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MOODYS.COM
3 OCTOBER 2016
NEWS & ANALYSIS Corporates 2 » Rice's Vantage Acquisition Will Boost Natural Gas Production
and Reduce Leverage » Steinhoff’s Equity Raise and Investment from Largest
Shareholder Are Credit Positive » Boeing Wins Another Round in Its Fight to Sustain Combat
Jet Production » Lockheed Martin Gets Boost from Australian Submarine
Contract and Initial US Approval of F-16 Sale to Bahrain » DTE's Purchase of Stonewall Stake Benefits Target, but
Increases Credit Risk for Buyer » Lufthansa's Brussels Airlines and Air Berlin Deals Will Benefit
Eurowings, a Credit Positive » Deutsche Post's Acquisition of UK Mail Is Credit Positive » China Evergrande's Disposal of Non-Core Businesses Will
Improve Profitability
Banks 10 » Wells Fargo’s Board Takes First Step to Repair the Bank’s
Reputation, a Credit Positive » US Regulator Signals Different Standards for Regional and
Global Systemically Important Banks » Consumer Confidence Index Hits a Nine-Year High, a Credit
Positive for US Banks » RBS' US Mortgage Settlement Is Credit Positive » Exchange of Monte dei Paschi's Subordinated Debt Would Be
Credit Positive for Senior Bondholders and Depositors » Commerzbank's Restructuring Caps Profits Near Breakeven for
About Three Years, a Credit Negative » Portugal Moves to Limit Banks' Contributions to Resolution
Fund, a Credit Positive » Cypriot Banks Will Benefit from Strong Deposit Inflows » Israel Discount Bank's Capital Raise Is Credit Positive
Insurers 26 » US Life Insurance Accounting Changes Would Improve
Financial Statements » Nationwide Financial's Acquisition of Jefferson National Life Is
Credit Positive » CNO Terminates Beechwood Reinsurance Agreements,
Recaptures Long-Term Care Block, a Credit Negative
Sovereigns 31 » Greece Moves Closer to €2.8 Billion Disbursement of Bailout
Funding, a Credit Positive
US Public Finance 33 » Federal Aid to Flint Will Ease Spending Pressure on Michigan, a
Credit Positive
CREDIT IN DEPTH
Deutsche Bank Potential Litigation Cost 35
Deutsche Bank has commenced negotiations with the US Department of Justice, aiming to settle civil claims in connection with the bank’s underwriting and issuance of residential mortgage-backed securities. We assess the effect of the potential settlement on DB’s common equity Tier 1 capital and its willingness and capacity to service its contingent convertible Tier One securities.
RECENTLY IN CREDIT OUTLOOK
» Articles in Last Thursday’s Credit Outlook 40 » Go to Last Thursday’s Credit Outlook
Click here for Weekly Market Outlook, our sister publication containing Moody’s Analytics’ review of market activity, financial predictions, and the dates of upcoming economic releases.
NEWS & ANALYSIS Credit implications of current events
2 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
Corporates
Rice’s Vantage Acquisition Will Boost Natural Gas Production and Reduce Leverage Last Monday, Rice Energy Inc. (B2 review for upgrade) said that it had agreed to buy Vantage Energy (unrated) and its midstream gas-gathering business, Vista Gathering LLC (unrated), for $2.7 billion, 85% of it funded with equity. The acquisition is credit positive for Rice, nearly doubling the exploration and production company’s Marcellus acreage in the Northeastern US, significantly increasing its natural gas-gathering capacity there, and materially improving its credit profile. The announcement led us to put Rice’s ratings on review for upgrade.
Along with the benefit to Rice’s cash flow, the deal will improve Rice’s leverage metrics substantially, since it relies heavily on equity and would retire Vantage’s existing debt. Rice’s consolidated ratio of retained cash flow/debt will reach more than 25% by the end of 2017, up from 11.3% for the 12 months through 30 June 2016. The company’s exploration and production debt/average daily production ratio should decline to less than $8,000 per barrel of oil equivalent by the end of 2017, from about $11,800 as of 30 June.
The acquisition marks a deviation from the recent upstream M&A we have seen, focusing on natural gas assets rather than oil, and involving assets in Appalachia rather than the Permian Basin in West Texas. The $2.7 billion transaction includes $1.4 billion to buy Vantage’s upstream business, $700 million to retire its outstanding debt, and $600 million to buy Vista. Rice has launched a $1 billion equity issuance to help finance the Vantage deal, and will use proceeds plus $980 million in equity issued directly to Vantage’s owners.
Meanwhile, Rice Midstream Partners LP (RMP, unrated), Rice’s 33%-owned master limited partnership, will either sell $250 million in equity units to Rice or issue $250 million units to the public, and draw $350 million on its revolver to help fund the acquisition of Vista.
The purchase would increase Rice’s current production by more than 50%, nearly doubling its Marcellus position to 179,000 net acres with more than 1,100 drilling positions, and would expand Rice’s Marcellus footprint by adding acreage adjacent to its existing production in southwestern Pennsylvania. The company’s natural gas reserves would more than double from year-end 2015 levels. Buying Vista will also increase Rice’s midstream throughput, solidifying its position as a leading gas gatherer in the Marcellus play.
RJ Cruz Vice President - Senior Analyst +1.212.553.7991 [email protected]
Rebecca Greenberg Associate Analyst +1.212.553.1631 [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 3 OCTOBER 2016
Steinhoff’s Equity Raise and Investment from Largest Shareholder Are Credit Positive Last Wednesday, Steinhoff International Holdings N.V. (Baa3 stable) announced that it had raised €2.447 billion in equity, the proceeds of which the company will use to repay a $1.8 billion bridge loan facility used to fund Steinhoff’s purchase of Mattress Holding Corp., which Steinhoff completed on 16 September. The remaining €846 million will predominantly go to further debt reduction. This development is credit positive because the steep reduction in debt will bring debt/EBITDA below our quantitative guidance for a rating downgrade of 3.5x and reduce Steinhoff’s interest expense. As part of Steinhoff’s additional share capital raise, its largest shareholder, the Wiese family, invested €1.587 billion, demonstrating its continued support for maintaining Steinhoff’s credit quality.
Steinhoff has delivered on its commitment to deleverage in accordance with its plan to quickly restore credit metrics back to levels commensurate with its Baa3 rating post acquisitions. The plan was factored into our affirmation of Steinhoff’s rating and outlook on 8 August, the day after the company announced the Mattress Firm acquisition. Also credit positive is the Wiese family’s growing commitment to the company by assisting Steinhoff in keeping leverage low. The Wiese family raised its stake to 23% from 17% through participation in the capital increase. The cash injection and the Wiese family’s increased stake are important qualitative analytical considerations in our credit assessment of Steinhoff, providing evidence of the company’s growing importance as the family’s single-largest investment.
Steinhoff’s ability to improve the margins of the companies it acquires arises from adding increased logistics volume and procurement to leverage economies of scale. High order volumes for products allow Steinhoff to attract bigger discounts from suppliers and shippers. At the same time, more volume flowing through the supply chain optimises usage and the incremental costs of Steinhoff’s logistics and warehousing infrastructure.
Douglas Rowlings Assistant Vice President - Analyst +971.4.237.9543 [email protected]
NEWS & ANALYSIS Credit implications of current events
4 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
Boeing Wins Another Round in Its Fight to Sustain Combat Jet Production Last Wednesday, the US initially approved an estimated $7 billion government-to-government sale to Qatar and Kuwait of F-15 and F-18 fighter jets (36 and 28, respectively) built by The Boeing Company (A2 stable). The deals are credit positive for Boeing and its key suppliers because they extend the production runs for these mature programs that otherwise would be winding down over the next several years. Among the other companies to benefit are engine suppliers General Electric Company (A1 stable) and United Technologies Corporation (A3 stable), and radar and weapons systems provider Raytheon Company (A3 stable).
The deals will support backlog growth that is not correlated to US defense budgets, which, despite modestly improving after a multi-year downturn, remain subject to extensive political and fiscal debate, and therefore considerably uncertainty. The development is a much-needed shot in the arm for Boeing’s St. Louis, Missouri, facility, which houses the company’s production of combat aircraft. Recent slowdowns in follow-on business and new business activity have led Boeing to cut the facility’s combat aircraft production rates to nearly bare- minimum levels that keep the lines going.
The US Navy values the F-18 program quite highly, especially the Growler variant with its electronic jamming capabilities, which the Navy sees as critical to future missions in an adjunct role alongside newer fighters such as Lockheed Martin Corporation’s (Baa1 stable) F-35, the biggest combat aircraft program going forward. Orders from Saudi Arabia, Singapore and now Qatar will extend production on the more internationally focused F-15 program into the early part of the next decade. However, the F-18 program needs additional orders for it to continue for more than another few years. Sustainment-related revenue streams for upgrades and servicing of the deployed fleet will remain sizable over the next decade or more.
Having lost out to Northrop Grumman Corporation (Baa1 stable) on the recently awarded B-21 (Raider) bomber program, the upcoming T-X Trainer competition remains even more critical to Boeing as the likely last chance at a sizable combat-related platform (considering both domestic and presumed follow-on international business). But several equally capable suitors are vying for this contract, which we expect will be awarded sometime next year, and the award may well determine if Boeing, one of only a handful of large prime US defense contractors with a longstanding history, continues in this role beyond the next decade.
Most defense contractors are aggressively pursuing international sales, given the relative paucity of new bid opportunities in a still constrained global spending environment. Industry participants are notably willing to invest in new facilities to accommodate more stringent offset agreements, including greater technology transfer and local production. We expect that this will remain integral to winning new business.
Commitments from political leaders in the US and other countries to pursue government-to-government sales in support of mature in-country platforms are on the rise. The recent string of international deal signings further substantiates our view that market opportunities in Europe, the Middle East and Asia will continue to be selectively available for defense contractors given rising security threats spurred on by elevated geopolitical risk. New business will subsequently continue, notwithstanding near universal lingering fiscal and budgetary pressures, albeit within a heightened competitive environment.
Russell Solomon Senior Vice President +1.212.553.4301 [email protected]
NEWS & ANALYSIS Credit implications of current events
5 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
Lockheed Martin Gets Boost from Australian Submarine Contract and Initial US Approval of F-16 Sale to Bahrain Last Thursday, Australia selected Lockheed Martin Corporation (Baa1 stable) as the preferred bidder to supply the combat systems for its forthcoming new fleet of 12 submarines, with work scheduled to begin in the next decade. The day before, the US government notified the company of initial approvals governing the sale of 19 Lockheed Martin-built F-16 fighter jets to Bahrain. These developments are credit positive for Lockheed Martin, the world’s largest defense contractor, because they provide international expansion, further diversify the company’s product offering and modestly extend what is perhaps the world’s longest running and most widely deployed combat aircraft program.
Lockheed Martin beat out Raytheon Company (A3 stable) – the combat systems integrator for the Australian Navy’s existing fleet of aging Collins class submarines – and will integrate the sensors, radar, navigation, imagery systems and weapons on the forthcoming vessels. Lockheed Martin will work with lead contractor DCNS, a 35%-owned investment of French defense contractor Thales S.A. (A2 stable), and leading US defense shipbuilder General Dynamics Corporation (A2 stable), among others.
