Investors Viewing European Banks With a Wary Eye

Credit indexes weakened slightly last week as the markets digested the broader potential impact of the Cyprus bank restructuring. The average spread of the Morningstar Corporate Bond Index widened 1 basis point to +140 and the average spread of the Morningstar Eurobond Corporate Index widened 3 basis points to +141, whereas the credit spreads of European banks widened significantly. For example, Markit's iTraxx Senior Financial credit default swap index widened almost 50 basis points to +205. 

The impetus for this spread widening is the market's realization that future bank bailouts will be conducted at the expense of shareholders, bondholders, and uninsured depositors (in that order), instead of being offloaded onto taxpayers. Under this new bank restructuring template, bondholders are now at a greater risk of impairment in future bailouts and are thus requiring a higher return. Another implication of this restructuring is that local politicians will have little, if any, say in a banking restructuring. While the original Cyprus proposal to "tax" the depositors required parliamentary approval, no such government approval was needed to effect the terms of the final restructuring.

Cyprus Losses Cut Deep Into Banks' Capital Structure
It appears that the Cyprus banks have been struggling with losses incurred from the Greek debt restructuring as well as substantial nonperforming loans for quite some time. It wasn't until deposits began to flee the country in earnest during February that a liquidity crunch quickly became a solvency issue. This highlights how a crisis can build over a longer time than you would expect; however, once liquidity begins to dry up for a financial institution, it can quickly become insolvent. We were surprised at the depth of the impairment into the capital structure and the severity of haircuts suffered (estimated between 40% and 80%) by the uninsured depositors. 

Based on the amount of these losses, even after the Cyprus banks had been through the European Central Bank's stress tests, we think investors will become increasingly distrustful of the sustainability and value of loans on banks' balance sheets made to peripheral borrowers. To cut this deep into the capital structure, estimates of recovery values on nonperforming loans must be extraordinarily low. Jim Leonard Morningstar's credit analyst covering the banking sector, said, "If you are an analyst covering the European banks, you should be increasingly skeptical--and I am!"

As we opined last week, policymakers were able to restructure the banks without impairing insured depositors. We think protecting the deposits of the average citizen will go a long way toward minimizing the risk of starting bank runs in other countries. However, we do expect that wealthy individuals and business owners with larger deposits in the peripheral eurozone banks will spread their deposits across multiple banks in order to reduce their total deposits to the insured limit. In addition to protecting the insured deposits, the European Union was able to resolve the crisis without forcing Cyprus to leave the eurozone, which we warned would have set a dangerous precedent.

Spanish and Italian Nonperforming Loans Still Increasing
We have long been wary of the credit quality of many Spanish and Italian banks, and even after multiple-notch downgrades by the rating agencies, our issuer credit ratings are still on average more than two notches below the agencies. It appears the recession in the eurozone continues to deepen. Spain expects its real GDP will decline 1.5% this year, and unemployment has risen to a staggering 26%. Italy's economy is also contracting, and after the most recent elections, the country has been unable to form a coalition government. As conditions deteriorate in both countries, nonperforming loans are steadily rising. We have been monitoring the amount and rate of increase of nonperforming loans at Banco Popular Espanol (B+) and  Intesa Sanpaolo (ISP) (BB-) as an indication of the overall trend of loan performance and bank credit quality in Spain and Italy.

source: Morningstar Analysts

Currently, Intesa's balance of gross nonperforming loans to customer loans is well over 13%, although Intesa points out that compared with its Italian bank peers it has the second-lowest percentage; the average percentage for Italian banks is 15.8%. These numbers are staggering, and they demonstrate how much Italy's economic slowdown has affected Italian bank loan portfolios. Intesa included a slide during its fourth-quarter earnings conference call that demonstrates the strict accounting standards to which Italian banks must adhere when accounting for nonperforming loans. The slide shows that at the end of 2011, Italian banks reported the balance of nonperforming loans/total loans at 9.9%, whereas Spanish banks reported only 8.5%. Intesa then stated that if Spanish banks had to report nonperforming loans in the same manner required by Italian banking standards, Spain's nonperforming loans would have been 25.3%. While we agree that this example does demonstrate the strict standards of Italian banking, we think it even further demonstrates the potentially dire situation for Spanish banks. Confidence rose and borrowing rates declined last fall after Spain received a EUR 40 billion bailout from the ECB, but as nonperforming loans continue to increase, we are concerned that this confidence may dissipate as credit metrics deteriorate and rising Spanish interest rates will increase the cost of funding for Spanish banks.

