
from the market, and this may benefit – at least moderately – other peripheral countries.

EMU countries will likely
surface in the foreign
currency market only
in the second half of
next year

EMU countries could look to the foreign currency bond market. Indeed, for Spain and Italy, the
cross currency swap becoming more negative would offer a good window of opportunity to
issue in USD. However, as risk aversion remains high, EMU countries might experience
difficulties in selling their bonds on a foreign currency market. If anything, EMU
countries will wait until some confidence is restored before tapping the foreign currency
market. Hence, this will not be the case until the second half of next year.

Difficult market conditions
should prevent heavy frontloading in the first part of
the year

This year,  EMU countries front-loaded much of their activity into 1Q. Indeed, they
completed 33% of total bond issuance for this year in the first three months. As we regard it
as unlikely that market conditions will improve dramatically in the first quarter of next year, we
do not expect front-loading to be as high as this year.

We estimate that EMU countries might issue EUR 246bn or 30% of total funding in 1Q, EUR 267bn
or 28% of total funding in 2Q, EUR 183bn or 22% of total funding in 3Q and EUR 162bn or
19% of total funding in 4Q.
Full report: Financial 2011 Outlook

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