The win over an incumbent is more significant than our expectation for economic returns that the company is likely to realize on the contract. At an estimated AUD3-AUD5 billion, the value is large on an absolute basis, but not so much in the context of being spread over a number of years and relative to Lockheed Martin’s roughly $50 billion revenue base. Also, various subcontractors are likely to share in the forward revenue streams. However, unseating an incumbent reinforces our view of the escalating competitive dynamic in a still fiscally austere defense-spending environment.
The F-16 deal is valued at an even more modest $1 billion, but adds about a year or more to the long-running program. System upgrades and sustainment-related revenue streams will remain sizable for an extensive globally deployed fleet of F-16s for some time. Although still subject to final lawmaker approval, we see little risk of the sale being blocked. Ostensibly, it has been approved for a couple of years, despite meeting some resistance owing to concerns from Israel. The approval is part of a broader series of government-to-government deals with countries looking to acquire other combat aircraft, including F-15s and F-18s from The Boeing Company (A2 stable). None of these deals correlates to US defense budgets, which, although improving somewhat following the recent multi-year downturn, remain subject to extensive political and fiscal debate, and therefore, considerable uncertainty.
The political influence behind government-to-government contracts has become more important in recent years given the contraction in industry spending and the need to protect the relative health of the industrial base. Most defense contractors are pursuing out-of-home/international market business and are competing increasingly hard for a relative paucity of new bid opportunities. In most cases, they are willing and able to invest in new facilities for localized production – something that we believe will remain integral to winning new business. News of the Lockheed wins did not include specific details of embedded offset arrangements, but a commitment to a heavy component of in-country production and a strong local presence in Australia more broadly almost certainly played a significant role in Australia’s decision to favor Lockheed Martin over Raytheon in awarding the new submarine combat systems contract.
Russell Solomon Senior Vice President +1.212.553.4301 [email protected]
NEWS & ANALYSIS Credit implications of current events
6 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
DTE’s Purchase of Stonewall Stake Benefits Target, but Increases Credit Risk for Buyer Last Monday, DTE Energy Company (A3 review for downgrade) said that it would spend $1.3 billion to buy a 55% stake in Stonewall Gas Gathering LLC (B2 review for upgrade) and all of Appalachian Gathering System (unrated) from M3 Midstream (unrated) and Vega Energy Partners (unrated). DTE will finance the purchase with a combination of new senior unsecured debt and new senior unsecured re-marketable debt that requires the forward purchase of DTE shares.
The transaction is credit positive for Stonewall and credit negative for DTE. The sale puts Stonewall under the majority ownership of an investment-grade company with an expanding midstream footprint and greater financial resources. DTE, meanwhile, plans to take on a significant amount of new debt to finance its purchase of a company with inherently more earnings volatility than its primary utility, pipeline, and gas storage assets. Following the announcement, we placed Stonewall’s ratings on review for upgrade and placed DTE’s on review for downgrade.
The agreement calls for DTE to acquire M3’s entire 40% stake in Stonewall and Vega’s 15% stake. WGL Midstream, a subsidiary of WGL Holdings, Inc. (A3 stable), will continue to own 30% of Stonewall, and Antero Resources Corporation (Ba2 negative), which owns the remaining 15%, maintains the right to sell its stake to DTE.
Stonewall benefits from its position as a gathering system close to interstate pipelines and markets for natural gas produced in the southwest part of the Marcellus Shale play in West Virginia, where producers have some takeaway capacity constraints. Stonewall can move 1.4 billion cubic feet per day (bcf/d), and can expand to 2.0 bcf/d with additional compression.
Stonewall’s benefit from its new ownership stake depends on its strategic importance to DTE and Stonewall’s existing owners, and their likelihood of credit support if needed. Stonewall today has low leverage under 3x debt/EBITDA and benefits from minimum volume commitment contracts from Antero, its anchor shipper, and other customers including Mountaineer Keystone (unrated). We expect that Stonewall will deleverage further through 2016 as its earnings grow.
The transaction will significantly increase DTE’s midstream presence in the Appalachian basin, consistent with its growth strategy and existing expertise in managing natural gas assets. However, nearly all of the revenues from the Stonewall assets come from volume-based contracts with natural gas producers, implying more overall business risk than its regulated businesses have today.
Although the purchase does not affect the credit quality of DTE subsidiaries, DTE Electric Company (A2 stable) or DTE Gas Company (senior secured Aa3 stable), buying Stonewall will increase the parent company’s exposure to natural gas midstream assets, which generate more volatile earnings and cash flow than its core regulated operations. Additionally, the transaction will increase DTE’s total debt burden by more than 10% from about $9.7 billion as of 30 June 2016. The percentage of parent company debt within the consolidated capital structure will increase to more than 30% from 22% at the end of 2015, resulting in higher structural subordination risk vis-à-vis the utility subsidiaries.
Morris Borenstein Assistant Vice President - Analyst +1.212.553.1409 [email protected] Laura Schumacher Vice President - Senior Credit Officer +1.212.553.3853 [email protected]
NEWS & ANALYSIS Credit implications of current events
7 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
Lufthansa’s Brussels Airlines and Air Berlin Deals Will Benefit Eurowings, a Credit Positive Last Wednesday, Deutsche Lufthansa Aktiengesellschaft’s (Lufthansa, Ba1 positive) supervisory board approved plans to buy the remaining 55% stake in Belgium’s Brussels Airlines (unrated) that it does not already own. Lufthansa also said that it had signed a letter of intent with Air Berlin Plc (unrated) on the wet lease of up to 40 aircraft: under a wet lease agreement, Air Berlin remains responsible for operating and maintaining the aircraft, and providing its cockpit and cabin crews for Lufthansa’s Eurowings and Austrian Airlines units. These moves are credit positive for Lufthansa because they will boost the size and scope of its low-cost airline, Eurowings.
We expect that both transactions will have limited effects on Lufthansa’s Moody’s-adjusted debt/EBITDA and retained cash flow/net debt. For the Brussels Airlines transaction, Lufthansa is not financing the takeover with debt and the price the company is paying is probably low (Lufthansa has not disclosed the price, but press reports speculate that the price is around €2.6 million). In the Air Berlin agreement, the effect of the operating lease adjustment on Lufthansa’s debt/EBITDA will be limited as long as the wet lease routes are not loss-making, because the company’s leverage is roughly in line with our rent expense multiple of 5x.
Lufthansa has not detailed how it will integrate Brussels Airlines’ 29 Airbus A319 and A320 aircraft into Eurowings’ short- and medium-haul fleet, which is composed of the same aircraft type, reducing complexity and maintenance costs, a key factor in the success of other low-cost airlines. At this point it is not clear whether Eurowings will retain Brussels Airlines’ 11 regional jets. Brussels Airlines also has nine long-haul aircraft, which would materially increase Eurowings’ long-haul capacity. Lufthansa acquired 45% of Brussels Airlines in 2009 for €65 million, with the option to buy the remaining 55%. Lufthansa expects to complete the transaction in early 2017.
Under the six-year agreement with Air Berlin, which would start in late March, 2017, subject to board and regulatory approval, Eurowings’ fleet will increase to around 175 aircraft from around 140 including Brussels Airlines’ 49 planes. This will make it more than half the size of competitor easyJet Plc’s (Baa1 stable) fleet and establish Eurowings as the clear No. 3 European low-cost airline. Reaching a critical scale is an important milestone in Lufthansa’s strategy for Eurowings, and prevents easyJet, Ryanair Ltd. (unrated), Norwegian Air Shuttle ASA (unrated) and others from taking Air Berlin’s slots, creating a barrier to these rivals’ expansion.
Additionally, by using a wet lease, the agreement with Air Berlin should remove some of the economic risk for Lufthansa of operating these flights. However, we believe success also depends on the not-yet-agreed wet lease fees and Eurowings’ ability to sell the additional capacity at satisfactory yields.
The wet lease agreement and takeover of Brussels Airlines show that Lufthansa must grow this business quickly and potentially accept low profitability for longer to establish Eurowings as a leading low-cost airline in Europe. We do not expect Lufthansa to quickly achieve margin-enhancing profitability by operating flights at cost structures similar to Brussels Airlines or Air Berlin. Air Berlin has struggled for years to make its flights economically viable.
Lufthansa’s efforts to maintain a lower cost base at Eurowings will be helped by a larger scale and an increasingly homogenous fleet. However, neither transaction will help Eurowings lower its cost base in areas such as personnel costs, which must decline if Eurowings aims to compete directly with Ryanair and easyJet.
Sven Reinke Vice President - Senior Credit Officer +44.207.772.1057 [email protected]
NEWS & ANALYSIS Credit implications of current events
8 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
Deutsche Post’s Acquisition of UK Mail Is Credit Positive Last Wednesday, Deutsche Post AG (A3 stable) agreed to acquire the entire capital of UK mail and parcel operator UK Mail Group Plc (unrated) for a cash amount of £243 million (approximately €280 million). Deutsche Post will offer £4.40 in cash per share and has already obtained the commitment of shareholders holding approximately 60% of the total capital to accept the offer. The directors of UK Mail intend to make a unanimous recommendation that shareholders accept the offer.
The acquisition is a good strategic fit for Deutsche Post and credit positive. It will allow the company to expand its footprint in the UK and strengthen its fast-growing cross-border parcel business. The UK parcel market is Europe’s largest and one of the most competitive. According to Royal Mail (unrated) estimates, the UK parcel market is likely to grow at approximately 4% annually in the medium term, owing to the continuing development of e-commerce, with the cross-border parcel business growing faster than the average.
The acquisition will have a limited effect on Deutsche Post’s financials and metrics, given its relatively small size. In the fiscal year that ended 31 March 2016, UK Mail generated revenues of £481 million (€558 million) and a recurring reported operating profit of £11 million (€12.8 million), corresponding to less than 1% of Deutsche Post’s fiscal 2015 revenue and operating profit. Though fully funded in cash, the acquisition will not materially affect Deutsche Post’s credit metrics and we expect that the company’s leverage, measured as gross debt/EBITDA (including Moody’s adjustments), will remain well below 3.0x in 2016 (from 2.7x in 2015 and as of June 2016), which is solidly within our quantitative guidance for the current rating.
Deutsche Post AG, based in Bonn, Germany, is the incumbent postal operator in Germany and the world's largest logistics service provider. The company operates under four different divisions: Post - eCommerce - Parcel; Express; Global Forwarding, Freight; and Supply Chain. The first division trades as both Deutsche Post and DHL, and the latter three divisions trade under the DHL brand. Deutsche Post generated €59.2 billion of total revenues and a reported EBIT of €2.4 billion in fiscal 2015.
Lorenzo Re Vice President - Senior Analyst +39.02.91481.123 [email protected]
NEWS & ANALYSIS Credit implications of current events
9 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
China Evergrande’s Disposal of Non-Core Businesses Will Improve Profitability On 28 September, China Evergrande Group (B2 negative) announced that it had disposed of all of its non-core grains and edible oils, dairy products and spring water businesses to separate independent third parties for an aggregate consideration of RMB2.7 billion. The disposal is credit positive because it will improve the company’s profitability and allow management to focus on its core property development business.
