Summary
- CDS indices are wider following Dubai debt fears
- High activity in the primary market
- S&P published its new capital ratio
Headlines from the credit market this week
Despite Thanksgiving in the US it has been an eventful week in the credit market. The debt fears in Dubai (see below) were the main trigger for the widening. Currently, iTraxx Europe and Crossover trade at 93bp and 562bp respectively. In the cash market the reaction was primarily seen in the Tier 1 market where bids largely disappeared. We think that credit markets – financials in particular – are likely to remain nervous in the weeks ahead until the full extent of the problems in the Middle East is known.
During the week we saw good activity in the primary market. In addition it seems that there are more deals in the pipeline for the upcoming weeks and thus December may turn out to be busier than usual.
Dubai World asks for debt standstill
The news that Dubai World is seeking a debt standstill rattled bond investors (as well as financial markets in general) on Thursday. Dubai World is an entity owned by the Government of Dubai and is the holding company responsible for developing real estate in Dubai. One of its subsidiaries, Nakheel, has USD3.5bn maturing next month and it is for this particular bond Dubai World has requested a standstill until May 2010. At this stage it is still uncertain whether this will be deemed a credit event and thereby trigger settlement of outstanding CDS contracts.
Dubai has been through a property market boom, which was ended by the credit crisis and the debt standstill highlights the problems Dubai is facing. From a credit perspective the most interesting aspect is the potential risk of a spill-over to banks – or other companies – exposed to Dubai. Initially, (sub) CDS prices of a number of British banks widened (more than the market) on the back of the Dubai news.
Although some UK banks have exposure to UAE (Dubai is only one of seven emirates) it is not material in our view. Below we list the largest exposures to UAE of Western banks.
As can be seen the exposure to the region is fairly limited. Furthermore, it should be stressed that so far we are only talking about one (big) company. Still, it is a factor to watch out for in case the problems are more widespread than they appear. Remember, back in 2007 virtually everybody agreed that subprime mortgage loans were a manageable and limited problem. So some caution is warranted.
S&P presents new capital ratio (Risk Adjusted Capital RAC)
In the beginning of the week, S&P presented its much awaited RAC (Risk Adjusted Capital) ratio. The aim of the RAC is to develop a ratio which bridges the gap between a simple leverage ratio and the opaque Basel II (in particular for IRB banks) Tier 1 ratio. The RAC is based solely on publicly available information and is globally comparable. The RAC will be used by S&P as a supplement to the existing rating process and will form the starting point of the analysis of bank capital. Of the 45 global banks that S&P has investigated so far only six have RACs above 8%, which is the threshold S&P sees as separating capital from being a negative rating factor.
This underlines that capital remains a key issue for banks worldwide and that we are by no means out of the woods yet. Loan losses are likely to stay at elevated levels for some time and continue to put pressure on capital ratios. For a number of banks (see table on next page) there is a considerable dispersion between the RAC and the reported Tier 1 ratio. The prime example is UBS, which has a Tier 1 of 13.2% but a RAC of only 2.2%. The prime reason for the big difference is S&P’s clear preference for equity capital and reserves over hybrid core capital. For banks with mandatory convertible hybrid capital the RAC and the Tier 1 ratio should therefore align over time and some caution is therefore warranted when looking at the RAC. In addition
to this, S&P applies a substantially higher risk weight to the trading book –even when including the expected increase in risk weight of the trading book that was agreed by the G20.
It should be highlighted that no regard is directed to differences in loan underwriting standards. Hence, S&P only takes a stance on the risk weight of the sector exposure and not the variance in credit quality among the clients within the same sector. In our view this punishes the more conservative banks that have stricter underwriting standards.
Hence for banks with large capital reliefs following the (full) implementation of Basel II significant dispersion can be anticipated between the Tier 1 and the RAC. In other words, banks with low (internally assessed) risk weights of their assets will have a relatively low RAC compared to their Tier 1 ratio.
RBS agrees terms of UK asset protection scheme (APS)
The UK authorities and RBS have agreed on changing the terms of the APS in order to better align it to the current needs of RBS. The amendment implies that RBS will commit to a larger first-loss piece and furthermore the pricing structure has been changed to better reflect current market conditions (the general appreciation of prices of risky assets). The re-priced scheme is designed such that RBS absorbs all of the expected losses in a basecase economic scenario and only calls upon the assistance of the UK government in the event of a substantial further deepening of the recession.
At the same time, RBS announced a restructuring plan which – in principle – has been agreed with the European Commission. This plan can be compared to what was announced last week by ING and is a consequence of the significant name-specific state aid (in the form of capital injections) that RBS has received during the financial crisis.
The restructuring plan will be invoked over four years and involves the following measures: RBS must divest some of the RBS branch network in England and Wales and the NatWest branches in Scotland and Direct SME customers across the UK.
Furthermore, RBS will have to divest RBS Insurance and Global Merchant Services. In addition to this, RBS will not pay investors any dividends or coupons on existing hybrid capital instruments (including preference shares and B shares) or exercise any call rights in respect of such existing securities for a two-year period unless there is a legal obligation to do so. Thereby the effects of the burden-sharing principle continue to be felt for the banks and highlights that for subordinated debt holders it will be key to avoid exposure to banks needing state aid.