In addition to widening spreads among the European banks, we saw other indications of the flight to safety. The yield on both German and Swiss 2-year bonds dropped to negative yields, the first time since the end of last year. Among longer-dated bonds, the yield on the 10-year U.S. Treasury bond dropped 6 basis points to 1.85%, and Germany's 10-year bond dropped 9 basis points to 1.38%. These yields are near their lowest levels since the beginning of the year. Spanish 10-year bonds rose 21 basis points to 5.06%, a 377-basis-point spread over German bonds, and Italian 10-year bonds rose 24 basis points to 4.76%, a 347-basis-point spread over German bonds. Besides the implications of the Cyprus bank restructuring, investors have become increasingly unsettled by the political gridlock in Italy and market rumors that one of the rating agencies may downgrade the country. Italy auctioned bonds last week, and the market clearing yield on the 5-year bond was 3.65%, its highest in five months.

We Reiterate Our Neutral Opinion on U.S. Banks
At the beginning of March, we revised our outlook on the U.S. banking sector to neutral from overweight. The impetus for that change was our increasing concern about the continuing growth in nonperforming loans in Spain and Italy. We think the increasing nonperforming loans will probably lead the markets to further question the stability of many European banks, and subsequent to the restructuring template in Cyprus, bondholders are also assuming a greater risk of bondholder impairment in a bailout situation. Therefore, we expect credit spreads of European banks are likely to widen, which may then lead to widening credit spreads among U.S. banks.

Click to see our summary of recent movements among credit risk indicators.

New Issue Notes

Navistar Paying Down Term Loan With $300 Million Add-On to Existing Notes; Remain Market Weight (March 27)
 Navistar International (B-, no moat) announced it is offering a $300 million add-on to its existing $900 million 8.25% senior notes due 2021 with proceeds used to reduce its $1 billion term loan. An amendment to the term loan is contingent upon the new bond offering getting priced. The move will improve bondholders' position in the capital structure as it reduces the amount of secured bank debt ahead of the 8.25% notes. Further, the maturity of the term loans will be fully extended to 2017 versus its previous terms, which included acceleration of maturity to July 2014 if $470 million of the $570 million senior subordinated convertible bonds due in October 2014 were not defeased by then. We shifted Navistar to market weight from underweight after first-quarter results showed continued progress as new CEO Troy Clarke transitions the company's engine strategy. Another key factor in our view is the increasing likelihood that the converts will get refinanced. We now view our credit rating as stable. The 8.25% senior notes have continued to rally to around $102, providing a yield of about 7.75%. We view this as roughly fairly valued (with a fair value range up to 8.0%) at about 225 basis points wide of the Merrill Lynch High Yield Index and effectively appropriate for a bond in the high CCC category.

In addition to the reduction in size of the term loan and maturity extension, pricing on the loan will be reduced by 100 basis points to Libor+450, which will lower interest expense. We believe the firm also has much greater flexibility in dealing with the convert given the stock's sharp rise to more than $34 from about $24 before the first-quarter results. Recall that Navistar sold about $200 million of shares in a secondary offering at $18.75 in October. The converts have a strike price of $50.27 and could theoretically get equitized should the stock continue to rally (our upside equity fair value estimate is $67). However, we believe the firm could also renegotiate terms with the existing owners to extend maturities, encourage equitization, or potentially refinance with another convert. Assuming the converts get addressed without a substantial use of cash, we believe liquidity including cash guidance of about $1 billion for the current quarter is sufficient to manage through the engine transition phase of the firm's heavy trucks, which is currently on target. While Navistar remains highly leveraged in a very cyclical industry, we believe the risks and rewards are now more balanced.

Assurant Issues at Attractive Spreads Across the Curve (March 25)
 Assurant (AIZ) (BBB, no moat) announced Monday that it is issuing new benchmark 5-, 10-, and 30-year notes. Initial price talk is a spread in the area of 200 basis points above the Treasury curve for the 5-year, 225 basis points for the 10-year, and 250 basis points for the 30-year. While Assurant is not one of our favorite names from a credit perspective, we think this pricing is attractive. For comparison, we rate  Hartford Financial Services Group (HIG) (BBB-, no moat) one notch lower and its 10-year trades with a spread above Treasuries of 140 basis points. We would recommend Assurant's 10-year all the way down to a spread of 150 basis points, with a similar 75 basis points tighter recommendation from the initial price talk for the other maturities.

From a credit perspective, we view Assurant as having a mediocre business model and lower-than-average financial metrics. In addition to property-casualty insurance products, which include force-placed homeowners' insurance, extended warranties, and employee benefits, the company underwrites health insurance. Assurant's sales in the health-care business are primarily to individuals, the segment most affected by health-care reform. It offers these products through channels where it faces less competition, which is a positive, but this has not generated consistent profitability. The firm's combined ratio has been average, a trend we expect to continue, and therefore it doesn't do very well in our underwriting metrics. Volatility surrounding underwriting performance, however, has been very low, making Assurant's profitability more stable than its competitors, which is a positive for our score.

Click here to see more new bond issuance for the week ended March 28, 2013.