Evergrande expects to recognize an unaudited before-tax gain of approximately RMB5.7 billion from the disposal, which is equal to around 18% of its 2015 before-tax profits of around RMB31.5 billion. We believe the difference between the larger RMB5.7 billion gain and the smaller RMB2.7 billion disposal consideration reflects the non-core businesses’ accumulated operating losses. In addition, we estimate that the improvement in Evergrande’s annual operating profit margins would be around two percentage points in the next two to three years because of these non-core businesses’ past material losses.
The disposal’s limited effect on revenue reflects the non-core businesses’ relative small size compared with Evergrande’s core property development business. Nor will the disposals materially boost Evergrande’s liquidity because they accounted for only around 1.3% of its cash holdings of RMB212 billion as of 30 June 2016.
Evergrande’s B2 rating is constrained by the high business and financial risks of its strategy to pursue rapid debt-funded growth. Its negative rating outlook reflects Evergrande’s high business, financial and liquidity risks, in view of its aggressive debt-funded acquisitions. Evergrande said that upon completion of the disposals, it would no longer have any interests in grains and edible oils, dairy products and spring water. However, it will retain interests in other businesses, such as financial, internet and health care businesses, after the disposal.
China Evergrande Group is one of the major residential developers in China. Founded in 1996 in Guangzhou, the company has rapidly expanded its business in China over the past few years. At 30 June 2016, its land bank totaled 186 million square meters in gross floor area across 175 Chinese cities.
Franco Leung Vice President - Senior Credit Officer +852.3758.1521 [email protected]
NEWS & ANALYSIS Credit implications of current events
10 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
Banks
Wells Fargo’s Board Takes First Step to Repair the Bank’s Reputation, a Credit Positive Last Tuesday, Wells Fargo & Company (A2 stable) announced an independent investigation into the bank’s retail sales practices led by its board’s independent directors and assisted by an independent law firm. The investigation follows the disclosure of widespread misconduct within the retail banking unit, and specifically, the unauthorized opening of up to 2.1 million deposit and credit card accounts.1 The board also took what it described as “initial steps” to hold management accountable, in particular, by “clawing back” or rescinding previously awarded incentive compensation from CEO John Stumpf and former head of Community Banking, Carrie Tolstedt.
The board’s first steps to repair the damage are credit positive. Mr. Stumpf will forfeit all of his outstanding unvested equity awards, valued at approximately $41 million. He will also forgo any salary while the board’s investigation is ongoing and will not receive a bonus for 2016. Ms. Tolstedt will similarly forfeit all of her unvested equity awards, valued at approximately $19 million, and will not receive a 2016 bonus. In addition, Wells Fargo terminated Ms. Tolstedt’s employment without paying severance and she has agreed not to exercise any vested stock options while the board’s investigation is ongoing. The board noted that its investigation might result in additional actions against Mr. Stumpf, Ms. Tolstedt or other executives.
By clawing back pay for senior executives, a rare step among public companies generally and the financial services industry in particular, Wells Fargo’s board shows that senior managers can be held accountable for material control failures and ineffective risk management that weaken a bank’s reputation. The clawback of senior management incentive compensation appears designed to address the harm to Wells Fargo’s reputation and may ease some of the recent political and media pressure on the bank, although we believe this widely publicized episode inflicts long-lasting reputational harm on Wells Fargo.
During the 2008-09 financial crisis, there were few clawback policies in place and the actual use of clawbacks was even less likely despite disclosures of many egregious risk-management and control failures during that period. Since then, bank regulators have proposed stronger rules, including clawbacks, to curb excessive risk-taking at banks and other large financial institutions.2 In this light, the Wells Fargo board’s actions highlight senior management’s personal responsibility for the bank’s wrongdoings, which was not previously the case and which we believe is positive for creditors.
On the other hand, when Mr. Stumpf testified before the US Senate Banking, Housing and Urban Affairs Committee on 20 September, he noted that both he and the board had been aware of the existence of deficient sales practices since late 2013-14. Although it is less clear when management and the board realized the scope of the problem, the fact that the board allegedly knew of the misconduct but did not act decisively until after it became public and the political and media firestorm was burning, indicates its shortcomings – and the board did not indicate whether its investigation will also look into the inadequacies of its own oversight responsibilities.
1 See Deficiencies in Wells Fargo’s Consumer Banking Sales Practices Are Credit Negative, 12 September 2016. 2 See Re-Proposed and Strengthened Pay Rules for US Banks are Credit Positive, 23 May 2016.
Allen Tischler Senior Vice President +1.212.553.4541 [email protected]
Christian Plath Vice President - Senior Credit Officer +1.212.553.7182 [email protected]
NEWS & ANALYSIS Credit implications of current events
11 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
US Regulator Signals Different Standards for Regional and Global Systemically Important Banks On 26 September, the US Federal Reserve published a proposal to modify its capital plan and stress testing rules for noncomplex banks, while separately, Federal Reserve Governor Daniel Tarullo delivered a speech titled “Next Steps in the Evolution of Stress Testing.” Together, the proposals would further differentiate the regulatory vigor applied to the eight large US global systemically important banks (GSIBs) and the noncomplex banks3 (regional banks). A more stringent regulatory stance toward US GSIBs would raise their capital and equity-holding requirements, a credit positive. However, it would also increase their existing challenge to generate an acceptable return on equity, which in aggregate, they are not yet meeting.
The effect on regional banks will be the opposite: the Fed’s proposal would eliminate the qualitative assessment of the comprehensive capital analysis and review (CCAR), which we consider credit negative because of lost transparency. Objections to regional banks’ capital plans would only be based on a bank’s failure to meet a regulatory capital minimum under a stress scenario. We consider the current CCAR qualitative assessment an incentive for bank managements to improve their capital and risk management processes. The CCAR qualitative assessment test also provides bondholders with a public and independent comparative assessment, which would be lost.
The Fed’s proposed modifications would also decrease the capital distributions that both GSIBs and regional banks can make in excess of their approved capital plans. Current rules allow a CCAR participant to make capital distributions equal to 1% of its Tier 1 capital in excess of the amount the Fed approved. The proposal reduces the allowed additional capital distribution to only 0.25% of Tier 1 capital, supporting greater capital retention for all banks.
Mr. Tarullo outlined several areas where the Fed will consider further CCAR modifications, which will likely result in greater capital requirements for the US GSIBs and lower capital requirements for regional banks. A major difference from current rules centered on the suggestion that the GSIBs’ firm-specific GSIB capital surcharge be incorporated in their minimum stress capital hurdles.
Mr. Tarullo suggested three other key changes in CCAR for banks of all sizes. He proposed introducing a stress capital buffer that would require a bank to maintain a capital buffer equal to the maximum decline in its common equity Tier 1 capital ratio under the severely adverse scenario before its planned capital distributions, with a minimum level of 2.5% equal to the capital conservation buffer, as shown below. He proposed assuming that dividends are maintained for only one year and repurchases are reduced, as opposed to the current assumption that dividends and repurchases continue for the nine-quarter CCAR horizon. The third change would be that balance sheets and risk-weighted assets remain constant under stress scenarios as opposed to increasing. Although the stress capital buffer will increase the required capital buffer, Mr. Tarullo’s latter two proposed assumption changes will partially offset that. If implemented, the CCAR participants in aggregate will need to hold a modestly higher amount of capital, with the increase skewed heavily to the eight US GSIBs.
3 A noncomplex bank holding company is defined as a firm with total consolidated assets of $50 -$250 billion, on-balance sheet
foreign exposure of less than $10 billion, and total non-bank assets of less than $75 billion.
Rita Sahu, CFA Vice President - Senior Credit Officer +1.212.553.1648 [email protected]
NEWS & ANALYSIS Credit implications of current events
12 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
Federal Reserve Governor Daniel Tarullo’s Proposed Stress Capital Buffer
Source: Federal Reserve
The elimination of the qualitative assessment and reducing capital requirements for regional banks is similar to the approach taken with the liquidity coverage ratio, which has a less stringent requirement for banks with $50-$250 billion of assets. The lower standard reflects US regulators’ view that the financial system is better able to absorb a capital stress event at a midsize bank, and that their smaller size, lower foreign exposure and less complex activities should make such banks less difficult to resolve. We agree with this rationale, but nonetheless believe that a lower standard is credit negative for creditors.
The Fed’s proposed modifications, if implemented, will be effective with the next Comprehensive Capital Analysis and Review (CCAR) in 2017, while Mr. Tarullo’s stress testing proposals, if executed, could be effective in 2018.
Capital requirements: Stress capital buffer
Counter-cyclical capital buffer
GSIB surcharge
4.5% minimum
Stress capital buffer: CCAR stress test
results (minimum 2.5%)
CCAR Stress Test Results
Minimum ratio
Starting ratio
Counter-cyclical capital buffer
GSIB surcharge
2.5% capital conservation buffer
4.5% minimum
Current capital requirements
NEWS & ANALYSIS Credit implications of current events
13 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
Consumer Confidence Index Hits a Nine-Year High, a Credit Positive for US Banks Last Tuesday, the Conference Board’s US consumer confidence index (CCI) for September jumped to its highest level in more than nine years. High consumer confidence suggests that consumer spending, a major contributor to US GDP, will remain firm. This confidence is a good bellwether for employment and economic growth prospects, and reduces the likelihood of a near-term increase in loan-loss provisions, a credit-positive development for US banks at a time of negative revenue pressure.
The CCI is based on consumers’ perception of current US business and employment conditions. The index includes consumers’ forward-looking expectation of business conditions, employment and income for the coming six months. As Exhibit 1 shows, the index, which had averaged 95.6 in the first seven months of this year, jumped to 101.8 in August and rose further in September to 104.1, solidifying the positive trend in consumer confidence.
EXHIBIT 1
US Consumer Confidence Index, 2016
Source: The Conference Board
Higher consumer confidence should support further consumer spending, which is positive for the broader economy. As Exhibit 2 shows, personal consumption expenditures are a major contributor to US GDP at almost 70%.
EXHIBIT 2
US Gross Domestic Product by Components
Source: US Bureau of Economic Analysis
86
88
90
92
94
96
98
100
102
104
106
Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16
-$2$0$2$4$6$8
$10$12$14$16$18$20
$ Tr
illio
ns
Personal Consumption Gross Private Domestic InvestmentGovernment Consumption and Gross Investment Net Exports of Goods and Services
Ram Sri-Saravanapavaan Associate Analyst +1.212.553.4927 [email protected]
Joseph Pucella Vice President - Senior Credit Officer +1.212.553.7455 [email protected]
NEWS & ANALYSIS Credit implications of current events
14 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
Our leading indicators for US bank asset quality also paint a positive picture for consumer credit. One of those leading indicators is initial unemployment insurance claims, which remain low. Exhibit 3 shows that claims are a good predictor of consumer loan net charge-off rates.
EXHIBIT 3
US Initial Unemployment Insurance Claims and Charge-Offs on Consumer Loans
Note: Charge-off rate on consumer loans for top 100 US banks by asset size. Sources: US Federal Deposit Insurance Corporation, US Department of Labor and US Federal Reserve
As Exhibit 4 shows, there is also a positive correlation between the CCI (inverted) and banks’ consumer loan net charge-off rates.
