The recent "Dutch" case of SNS Reaal has indeed illustrated the shortcomings of the restructuring credit events in financial CDS. Given the Dutch government expropriated all of the lender's subordinated debt in February before a CDS auction could be held, we wonder if the Subordinated market will indeed suffer a similar fate to the Sovereign CDS market and SOVx in particular. CDS notionals have remained on a downward trend since the market's peak of USD 58trn notional outstanding at the end of 2007, touching a new low of USD 27 trillion at the end on June 2012, according to the Bank for International Settlements. A dying market or simply yet another victim of our European Gunfight at the O.K. Corralito. We wonder...
Another "unintended consequence of the European Gunfight, has no doubt been the growing divergence between European volatility gauge V2X and its US equivalent VIX - source Bloomberg:
And, as we posited in "Winner-take-all", should a deposit flight occur in Europe, depositors will no doubt seek a German bank sanctuary.
In this European Gunfight at the O.K. Corralito, we wonder if Germany is really a "straight-shooter" when looking at the level of capitalization of some of its banks which have been deeply impacted by their venture into structured finance and shipping in particular fuelled by cheap credit.
We discussed in depth the issues plaguing Germany's second largest bank Commerzbank in our conversation Dumb Buffers: "Not only have overbuilding occurred due to cheap credit that fuelled an epic bubble in the Baltic Dry Index, but, the on-going decline on vessel prices, will no doubt exert additional pressure on recovery values for Commerzbank's loan book".
Another high profile German institution which had been on the receiving end of state aid has been HSH Nordbank:
"In December 2008 HSH was granted to issue up to EUR 30bn guaranteed notes under the German SoFFin program. One requirement that was imposed on HSH was to raise the capital ratio to at least 8%. On January 20, 2009 EUR 3bn 3 year guaranteed notes were issued. On February 24, 2009 HSH received new capital of EUR 3bn and credit guarantees of EUR 10bn by the two main shareholders, the states of Hamburg and Schleswig-Holstein. The other shareholders, JC Flowers and the savings bank association, did not participate in the capital infusion. Together with this increase of its core-capital, HSH announced further restructuring. It plans to spin off non-strategic activities and the Toxic asset portfolio into a—yet to be created—Bad Bank." - source Wikipedia
Could HSH subordinated bondholders suffer the same fate as Dutch bank SNS? Of course!
We agree with a recent note from Bank of America Merrill Lynch on this subject entitled "At the mercy of shipping":
"The most recent legislative proposals in the German banking sector do not appear to allow for direct bondholder expropriation by the German government / states, as happened with SNS REAAL. But if HSHN’s key sector exposure (ie, shipping) does not show signs of stabilization in the near term, negative outcomes for bondholders (ie, (very) low recoveries) could be achieved through transfer orders and/or recovery / resolution plans, we think. Also, when considering the relentless drive by the EU towards bailing in sub bondholders, we would not necessarily take the existing regulatory framework and – proposals in Germany as the last word on burden sharing by sub bondholders." - source Bank of America Merrill Lynch.
For, us, you probably know by now, why shipping is a leading credit indicator. For Dutch SNS it was commercial real estate, for HSH (and Commerzbank as well) it is shipping issues first:
"Shipping – plagued by overcapacity
At end-1H12, HSHN’s exposure to shipping was EUR32bn, of which about EUR12bn was housed in the restructuring unit. The bank finances ship owners, not ship yards. Due to the overcapacity in shipping and the low level of fleet utilisation (exacerbated by weaker economic growth and reduced global trade flows), the sector has been struggling for some time now, which has led to higher problem loans for most lenders in this field. Collateral values (ie, ship prices) have also come down.
Overcapacity in the shipping industry is unlikely to be resolved until 2014 at the earliest, due to the high number of new ships ordered over the past few years. A number of competitors are retrenching from shipping finance. On the one hand, this could result in financing problems for some shipping companies. On the other hand, it could improve the competitive position of the remaining players. As for HSHN, it has agreed with the EC to reduce its shipping exposure to about EUR15bn by end-2014 and to limit its share of new business in worldwide ship financing to 5% until end-2014." - source Bank of America Merrill Lynch
As far as HSH credit metrics are concerned, they are indeed very weak as indicated by Bank of America Merrill Lynch in their note:
"HSHN’s asset quality is weak. At end-1H12, its reported NPL ratio was 12.6% and this is expected to have increased significantly in 2H12. The bank’s reliance on wholesale funding remains high, with a loan/deposit ratio of 195% at end-3Q12. Its profitability has been very poor in recent years - it was loss-making in 2008, 2009 and 2011. It expects to be loss-making again in FY12 and in FY13. The bank will report FY12 results on 11 April." - source Bank of America Merrill Lynch.