EXHIBIT 4
Charge-offs on US Banks’ Consumer Loans and the Consumer Confidence Index (Inverted)
Note: Charge-off rate on consumer loans for top 100 US banks by asset size. Sources: US Federal Reserve and Haver Analytics
0%
1%
2%
3%
4%
5%
6%
7%
8%
0
1
2
3
4
5
6
7
8
91Q
062Q
063Q
064Q
061Q
072Q
073Q
074Q
071Q
082Q
083Q
084Q
081Q
092Q
093Q
094Q
091Q
102Q
103Q
104Q
101Q
112Q
113Q
114Q
111Q
122Q
123Q
124Q
121Q
132Q
133Q
134Q
131Q
142Q
143Q
144Q
141Q
152Q
153Q
154Q
151Q
162Q
16
Mill
ions
Initial Unemployment Insurance Claims - left axis Annualized Charge-Offs on Consumer Loans - right axis
0
20
40
60
80
100
1200%
1%
2%
3%
4%
5%
6%
7%
8%
2006
Q1
2006
Q2
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Q3
2006
Q4
2007
Q1
2007
Q2
2007
Q3
2007
Q4
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Q3
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Q4
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Q4
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Q4
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Q4
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Q3
Annualized Charge-Off Rate - left axis Consumer Confidence Inverted - right axis
NEWS & ANALYSIS Credit implications of current events
15 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
RBS’ US Mortgage Settlement Is Credit Positive Last Wednesday, The Royal Bank of Scotland Group plc (RBS, Ba1 positive) reached a final $1.1 billion (£846 million) settlement with the US National Credit Union Administration (NCUA), resolving two outstanding civil lawsuits over allegations of mortgage mis-selling to two credit unions. Although the settlement is at the upper end of what other banks have paid (see Exhibit 1), it is credit positive because it reduces the uncertainties related to litigation costs and will have no material effect on RBS’ regulatory capital, given that the amount is substantially covered by existing provisions.
EXHIBIT 1
Bank Settlements with the US National Credit Union Administration
Bank Date Amount Percent of RMBS Sold to the
Two Credit Unions*
JPMorgan Chase November 2013 $1.4 billion 19% Wachovia October 2015 $53 million 26%
Barclays October 2015 $325 million 38% Morgan Stanley December 2015 $225 million 23%
RBS September 2016 $1.1 billion 34%
Note: * Damage exposures are based on the original principal balance and the performance of the RMBS certificates, among other factors. Sources: National Credit Union Administration and Moody’s Investors Service
The settlement relates to cases that the NCUA brought as receiver for two failed credit unions, the US Central Federal Credit Union and Western Corporate Federal Credit Union. Although the settlement resolves these matters, RBS remains subject to a number of other investigations and lawsuits related to US residential mortgage-backed securities (RMBS) that are likely to lead to far larger settlements. The two largest of these involve a lawsuit filed by the US Federal Housing Finance Agency over private-label RMBS sold to Fannie Mae and Freddie Mac, and investigations by the US Department of Justice and other members of the RMBS Working Group over the underwriting and sale of private-label RMBS.
Even though the NCUA settlement is credit positive, the crystallisation of unsettled conduct and litigation costs related to high-profile pending investigations will weigh heavily on RBS’ profits, impair the bank’s ability to generate capital internally (see Exhibit 2) and challenge the execution of its multi-year restructuring programme. Furthermore, we expect that ongoing and future litigation costs, which tend to be unpredictable, will produce earnings volatility.
EXHIBIT 2
Moody’s Estimated Cost for RBS to Settle Remaining Major RMBS Legal Matters and Effect on Common Equity Tier 1 Capital Ratio
Median High-End
Estimated Settlements
Federal Housing Finance Agency $3.2 billion $4.3 billion
Department of Justice $3.5 billion $8.8 billion
Total $6.7 billion $13.1 billion
Effect on Common Equity Tier 1 Capital Ratio
Federal Housing Finance Agency 0.2% -0.1%
Department of Justice -1.1% -2.8%
Total -0.9% -2.9%
Note: Estimates are based on the median and high-end of the settlements of other institutions, calculated as a percentage of private label RMBS sold or underwritten. We assume £3.0 billion Federal Housing Finance Agency existing provisions and that settlements are not tax deductible. Source: Moody’s Investors Service
Alessandro Roccati Senior Vice President +44.20.7772.1603 [email protected]
Laurie Mayers Associate Managing Director +44.20.7772.5582 [email protected]
NEWS & ANALYSIS Credit implications of current events
16 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
RBS’ capital position is currently one of the strongest among domestic and global peers, with a common equity Tier 1 capital (CET1) ratio of 14.5% at the end of June 2016 (see Exhibit 3). RBS targets a CET1 ratio of 13% after the settlement of large pending litigations and the remaining budgeted restructuring costs (of more than £1 billion). We continue to expect that RBS’ capital ratios will experience some volatility in the coming quarters while the bank executes its restructuring plan and continues to incur restructuring costs as well as other expenses, such as litigation and other regulatory fines.
EXHIBIT 3
Global Investment Banks’ Common Equity Tier 1 and Tier 1 Leverage Ratios as of June 2016
Notes: * As defined by the Bank for International Settlements. CET1 and leverage ratios are on a look-through/fully loaded basis. Medians include RBS. The banks’ baseline credit assessment (BCA) of the operating bank are shown for all except HSBC, for which the BCA is the intrinsic standalone financial strength of HSBC Holdings. Sources: The banks and Moody’s Investors Service
15.8%14.5% 14.2%
12.5% 12.1% 11.9% 11.8% 11.8% 11.6% 11.1% 11.1% 10.8% 10.5%
6.1%5.2%
4.2%
7.5%
5.1%
6.6%
4.4%
6.1%
4.2% 4.0% 3.9% 3.4%
6.9%
0%
3%
6%
9%
12%
15%
18%
MorganStanley(baa2)
RoyalBank of
Scotland(ba1)
UBS*(baa1)
Citigroup(baa2)
HSBCHoldings
(a1)
JP Morgan(a3)
CreditSuisse*(baa2)
GoldmanSachs(baa1)
Barclays(baa2)
BNPParibas(baa1)
SocieteGenerale
(baa2)
DeutscheBank (ba1)
Bank ofAmerica(baa2)
CET1 Ratio Tier 1 Leverage Ratio Median CET1 Ratio = 11.8% Median Leverage Ratio = 5.1%
NEWS & ANALYSIS Credit implications of current events
17 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
Exchange of Monte dei Paschi’s Subordinated Debt Would Be Credit Positive for Senior Bondholders and Depositors On 26 September, Banca Monte dei Paschi di Siena S.p.A. (Montepaschi, B2/B3 review direction uncertain, ca review direction uncertain4) announced that it may include a voluntary exchange of debt for equity in the 24 October update of its business plan. The bank is most likely to make its offer to subordinated debt holders; such an exchange would be credit positive for senior debtholders and depositors.
As of December 2015, the bank had €5 billion of Additional Tier 1 and Tier 2 instruments outstanding and a successful exchange of some of these securities would reduce the size of the €5 billion capital increase the bank included in its initial restructuring plan, in late July. Furthermore, the bank said that it has already explored the exchange option with investors, who despite potentially high losses, may be better off with an exchange than running the risk of a more punitive scenario.
If Montepaschi is unable to execute its restructuring plan, the bank could be subject to regulatory intervention, the effect of which may extend beyond subordinated debt and impinge on senior bondholders.
The success of such an exchange would depend on its details, which remain unknown. In particular, the type and amounts of instruments and warrants that would be given to debtholders that participate in the exchange. We expect a final decision on the exchange along with details of the operation when Montepaschi announces its new business plan in October. Montepaschi’s earlier plan to revise the business plan by the end of September was postponed when the bank installed a new CEO in mid-September.
Executing Montepaschi’s planned €5 billion rights issue will be very challenging since it compares with less than €0.6 billion market capitalisation. The bank’s management is facing the delicate task of being attractive to new investors and the need to create capital by imposing losses on current Additional Tier 1 and Tier 2 investors. In short, the operation carries risks which are to be dealt with carefully given the fragility of the banking system. A successful restructuring of Montepaschi would bode well for other bank’s upcoming restructurings. Conversely, a failure could affect the rest of the Italian banking system.
4 The bank ratings shown in this report are the deposit rating, senior unsecured debt rating and baseline credit assessment.
London +44.20.7772.5454
NEWS & ANALYSIS Credit implications of current events
18 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
Commerzbank’s Restructuring Caps Profits Near Breakeven for About Three Years, a Credit Negative Last Thursday, Commerzbank AG (A2 stable/Baa1 stable, baa35) announced a major restructuring of the bank that involves breaking up its most important segment, the so-called Mittelstandsbank (MSB) that serves small and medium-sized businesses, and significantly scaling back its investment banking activities.
The strategic revamp is credit negative because it materially limits Commerzbank’s capacity to increase its capital through retained earnings in the coming years and because the restructuring largely affects Commerzbank’s most important division, the MSB, as measured by its prior years’ profit contribution and competitive positioning. The MSB division, which currently serves the small and mid-sized enterprises that are the backbone of Germany’s economy, will be split and merged with the bank’s existing commercial and investment banking business (i.e., Commerzbank’s previous Corporates & Markets division). Smaller MSB clients will be added to the retail banking operations (i.e., Commerzbank’s previous Private Customers division).
The new strategy targets significant efficiencies by digitalizing 80% of its processes, and increasing the focus on its core business, which results in downsizing higher-risk and high-cost investment banking activities. As result of the plan, Commerzbank targets a cost base of €6.5 billion by 2020, which compares with annualized costs of €7.2 billion in the first half of 2016, chiefly through a net reduction of 7,300 full-time positions. The bank expects to incur a €700 million impairment of goodwill and other intangible assets in the third quarter of 2016 and to book overall €1.1 billion restructuring costs in 2017 and 2018. The bank expects a moderate improvement of its common equity Tier 1 (CET1) ratio to above 12% in 2018 from nearly 12% in 2016.
From 2012-15, the MSB contributed 62% to the core bank’s operating profits and 112% to the group’s operating profits, forming a major part of the bank’s capital-generation capacity. Tackling the restructuring of the bank through a split-up of this division therefore exposes Commerzbank to meaningfully higher execution risk compared with a general efficiency programme. If not executed carefully, this move could disrupt the bank’s MSB franchise and erode Commerzbank’s strong position in that business segment. Addressing 9,600 gross job cuts (or 21% of the bank's year-end 2015 full-time personnel base) comes after several years where the group undertook multiple cost-cutting exercises and substantial restructuring as well as de-risking efforts. While having been successful in reaching its announced cost-cutting targets, executing its current programme will become more difficult and be a bigger strain on the bank than earlier programmes because the easy cost cutting options have been exhausted during earlier restructurings.
Although the cost targets look feasible from today’s perspective, the strategic overhaul and its related costs come amid significant pressure on the bank’s revenues and earnings, largely driven by the persistently low interest-rate environment and increasing loan losses on the bank’s remaining €7 billion shipping portfolio.
As the bank’s proposed re-engineering proceeds, Commerzbank will be challenged to improve its capital adequacy. The bank’s fully loaded common equity Tier 1 (CET1) ratio slipped back to 11.5% during the second quarter of 2016 from 12.0% at year-end 2015, and it will not be able to meaningfully increase this ratio before 2019.
However, we believe that successfully focusing on two re-sized and client-focused pillars of its business model will help Commerzbank further improve its profile, reduce its balance sheet to below €500 billion by 2020, improve leverage and free up capital for investment. In addition, reduced earnings volatility and lower risk-weighted assets from capital-market related businesses should benefit the bank’s risk profile.
5 The ratings shown are Commerzbank’s deposit rating and senior unsecured debt rating, and its baseline credit assessment.
Michael Rohr Vice President - Senior Credit Officer +4969.70730.0901 [email protected]
Alexander Hendricks, CFA Associate Managing Director +4969.70730.0779 [email protected]
NEWS & ANALYSIS Credit implications of current events
19 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
Portugal Moves to Limit Banks’ Contributions to Resolution Fund, a Credit Positive Last Wednesday, Portugal’s Ministry of Finance announced that it will review the terms for state loans to the country’s bank resolution fund to ensure that Portuguese banks’ annual contributions to the fund do not increase even if future contingencies materialize. This review is credit positive for Portuguese banks because it protects them against a shortfall in the sale of Novo Banco, S.A. (Caa1/Caa1 developing, caa26), which the resolution fund currently owns.
The review, which is part of an agreement between the Ministry of Finance and the resolution fund, and which the European Commission approved, ensures the extension of the maturity of the state loans in case of need so that Portuguese banks’ annual contributions remain at current levels, even if a contingency arises. The agreement also specifies the applicable interest rate, which will be indexed to the Portuguese sovereign debt rate.
Novo Banco received a €4.9 billion capital injection from the resolution fund in 2014 that was in part funded by a €4.5 billion loan from the Portuguese government. Currently, the resolution fund owes the government €3.9 billion, and if proceeds from Novo Banco’s privatization (which must be completed by August 2017) do not cover this amount, Portuguese banks would be required to bear a portion of the shortfall because they are liable for financing the resolution fund. However, Wednesday’s announcement means that they will not need to make extraordinary contributions to the fund, thereby limiting the effect on banks if Novo Banco’s sale misses its target price. Novo Banco has weak credit quality and it is highly unlikely that the resolution fund will obtain sufficient funds to repay the outstanding government loan.
The decision to extend state loans’ maturities in case of need will alleviate pressure on Portuguese banks’ already-weak solvency (see exhibit). However, Portuguese banks will continue to be challenged by poor profitability prospects and limited capacity to generate capital from internal resources.
Moody’s-Rated Portuguese Banks’ Tangible Common Equity Ratio, December 2015
Notes: Our more conservative capital assessment relative to regulators’ capital ratios is primarily because regulators do not deduct convertible deferred tax assets from the capital base, while we give benefit as a capital component to only a share of them. We also apply more conservative risk weighting to the sovereign exposures compared with regulators’ risk weighting of 0%. Source: Moody’s Financial Metrics
6 The bank ratings shown in this report are Novo Banco’s deposit rating, senior unsecured debt rating and baseline credit assessment.
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
Caixa Geral deDepositos
Banco ComercialPortugues
Novo Banco Banco Santander Totta Banco BPI Caixa EconomicaMontepio Geral
Maria Vinuela Assistant Vice President - Analyst +34.91.768.8237 [email protected]
Pedro Rodríguez Associate Analyst +34.91.768.8244 [email protected]
NEWS & ANALYSIS Credit implications of current events
20 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
The announcement also comes ahead of Portuguese banks’ increased regulatory and prudential capital requirements starting in 2017, which will force them to improve upon current solvency levels. The European Central Bank’s supervisory review and evaluation process requirements have not been disclosed yet for Portuguese banks, but the Bank of Portugal, the central bank, has imposed additional requirements on systemically important banks.7 We expect that banks will be challenged to comply with upcoming capital requirements with an adequate buffer.
7 On 29 December 2015, Bank of Portugal identified Portugal’s six largest banks as systemically important institutions and imposed
additional capital buffers of 0.25%-1.00%. The banks are Caixa Geral de Deposits, Banco Comercial Portugues, Novo Banco, Banco BPI, Banco Santander Totta SGPS and Caixa Economica Montepio Geral.
NEWS & ANALYSIS Credit implications of current events
21 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
Cypriot Banks Will Benefit from Strong Deposit Inflows Last Tuesday, the Central Bank of Cyprus released data showing that the Cyprus banking system’s total deposits in August 2016 rose to a three-year high following the largest monthly deposit inflow since April 2012. Although Cypriot banks have a high stock of problem loans that will challenge them for a prolonged period, the increase in deposits, which was driven by less confidence-sensitive domestic residents’ deposits, will improve banks’ funding structure, a credit positive.
August’s €873 million increase in deposits was the first time in six years there has been a net deposit inflow for five consecutive months (see Exhibit 1), indicating improved funding conditions in a system where depositor confidence remains fragile following depositors’ losses in March 2013. The improved economic sentiment, as a consequence of accelerating economic growth, declining unemployment, and the conclusion of Cyprus’ Economic Adjustment Programme in March 2016, has partly restored depositor confidence, which led to the gradual return of mattress money (deposits withdrawn from the Cypriot banking system). Record tourism revenues this year8 also supported increased deposit inflows.
EXHIBIT 1
Cypriot Bank Deposit Inflows Have Been Positive the Past Five Months
Source: Central Bank of Cyprus
The 6.4% annual growth rate in deposits, adjusted for foreign-exchange rate movements, marked the strongest rate of increase in banking system deposits in five years (see Exhibit 2). Deposits have grown year on year since October 2015, despite the abolition of deposit controls in April 2015. Deposits from Cypriot and other euro area residents are driving the growth, with their deposits rising to the highest levels since May 2013 (two months after the depositor bail-in and imposition of deposit controls).
8 See Cypriot Banks Benefit from Strong Tourism in 2016, 21 July 2016.
-€ 4.5-€ 4.0-€ 3.5-€ 3.0-€ 2.5-€ 2.0-€ 1.5-€ 1.0-€ 0.5€ 0.0€ 0.5€ 1.0€ 1.5€ 2.0€ 2.5€ 3.0
Jan-
10
Apr-
10
Jul-
10
Oct
-10
Jan-
11
Apr-
11
Jul-
11
Oct
-11
Jan-
12
Apr-
12
Jul-
12
Oct
-12
Jan-
13
Apr-
13
Jul-
13
Oct
-13
Jan-
14
Apr-
14
Jul-
14
Oct
-14
Jan-
15
Apr-
15
Jul-
15
Oct
-15
Jan-
16
Apr-
16
Jul-
16
€Bi
llion
s
Antypas Asfour, CFA, PRM Associate Analyst +357.2569.3033 [email protected]
NEWS & ANALYSIS Credit implications of current events
22 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
EXHIBIT 2
Cypriot Banks’ Deposits by Depositors’ Residence 2010-16 Bank deposits this year have grown at the highest annual rate in five years.
Source: Central Bank of Cyprus
Despite the nation’s increased economic activity, we expect deposit growth to remain modest as an increasing number of borrowers use a portion of their income to repay debt. Although all three large domestic banks, the Bank of Cyprus Public Company Ltd (BoC, Caa3 positive, (P)Caa3, caa39), the Hellenic Bank Public Company Ltd (Caa2 positive, caa3), and the Cooperative Central Bank (unrated), stand to benefit from rising depositor confidence in the banking system, BoC is currently the entity with the weakest funding structure and consequently has the most to gain. We expect that the growing deposit balances and increased financing from other financial institutions as creditor confidence strengthens will enable BoC to fully repay its Emergency Liquidity Assistance (ELA) funding during 2017. BoC’s reliance on ELA has declined by €9.9 billion since its peak to €1.5 billion (around 7% of assets) as of August 2016 (see Exhibit 3), ahead of its restructuring plan.
EXHIBIT 3
Bank of Cyprus’ Eurosystem Funding
Sources: Bank of Cyprus and Moody’s Investor's Service
9 The bank ratings shown in this report are the bank’s deposit rating, senior unsecured debt rating (where applicable), and baseline
credit assessment.
-25%
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
€ 0
€ 10
€ 20
€ 30
€ 40
€ 50
€ 60
€ 70
€ 80
Jan-
10
Apr-
10
Jul-
10
Oct
-10
Jan-
11
Apr-
11
Jul-
11
Oct
-11
Jan-
12
Apr-
12
Jul-
12
Oct
-12
Jan-
13
Apr-
13
Jul-
13
Oct
-13
Jan-
14
Apr-
14
Jul-
14
Oct
-14
Jan-
15
Apr-
15
Jul-
15
Oct
-15
Jan-
16
Apr-
16
Jul-
16
€Bi
llion
s
Cyprus - left axis Other Euro Area - left axis Rest of World - left axis Annual Growth - right axis
€ 11.4 € 11.1 € 9.9 € 9.6 € 9.5 € 8.8
€ 7.7 € 7.4 € 6.9 € 5.9
€ 4.9 € 3.8 € 3.3
€ 2.4 € 1.5
€ 1.3 € 1.4 € 1.4 € 1.4
€ 0.9 € 0.9 € 0.8
€ 0.5 € 0.5
€ 0.7 € 0.5
€ 0.7 € 0.7
0%
5%
10%
15%
20%
25%
30%
35%
40%
€ 0
€ 2
€ 4
€ 6
€ 8
€ 10
€ 12
Apr-13 Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Jun-16 Aug-16
€Bi
llion
s
Emergency Liquidity Assistance - left axis European Central Bank - left axisELA Funding to Total Assets - right axis
NEWS & ANALYSIS Credit implications of current events
23 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
Creditor confidence, though strengthened, remains fragile, and although not our base scenario, a weakening in the banks’ solvency would likely spark outflows.
NEWS & ANALYSIS Credit implications of current events
24 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
Israel Discount Bank’s Capital Raise Is Credit Positive Last Thursday, Israel Discount Bank (IDB, Baa1 stable, ba110) announced that it had raised NIS580 million ($155 million) in capital by issuing shares and warrants to institutional investors and the public. The capital increase is credit positive because it will strengthen the bank’s capital and loss-absorption buffers and support the bank’s accelerating loan book growth as the bank undertakes efforts to enhance profitability and improve its weak efficiency metrics.
The Bank of Israel’s (BoI) tighter capital requirements have prompted Israeli banks to boost their capital ratios, either by reducing their risk-weighted assets via sales of loans and mortgages or by building capital levels via retained earnings or issuing Basel III Tier 2 contingent convertible capital instruments. Although raising equity directly via the capital markets is uncommon for Israeli banks, last week’s issuance marked the second time that the bank had completed an equity issuance (the first was a share offer and rights issue in 2010 and raised NIS450 million). We expect that the capital issuance will increase the bank’s common equity Tier 1 (CET1) ratio to 9.9% from 9.5% as of 30 June 2016, above the BoI regulatory threshold of 9.2% to be met by 1 January 2017. Assuming a full exercise of warrants, exercisable by 31 March 2017, the bank’s CET1 ratio will rise an additional 0.1 percentage point.
The bank’s enhanced capital buffers will allow it to adhere to one of the main pillars of a strategic plan initiated in 2014, and which aims to grow its credit portfolio and extend credit to its targeted segments, mainly retail, small and midsize enterprises (SMEs) and mortgages. In previous years, IDB’s growth lagged that of its peers owing to the bank’s weakening profitability and efficiency metrics (see exhibit).
Israeli Banks’ Gross Loan Growth Rate
Sources: Banks’ financial statements and Moody’s Investors Service
Increased lending will boost IDB’s revenues and offset the negative pressure on profitability arising from low interest rates in Israel. The bank’s efficiency metrics will also improve as it intensifies its streamlining efforts, including an early retirement plan aimed at reducing costs by shrinking its workforce,11 closing branches and shedding real estate.