And given structured finance and shipping loan books are very dependent on the evolution of the US Dollar, we expect trouble ahead in accordance with Bank of America Merrill Lynch's note:
"However, in 1H12, the bank’s RWAs jumped by 32%. This was due to ‘the renewed appreciation of the USD […] as well as the crisis in the shipping markets, which caused the risk parameters to deteriorate significantly.’ The negative impact of this RWA increase on the bank’s capital ratios was mitigated by:
- the EUR500mn capital injection by the federal states of Hamburg and Schleswig-Holstein in January 2012 (see below); and
- the est. EUR260mn gain on the cash tender offer for LT2 bonds in February
But this was insufficient to offset the decrease in the bank’s capital ratios caused by the negative rating migration and USD appreciation in the shipping portfolio. This has meant that HSHN now needs the additional capital relief of lower RWAs. Therefore, in February 2013 the bank asked the two states to return the asset guarantee to its original size of EUR10bn." - source Bank of America Merrill Lynch.
So yes, we think, that looking at the shipping industry HSH subordinated bondholders could indeed face the SNS treatment at some point...and we also think that German banks will most likely welcome deposits from stricken peripheral countries. Michelle Wiese Bockmann in her Bloomberg on the 1st of March entitled - German Banks With Record Soured Ship Loans Forgo Seizing Vessels:
"Deutsche Bank AG and two other German lenders providing about 14 percent of credit to ship owners are forgoing seizing vessels even after soured loans to the industry rose to a record.
Europe’s biggest bank by assets, as well as HSH Nordbank AG, the largest in the market, and Norddeutsche Landesbank Girozentrale, which finances 1,500 ships, are restructuring loans and setting money aside instead of repossessing vessels, officials from the companies said. They have about $69 billion in loans to the industry out of $500 billion in total, according to data compiled by the banks and Petrofin Research SA, an Athens-based consultant" - source Bloomberg
It looks to us that the German gunslinger, is no doubt, a "fast-draw" artist in this European Gunfight at the O.K. Corralito.
The other "unintended consequences" for large depositors could as well benefit the buy-side, with large depositors seeking potentially the havens of managed funds rather than concentrating their deposits in banks as indicated in another note from Bank of America Merrill Lynch:
"Yet large depositors have clearly been put on notice that they should be careful where they invest. In our view, this could push larger sums out of the banking system into managed funds, e.g. money market funds or fixed income funds, and will likely spread deposits across a country’s banking sector at the insured level (which may be positive for risk assets)." - source Bank of America Merrill Lynch - A backward step - 26th of March 2013.
One thing for sure, in similar fashion to the O.K. Corral gunfight, this European O.K. Corralito, will not end up nicely for some in particular and for the euro in general.
On a final note, we were entertained by Bank of England's announcement that UK banks had a capital shortfall of 25 billion pounds (38 billion USD), to cover higher estimates for loan losses due to their exposure to commercial real estate as reported by Ben Moshinsky in Bloomberg in his article - BOE Says U.K. Banks Have Capital Shortfall of $38 Billion:
"The BOE said expected losses on loans could exceed provisions by 30 billion pounds, while future conduct costs could be 10 billion more than banks expect. It said lenders underestimated assets weighted for risk by 170 billion pounds, leading to a 12 billion-pound capital shortfall in that category. While the full impact of the three areas could deplete lenders’ capital by 52 billion pounds, some banks already have enough resources to cover them, leading to a total 25 billion-pound shortfall." - source Bloomberg.
Lloyds noted at FY12 earnings that U.K. commercial real estate values fell in 2012, and were down 4.2% yoy, with non-London asset values struggling and only 5% higher than their 2009 trough." - source Bloomberg.
What was our previous comment in our last conversation "The Doubt in the Shadow" on Chancellor of the Exchequer George Osborne's latest 130 billion pound worth of mortgages guarantees?
"This is pure madness and will end up in tears"
"Insanity - a perfectly rational adjustment to an insane world."- R. D. Laing, Scottish psychologist.