10 The bank ratings shown in this report are the bank’s deposit rating and baseline credit assessment. 11 See Israel Discount Bank's Early Retirement Plan for Employees Is Credit Positive, 19 September 2016.
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
12%
2009 2010 2011 2012 2013 2014 2015 H1 2016
Bank Hapoalim Bank Leumi Israel Discount Bank Mizrahi Tefahot Bank First International Bank of Israel
Corina Moustra, CFA Associate Analyst +357.25.693003 [email protected]
NEWS & ANALYSIS Credit implications of current events
25 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
The capital increase also will enhance the bank’s loss-absorption buffers against problem loans and borrower concentrations, which are higher than those of its domestic peers. Extending loans to the retail, SME and mortgage segments will allow the bank to reduce its large borrower concentrations and diversify its loan book. As of the end of 2015, 8% of IDB’s extended credit was to borrowers with loans greater than 5% of the bank’s equity. Thirty-nine percent of its extended credit was to borrowers with debt of more than NIS40 million. The increased capital will also better insulate the bank from systemic credit risks arising from geopolitical developments and threats arising from rising house prices.
NEWS & ANALYSIS Credit implications of current events
26 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
Insurers
US Life Insurance Accounting Changes Would Improve Financial Statements Last Thursday, the Financial Accounting Standards Board (FASB) issued a proposed Accounting Standard Update (ASU) targeting insurance companies that issue long-duration contracts such as life insurance, disability income, long-term care and annuities. The proposed changes aim to provide a more up-to-date view of insurance liabilities, increase comparability and transparency, and simplify certain overly complex accounting concepts related to long-duration contracts. The changes included in this proposal are substantial, and would significantly affect life insurers’ balance sheets and income statements, including reported earnings. The changes would benefit investors and other users of financial statements.
After years of working on a converged accounting standard with the International Accounting Standards Board (IASB), only to abandon the 2013 exposure draft a year later after considering stakeholder feedback, the FASB’s proposed ASU addresses specific flaws under current US Generally Accepted Accounting Principles (GAAP). The changes include:
» Updating assumptions related to the liability for future policy benefits. Under current GAAP, assumptions (e.g., cash flow) are locked-in for the duration of the contract unless a premium deficiency is identified (i.e., premiums are not expected to cover losses). This results in insurers reporting liabilities with assumptions that are out-of-date and do not reflect current trends or market experience. Under the proposed ASU, cash flow assumptions will be updated annually (at the same time each year) or more frequently if needed, while discount rates will be updated quarterly, presenting a more up-to-date liability valuation. Liability changes because of updated discount rates will be included in Other Comprehensive Income while changes from updating cash flow assumptions will be included in income.
» Using a high-quality fixed-income yield to discount insurance liabilities. Instead of insurers using their expected investment yield to discount liabilities for future policy benefits, they will discount them at a yield for high-quality fixed-income instruments. Using a specified rate as opposed to individual insurers’ expected future investment yield will provide better comparability across insurers. In addition, this rate will be consistent with the rates required to discount pension obligations.
» Simplified deferred acquisition cost (DAC) model. DAC will be amortized in proportion to the amount of insurance in force if reliably predictable, or on a straight-line basis. Current amortization models are overly complex and difficult to understand. Expense patterns will be more easily predictable under the proposed methods and will no longer fluctuate in tandem with an insurance company’s investment or underwriting performance.
» Simplified accounting for guaranteed benefits related to variable annuity and variable life insurance contracts. Unlike current US GAAP that employs two different accounting models depending on the type of benefit, guaranteed benefits12 will all be measured at fair value, with changes in fair value included in the income statement (excluding changes in own credit, which will be included in Other Comprehensive Income). Although accounting complexity is reduced, earnings volatility will likely increase.
» Enhanced disclosure. Added disclosures include liability roll-forwards and qualitative and quantitative information about significant inputs, judgments and assumptions used in measurement.
Although the effects of this proposal will vary by insurer depending on several factors, including its business mix and how current its assumptions are at the time of adoption, financial statement users will need to adjust to a new landscape and calibrate their view of life insurers’ financial strength and performance. Comments are due on the proposal by 15 December 2016, but no effective date has been set. 12 Includes guaranteed minimum death benefits (GMDB), guaranteed minimum income benefits (GMIB), guaranteed minimum
withdrawal benefits (GMWB) and guaranteed minimum account balances (GMAB).
David Chan, CPA Vice President - Senior Accounting Analyst +1.212.553.1895 [email protected]
NEWS & ANALYSIS Credit implications of current events
27 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
Nationwide Financial’s Acquisition of Jefferson National Life Is Credit Positive Last Wednesday, Nationwide Financial Services, Inc. (Nationwide Financial, Baa1 stable), a wholly owned subsidiary of Nationwide Mutual Insurance Company (financial strength A1 stable), announced that it had reached an agreement to acquire Jefferson National Life Insurance Company (Jefferson, unrated) for an undisclosed amount. The acquisition is credit positive for Nationwide Financial and Jefferson.
Nationwide Financial will benefit from Jefferson’s robust proprietary technology platform, which is integrated with advisors, brokerages and clearing houses. This is a key strategic priority for Nationwide Financial as it seeks to improve efficiency and profitability. Jefferson will benefit from being part of the larger Nationwide family from both a capital as well as a brand name perspective.
Jefferson has a modest risk profile in its underlying business, which is primarily variable annuity contracts without any guarantees. Nationwide Financial will gain access to a new distribution channel in the form of registered investment advisors, a channel that has historically been subject to fiduciary standards and therefore will not be as affected by new Department of Labor (DOL) regulations, which establish stringent fiduciary standards across all distributor compensation arrangements. In addition, Jefferson’s well-connected technology platform creates an opportunity for Nationwide Financial to enhance and leverage its own technology platform to sell other products through Jefferson’s existing relationships with registered investment advisors.
The acquisition, which the parties expect to close in first-quarter 2017, will be financed with excess capital at Nationwide Life Insurance Company (Nationwide Life, financial strength A1 stable), the primary life insurance operating company of Nationwide Financial. As of year-end 2015, Nationwide Life reported National Association of Insurance Commissioners company action level risk-based capital ratio of 639% and statutory total adjusted capital of $5 billion.
Jefferson primarily markets variable annuity contracts without any guarantees and these contracts constituted $3.5 billion of its assets under management, which totaled around $4.7 billion at 30 June 2016. The company sells $800 million in annual variable annuity sales through its network of nearly 4,000 registered investment advisors, or about 6% of the industry. The exhibit below shows the trend in variable annuity sales for Nationwide Financial, almost one-third of which are from the independent broker/dealer channel, which will be subject to the DOL’s fiduciary standards per its recent ruling. The acquisition of Jefferson and access to the advisor force helps offset some of the adverse effect (i.e., lower annuity sales) of the DOL ruling particularly from sales coming through Nationwide Financial’s broker/dealer channel. The acquisition also creates additional avenues for the company to sell other life insurance, annuity and mutual fund products.
Manoj Jethani Assistant Vice President - Analyst +1.212.553.1048 [email protected]
NEWS & ANALYSIS Credit implications of current events
28 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
Nationwide Financial Services’ Individual Variable Annuity Sales
Source: Nationwide Financial Services
$0
$1
$2
$3
$4
$5
$6
$7
$8
2011 2012 2013 2014 2015
$ Bi
llion
s
NEWS & ANALYSIS Credit implications of current events
29 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
CNO Terminates Beechwood Reinsurance Agreements, Recaptures Long-Term Care Block, a Credit Negative On Thursday, CNO Financial Group, Inc. (Ba1 stable) announced that its subsidiaries, Bankers Conseco Life Insurance Company (BCLIC, unrated) and Washington National Insurance Company (WNIC, financial strength Baa1 stable), terminated their reinsurance agreements with Beechwood Re, Ltd. (unrated) and recaptured approximately $550 million of closed-block long-term care liabilities. The recapture, which the company announced in an 8-K with the US Securities and Exchange Commission, is credit negative because CNO will record an after-tax loss resulting from a writedown on certain acquired assets. The move also increases the liabilities associated with the long-term care business, takes back policyholder administration responsibility and will require additional capital to support the assets and liabilities.
CNO announced in August that it had commenced an independent third-party audit of approximately $116 million (previously reported as $126 million) of Level 3 investments that were held in trusts on behalf of CNO’s subsidiaries. Based on the initial information the company received in its audit and in discussions with the New York Department of Financial Services and the Indiana Department of Insurance, its main regulators, the company concluded that a significant portion of the investments did not comply with applicable regulatory requirements for assets supporting the reinsurance agreements. As a result, the two state insurance regulators directed BCLIC and WNIC, respectively, to remedy the deficiency.
The recapture brings the related assets and liabilities onto CNO’s balance sheet, which will require CNO to revalue the assets and liabilities consistent with its methodologies. This will lead CNO to record a GAAP after-tax charge of approximately $55 million (estimated at less than one quarter of GAAP earnings), calculated on a pro forma basis as if a recapture of this business had occurred on 30 June 2016. In addition, the termination and recapture-related charge and additional capital required to support the business will necessitate a capital infusion of approximately $200 million into its insurance subsidiaries.
CNO Holding Company Liquidity Second-Quarter and First-Half 2016, $ Millions
Second-Quarter 2016 First-Half 2016
Cash and Investments Beginning Balance $374.7 $382.2
Sources
Net Dividends from Insurance Subsidiaries $41.9 $130.6
Dividends from Non-insurance Subsidiaries $1.1 $9.0
Interest/Earnings on Corporate Investments $5.4 $10.0
Surplus Debenture Interest $12.1 $24.2
Service and Investment Fees, Net $26.7 $28.5
Other $3.3 $3.3
Total Sources $90.5 $205.6
Uses
Interest $21.1 $21.8
Share Repurchases $52.0 $145.7
Common Stock Dividend $14.3 $27.0
Holding Company Expenses and Other $6.0 $25.7
Total Uses $93.4 $220.2
Non-cash changes in investment balances $3.9 $8.1
Cash and Investments Balance at 30 June 2016 $375.7 $375.7
Source: CNO Financial Group second-quarter 2016 earnings presentation
Bob Garofalo Vice President - Senior Credit Officer +1.212.553.4663 [email protected]
Vincent Del Gatto Associate Analyst +1.212.553.7749 [email protected]
NEWS & ANALYSIS Credit implications of current events
30 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
At this time, CNO will fund these items with existing holding company liquidity. Thereafter, the holding company will have approximately $175 million of cash and investments as of 30 September 2016 and likely maintain its liquidity from ongoing dividends, fees and interest income from its approximately $75 million per quarter investments in operating companies. In addition, CNO has suspended its share-repurchase program, has no debt maturities until 2019 and does not plan to raise additional capital at this time. However, we will continue to monitor more findings from the audit process on the Level 3 assets because they threaten to weaken the credit quality of the investment portfolio, capital adequacy levels, the recapture process, and the arbitration proceedings that risk further harming CNO’s credit quality.
Reducing long-term care exposure has been one of CNO’s focuses over the past few years and the company has indicated a goal of reducing its long-term care risk. However, this recapture is a step back from that goal because it increases CNO’s exposure to long-term care risk.
NEWS & ANALYSIS Credit implications of current events
31 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
Sovereigns
Greece Moves Closer to €2.8 Billion Disbursement of Bailout Funding, a Credit Positive Last Tuesday, Greece (Caa3 stable) moved closer to receiving €2.8 billion in bailout funding from the European Stability Mechanism (ESM, Aa1 stable) after its parliament passed an omnibus bill that included structural reforms essential to unlocking the funds. The disbursement was conditional on the Greek government implementing 15 outstanding actions, most of which were included in the omnibus bill passed by parliament on Tuesday.
We expect that Greece will have the funds after the next Eurogroup meeting scheduled for 10 October, and use them to reduce some €5.5 billion of government arrears to the private sector, a credit positive. The arrears constrain a recovery in consumption and investment. Additionally, passage of the omnibus bill indicates the government’s continued commitment to reform, which supports increasing confidence in the economy.
The bill included legislation on the transfer of additional state-controlled companies to the new privatisation fund, the harmonisation of social security contributions, and the liberalisation of the electricity market. The remaining actions, including an additional draft bill relating to the civil aviation authority, are expected to be completed before the next Eurogroup meeting on 10 October.
Greece’s debt repayment schedule is relatively light until the start of 2017 and there are no immediate liquidity pressures. Over the remainder of 2016, the sole repayment consists of around €297 million owed to the IMF in December. The latest data available from the Greek public debt management agency indicates that Greece had €3.2 billion in cash deposits at the end of June 2016, although this sum is likely to have declined after debt repayments to institutional creditors in July.
That said, the release of the ESM-funded €2.8 billion sub-tranche will provide cash inflow to reduce the stock of government arrears to the private sector, which amounted to €5.5 billion in July 2016 (3% of GDP). In turn, this should help drive a partial economic recovery heading into 2017, after a 1.0% annual contraction in real GDP over the first half of 2016. Confidence and external trade have remained constrained by the capital controls introduced in June 2015, investor uncertainty, and VAT increases that have negatively affected consumption.
Greece’s General Government Arrears to the Private Sector, € billion
Sources: Greek Ministry of Finance and Moody’s Investors Service
€ 0
€ 1
€ 2
€ 3
€ 4
€ 5
€ 6
€ 7
€ 8
€ 9
€ 10
Dec
-10
Feb-
11
Apr-
11
Jun-
11
Aug-
11
Oct
-11
Dec
-11
Feb-
12
Apr-
12
Jun-
12
Aug-
12
Oct
-12
Dec
-12
Feb-
13
Apr-
13
Jun-
13
Aug-
13
Oct
-13
Dec
-13
Feb-
14
Apr-
14
Jun-
14
Aug-
14
Oct
-14
Dec
-14
Feb-
15
Apr-
15
Jun-
15
Aug-
15
Oct
-15
Dec
-15
Feb-
16
Apr-
16
Jun-
16
€Bi
llion
sAlpona Banerji Vice President - Senior Credit Officer +44.20.7772.1063 [email protected]
Mickaël Gondrand Associate Analyst +44.20.7772.1085 [email protected]
NEWS & ANALYSIS Credit implications of current events
32 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
Clearing the arrears will offset some of the negative economic effect on consumption and private investment from the fiscal consolidation program, which has resulted in an increase in the tax burden. Robust tourism, as well as a recovery in gross capital formation, which grew by 22.8% annually in the second quarter mainly because of inventories growth, will also support the economy. Consequently, we expect Greece’s economy to grow 1.8% in 2017 (up versus our projection of -0.7% for 2016), on the basis of improved consumer and investor confidence amid the support of the third bailout package’s continued implementation.
The completion of the €2.8 billion disbursement will also open up the negotiations of the second review, focusing on labour market and product market reform. The proposed reforms would include, among other elements, steps to open up remaining closed professions, a new system to calculate the minimum wage in the private sector, and measures to bring the frameworks for Greece’s mass dismissals in line with international best practices.
We expect the risks to continued reform implementation to remain high given the Greek government’s small parliamentary majority (the latest omnibus bill was passed by only 152 of parliament’s 300 members), the country’s weak institutions and domestic social discontent.
NEWS & ANALYSIS Credit implications of current events
33 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
US Public Finance
Federal Aid to Flint Will Ease Spending Pressure on Michigan, a Credit Positive Last Wednesday, the US Congress approved a bill that would qualify Flint, Michigan (unrated) for upward of $170 million to aid in the recovery from its water contamination crisis. The bill is credit positive for the State of Michigan (Aa1 stable), which we assume will be responsible for overseeing the remediation of Flint’s water infrastructure. Every dollar of federal aid devoted to Flint’s recovery is a dollar Michigan will not spend of its own resources.
Although $170 million dollars is small relative to Michigan’s $23 billion budget,13 the federal aid is helpful considering the potential slowdown in Michigan’s revenue growth. Already, the Flint crisis, as well as a few other challenges, have essentially absorbed the revenue growth Michigan has experienced. Moreover, we believe Michigan faces a revenue slowdown following a solid multi-year period of revenue growth and buildups in its rainy day fund balance (see exhibit). The state in the coming years may have less capacity to comfortably pay for problems such as the Flint water crisis.
Michigan’s Annual Tax Revenue Growth
Note: Exhibit shows baseline revenue growth, which adjusts for tax policy changes in order to reflect economically driven changes in tax revenues. Source: State of Michigan
It is not clear exactly how much remediating Flint’s water infrastructure will cost, but one independent expert estimated $1.5 billion. The state has appropriated nearly $200 million combined for Flint in fiscal 2016 (which ended 30 September 2016) and fiscal 2017, meaning the costs of helping the city are certain to exceed Michigan’s $195 million contribution to the bankruptcy of the City of Detroit (B2 stable), a city seven times larger than Flint. The state recognizes that future appropriations will be necessary.
The aid to Flint would also be positive for Genesee County (general obligation limited tax A2 no outlook), where Flint is located, and the Karegnondi Water Authority (KWA, A2 no outlook). Flint is still scheduled to link up to KWA’s pipeline, which is under construction and will deliver water from Lake Huron.
13 All references to Michigan’s budget and revenues in this report refer to the state’s general fund and school aid fund combined.
2.1%
7.1%
4.5%
7.4%
5.0% 5.1%
2.4%
3.0%3.3%
0%
1%
2%
3%
4%
5%
6%
7%
8%
2010 2011 2012 2013 2014 2015 2016 2017 2018
Estimated
Dan Seymour, CFA Assistant Vice President - Analyst +1.212.553.4871 [email protected]
David Levett Assistant Vice President - Analyst +1.312.706.9990 [email protected]
NEWS & ANALYSIS Credit implications of current events
34 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
To the extent that aid to Flint allows the city to participate in the project and pay its share of the debt service on KWA’s bonds, it would relieve pressure on Genesee County because the county is guarantor for Flint’s debt service payments on KWA’s bonds. Flint’s share of the debt service will approach $7 million a year by 2017, which is 8% of the county’s general fund revenues.
CREDIT IN DEPTH Detailed analysis of an important topic
35 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
Potential Litigation Costs Pose a Hurdle for Deutsche Bank’s Reengineering Efforts On 15 September, Deutsche Bank14 announced that it had commenced negotiations with the US Department of Justice (DoJ), aiming to settle civil claims in connection with the bank’s underwriting and issuance of residential mortgage-backed securities (RMBS) and related securitization activities between 2005 and 2007.
CREDIT IMPLICATIONS Eliminating the claims’ litigation tail risk at a manageable cost would be credit positive for Deutsche Bank, but negotiations have just begun and the final cost of settlements of complex capital markets litigation remains very difficult to predict.15 In recent days, this uncertainty has contributed to pressure on the prices of Deutsche Bank’s common stock and its contingent convertible Tier One securities (AT1s).16
It is important to note that this is a settlement negotiation related to the DoJ’s civil claims referenced above. If the two sides do not come to an agreement, then the next step would be for the DOJ to file a lawsuit in US federal court. Deutsche Bank cannot be compelled to make a payment to the DoJ against its wishes until there has been a trial, a guilty verdict and a determination of damages by a federal court. Such an outcome is not certain and could take years to progress through the court. Both sides have an incentive to avoid the time, expense and uncertainty of a complex lawsuit. But Deutsche Bank retains considerable control over the timing of any settlement with the DoJ. We do not expect that management will settle for an amount that would jeopardize its ability to meet its AT1 coupon payments, the next of which are due in April 2017.
Our ratings of Deutsche Bank today incorporate the possibility for a modest loss and substantial litigation costs in 2016 and the potential for limited profitability in 2017. However, an expensive settlement with the DOJ (for example, beyond levels that peers have agreed to) that pressured capital ratios, an extended delay in the closure of the Hua Xia sale or weaker than anticipated operating performance could negatively pressure DB’s ratings.
Finally, customer engagement and counterparty confidence remain important elements of Deutsche Bank’s fundamental creditworthiness. A sudden or extended decline in these factors can lead to franchise or liquidity erosion – which would also negatively pressure ratings.
In this note we assess the effect of potential settlement costs on DB’s overall capital position as measured by its CET1 ratio on a fully-loaded basis and on its willingness and capacity to service its AT1s under the two key tests that determine its ability to make payments on these securities.
14 Deutsche Bank AG is rated Baa2 stable for senior unsecured long-term debt and A3 stable for long-term deposits. Its Counterparty
Risk Assessment is A3(cr)/P-2(cr) and its Baseline Credit Assessment is ba1. 15 Specifically, Deutsche Bank confirmed that it had received an initial settlement proposal from the DoJ of $14 billion and that
Deutsche Bank has no intent to settle “anywhere near” the DoJ’s proposed amount, and that it expects negotiations will “lead to an outcome similar to those of peer banks which have settled at materially lower amounts.”
16 Deutsche Bank’s contingent convertible Tier One securities (AT1s) are rated B1(hyb).
Peter Nerby, CFA Senior Vice President +1.212.553.3782 [email protected]
CREDIT IN DEPTH Detailed analysis of an important topic
36 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
THE EFFECT OF POTENTIAL SETTLEMENT COSTS ON DEUTSCHE BANK’S CAPITAL POSITION Deutsche Bank has indicated that it may be willing to consider settlements at a cost broadly in line with peers’ settlements. However, peers’ settlements with the DoJ have varied widely, ranging from $1.7 million to $8.9 million per basis point of RMBS league table share (see Exhibit 1). Basing litigation exposure solely on market share is an approximation, but it helps dimension the adequacy of reserves and potential income statement effect.
EXHIBIT 1
Selected RMBS Settlements with US Department of Justice and State Attorneys General, RMBS Market Share and Settlement Cost Per Basis Point of Market Share
RMBS Market Share 2004-07 Settlement Date
Settlement Amount $ Billion
Settlement Cost per Basis Point of Market
Share $ Millions
JP Morgan 17.98% 19-Nov-13 $3.1 $1.7
Citibank 4.94% 14-Jul-14 $4.3 $8.7
Bank of America 16.48% 21-Aug-14 $5.9 $3.6
Morgan Stanley 3.11% 11-Feb-16 $2.8 $8.9
Goldman Sachs 7.35% 11-Apr-16 $2.6 $3.6
Notes: JPMorgan includes Bear Stearns; Bank of America includes Countrywide and Merrill Lynch. Market shares include resecuritizations of RMBS into collateralized debt securities. Settlement amounts shown include only payments to DOJ and state Attorneys General. Payments to other government agencies and consumer relief are not included since Deutsche Bank has already reached settlements with other agencies and consumer relief typically does not result in an expense. Source: Asset Backed Alert and US Department of Justice
At the end of the second quarter of 2016, Deutsche Bank had €5.5 billion of litigation reserves, for a variety of legal matters, but the bank has not disclosed the size of reserves for any specific action. For the analysis below, we assume that at least half of the litigation reserve could be made available for a DoJ settlement. If Deutsche Bank can eliminate this tail risk and settle within or near our assumed reserve of €2.75 billion (or $3.1 billion), it would be positive for bondholders.
Based on Deutsche Bank’s 6.4% market share, (as reported by Asset Backed Alert over the 2004-2007 period), a settlement at the low end ($1.7 million per basis point, totaling $1.1 billion) or even at the settlement range mid-point ($3.6 million per basis point, totaling $2.3 billion) would be well covered by our assumed DoJ settlement reserve.
However, a DB settlement at the high end of peer settlements ($8.9 million per basis point) would total $5.7 billion. This would require an addition to our assumed DoJ settlement reserve of €2.4 billion, which would dent 2016 profitability (pretax earnings for first-half 2016 totaled €1 billion), but would not significantly impair its capital position.
To create the waterfalls in Exhibits 2-4 below we also considered the benefit of DB’s recently announced sale of Abbey Life and its pending Hua Xia sale that management expects to generate an aggregate +50 basis points benefit to its CET1 ratio. The Hua Xia sale closing has been delayed, but is expected during the second half of the year.
Finally, we assumed profits before taxes (and before additional litigation charges) of €0.9 billion resulting in after tax profits17 of €0.6 billion in the first half of 2016, equivalent to 16 basis points of CET1 generation. Deutsche Bank will not pay a common dividend for fiscal year 2016.
17 We assume a tax rate of 33% for first half 2016 profits and that litigation provisions are not tax deductible.
CREDIT IN DEPTH Detailed analysis of an important topic
37 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
DEUTSCHE BANK RETAINS ADDITIONAL DISTRIBUTABLE INCOME CAPACITY EVEN IN A HIGHER-END SETTLEMENT SCENARIO
To pay its AT1 coupons, DB has to manage two constraints: a requirement to maintain sufficient Additional Distributable Income (ADI), a German GAAP concept based on the results of the DB AG legal entity, and having a level of CET1 capital above a combined (CET1) buffer requirement (set at 10.76% CET1). Using the assumptions outlined above, the waterfalls below depict ADI payment capacity under German GAAP and pro-forma CET1 transitional capital ratios (relevant for capacity to make AT1 payments under the Capital Requirements Directive).
The amount of ADI is based on Deutsche Bank AG unconsolidated financial statements as calculated under German GAAP (which differs from IFRS). They are calculated as: year-end profit (Gewinn) for the year preceding the interest payment; plus any profits carried forward and distributable reserves (ausschüttungsfähige Rücklagen, which are CET1 components and include HGB340e/g reserves); minus any losses carried forward and any profits that are non-distributable.18 Deutsche Bank has created additional flexibility to meet its AT1 payments by eliminating its common dividends payable in 2017 (payable in May each year). Exhibit 2 evaluates Deutsche Bank’s ability to make its AT1 securities payments (totaling approximately €350 million on the contingent convertible securities) given the potential development of its ADI.
EXHIBIT 2
Deutsche Bank Additional Distributable Income in Different Settlement Scenarios Even a settlement at the higher end of peers’ settlements leaves Deutsche Bank with ADI payment capacity.
Note: *Excluding litigation provisions.**Low settlement and mid-point settlement scenarios are fully covered by assumed litigation reserves available for absorbing the settlement. Sources: Deutsche Bank disclosures and Moody’s Investors Service analysis
18 Deutsche Bank has not updated its yearend 2015 estimate for its HGB340e/g reserves for first half 2016 results so we have used the
€1.9 billion yearend 2015 amount. Management has also noted that the Abbey Life sale has an immaterial effect on Additional Distributable Income.
€ 1.9 € 2.0€ 2.8
€ 1.6
€ 0.9
(€ 2.4)€0-€2.4
€ 0.8
€0-€2.4
€ 0
€ 1
€ 2
€ 3
€ 4
€ 5
€ 6
Remaining HGB340e/g
Reserves
Xua Hia Est.Sale Impact
2016 Est. NetIncome*
High Settlement** ADI End-2016 Est.
Interest Expense(Tier 1
Instruments)
AT1 PaymentCapacity End-2016
Est.
€Bi
llion
s
€2.0-€4.4
€2.8-€5.2
CREDIT IN DEPTH Detailed analysis of an important topic
38 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
WE ESTIMATE DEUTSCHE BANK RETAINS HEADROOM ABOVE THE COMBINED CET1 BUFFER REQUIREMENT
According to the European Union’s Capital Requirements Directive (CRD IV), any bank in breach of its combined (CET1) buffer requirement will be subject to some limitations on the distribution of its net earnings and reserves. Banks that do not meet the combined buffer requirement will have to calculate a maximum distributable amount (MDA) which could restrict or prevent the bank from making dividend payments, paying bonuses or AT1 coupons. In particular, loss-making banks in breach of the combined buffer requirement will be prevented from making any of these distributions, even if the bank can demonstrate that it could replenish its capital buffer quickly.
Under our assumptions, Deutsche Bank maintains 145 basis points of headroom above the MDA trigger point determined earlier in the year – even before the relaxation of supervisory guidance described below.
EXHIBIT 3
Deutsche Bank Transitional Common Equity Tier 1 in Different Settlement Scenarios We estimate Deutsche Bank can largely cover a high-end settlement through sales of non-core subsidiaries and with profits for the year before litigation expense.
Note: *Excluding litigation provisions. ** Low settlement and mid-point settlement scenarios are fully covered by assumed litigation reserves available for absorbing the settlement. Sources: Deutsche Bank end-2015 disclosures and Moody’s Investors Service analysis
DEUTSCHE BANK’S AT1 PAYMENT FLEXIBILITY UNDER SREP WILL INCREASE European banks, including Deutsche Bank, are required to comply with a minimum “Pillar 1” capital ratio of 8% of risk-weighted assets (RWAs), of which 4.5% must be met with CET1. On top of this, banks have to hold additional “Pillar 2” capital to reflect shortcomings in the measure of RWAs and to mitigate other risks identified by supervisors. This is set on a bank-by-bank basis and usually establishes a further capital requirement above the Pillar 1 obligation. Moreover, banks are also compelled to hold further buffers of capital that can absorb losses under stress, i.e. capital conservation and counter-cyclical buffers. These have to be met from CET1 capital.
A bank that breaches these minimum capital requirements will be subject to regulatory action. In the first instance this would likely take the form of remedial actions to restore their capital position including through asset disposals or capital issuance.
12.16% 12.21%
0.50%
0.16%
(0.61%) 0-61 bp
11.4%
11.6%
11.8%
12.0%
12.2%
12.4%
12.6%
12.8%
13.0%
Transitional CET1 ratio,End-June 2016
Xua Hia/Abbey Sale Est.Sale Impact
H2 2016 Est. Net Income* High Settlement** Transitional CET1 ratioEnd-2016 Est.
12.21%-12.82%
CREDIT IN DEPTH Detailed analysis of an important topic
39 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
For firms the European Central Bank (ECB) directly supervises, including Deutsche Bank, this total requirement currently includes the non-phased in element of the capital conservation buffer as well as taking into account the effects of adverse stressed scenarios, and is referred to as the “SREP ratio.” This is further complemented by systemic buffers in case of systemically important institutions. It is this combined buffer ratio (SREP plus any systemic buffers) that Deutsche Bank and other European banks must manage toward and this requirement for Deutsche Bank stood at 10.76% based on original regulatory guidance.
However, from 2017, the ECB will change the current approach to defining Pillar 2 element of the SREP. The current Pillar 2 requirement will be broken down into two components: (1) a formal Pillar 2 Requirement, which would need to be maintained at all times; and (ii) a new Pillar 2 Guidance sitting above the required buffers in the capital structure for the purpose of covering risks to which a bank may become exposed over a forward-looking planning horizon. Only the formal Pillar 2 Requirement will be used to determine the combined buffer requirement and will also exclude the non-phased in element of the capital conservation buffer (1.25% in 2017). This will increase DB’s flexibility with respect to being able to make capital distributions (including paying its AT1 coupons). Regulators are expected to provide visibility on the size of the revised combined buffer requirement before the end of the year following the annual SREP exercise.
Exhibit 4 illustrates the expected evolution of Deutsche Bank’s fully loaded CET1, its most widely scrutinized capital ratio, even though it is not directly tied to AT1 payment capacity. However, this broadly followed ratio is an important metric that we monitor as Deutsche Bank executes its multi-year reengineering.
EXHIBIT 4
Deutsche Bank Fully-Loaded Common Equity Tier 1 in Different Settlement Scenarios We estimate Deutsche Bank’s fully-loaded CET1 ratio would not be materially changed under our high litigation settlement scenario.
Note: *Excluding litigation provisions. ** Low settlement and mid-point settlement scenarios are fully covered by assumed litigation reserves available for absorbing the settlement. Sources: Deutsche Bank end-2015 disclosures and Moody’s Investors Service analysis
In summary, we believe that in its negotiations with the Justice Department, Deutsche Bank has strong incentives and flexibility to make its AT1 payments in April 2017, absent some large unforeseen event.
10.82% 10.87%
0.50%
0.16%
(0.61%) 0-61 bp
10.0%
10.2%
10.4%
10.6%
10.8%
11.0%
11.2%
11.4%
11.6%
Fully-Loaded CET1 ratio,End-June 2016
Xua Hia/Abbey Sale Est.Sale Impact
H2 2016 Est. Net Income* High Settlement** Fully-Loaded CET1 ratioEnd-2016 Est.
10.87%-11.48%
RECENTLY IN CREDIT OUTLOOK Select any article below to go to last Thursday’s Credit Outlook on moodys.com
40 MOODY’S CREDIT OUTLOOK 3 OCTOBER 2016
NEWS & ANALYSIS Corporates 2 » Office Depot Will Sell Its European Business, a Credit Positive » India's Rafale Purchase Is Credit Positive for Dassault, Thales,
Airbus, BAE Systems and Finmeccanica » Travelex's Disposal of Its US Insurance Business Is
Credit Positive » Maersk's Planned Split Is Credit Negative » Saipem Wins $430 Million in New Onshore Drilling
Contracts, a Credit Positive
Banks 8 » Saudi Banks Will Benefit from Central Bank's Latest
Liquidity Support
Insurers 10 » Draft Capital Requirements for Canadian Mortgage Insurers
Are Credit Positive
Exchanges 12 » CBOE's Acquisition of Bats Is Credit Positive
Sovereigns 14 » Lebanon's Weak Fiscal Performance During the First Half of
2016 Is Credit Negative
US Public Finance 16 » Atlantic City, New Jersey's Impending Technical Default Is
Credit Negative » Court Rules Kentucky Governor Must Release University
Funds, a Credit Negative
MOODYS.COM
Report: 192449
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