Even with market liquidity still tight and the credit bubble "unwind" likely to continue into 2008, the latest evidence suggests a fragile stability setting in, according to Standard & Poor's Ratings Services Financial Institutions analysts participating in a Sept. 27, 2007, teleconference.
At the root of Standard & Poor's belief that the credit markets may be calming down is the continued strength of diversified financial conglomerates. These firms' risk management and diversification techniques, developed industry-wide during the past decade, have generally helped them weather a credit crunch that some expected would take a much harder toll on financial institutions of all kinds. As just one example, the four big U.S. broker-dealers that reported third-quarter earnings the week of Sept. 17, 2007—Goldman Sachs, Morgan Stanley, Bear Stearns, and Lehman Brothers—announced better-than-expected results, despite writing down leveraged loan and other commitments.
If history is any guide, the broker-dealers' earnings reports provide some insight into the potential results of large complex banks. "The broker-dealer results could foreshadow a very manageable decline in earnings for banks that are well-diversified," said Standard & Poor's credit analyst Tanya Azarchs.
Indeed, a deeper review of bank liquidity, described in more detail below, illustrates that large financial conglomerates along the lines of HSBC, Bank of America, and BNP-Paribas seem relatively well-positioned to manage through this correction. In our opinion, banks such as these have the capacity to finance contingent commitments during a stressed environment. For example, for third-quarter 2007, we expect UBS to write down $3.44 billion in its fixed-income portfolio, and we expect Citigroup's earnings to fall 60% from third-quarter 2006. Yet, both firms' balance sheets can absorb the pain.
"We take comfort in the overall credit strength of large financial groups and the timely central bank injections of liquidity into the interbank market," said Standard & Poor's credit analyst Scott Bugie. "Both have helped the financial sector through the recent turbulent correction."
Liquidity Diversification Means Resiliency
We have always considered liquidity as one of several key factors in the ratings. Given the liquidity issues in the market, we have been reviewing with banks the potential effect of conditions that are substantially less favorable than those currently being created by the credit squeeze. This deeper liquidity analysis specifically considers how a wide range of financial institutions would perform in a hypothetical six-month period when, according to Standard & Poor's credit analyst Diane Hinton, "the faucet is completely shut off," and firms have no access to the debt markets.
We have been reviewing with banks the cumulative effects of a wide range of contingent obligations and exposures—including leveraged loans, ABCP conduits, structured investment vehicles, and maturing debt—to determine firms' potential exposures in a stress situation in which these exposures convert into obligations. Counterbalancing this potential exposure, Standard & Poor's analysts are considering potential funding sources, such as access to Central Bank funding, committed credit facilities, and the borrowing value of collateral (while purposely excluding access to the debt markets to create what Hinton called a "stand-still scenario" during a six-month period).
The results of our reviews have been illuminating, but not particularly surprising. A test batch of the largest global banking groups holds up well in this scenario because of the numerous and diversified funding sources available to these entities. Organic deposit funding, committed credit facilities, and access to Central Bank funding would help large banks counteract the shutting off of the liquidity spigot.
The big U.S. broker-dealers, with their many funding sources, would show adequate liquidity during the six-month period, despite their large leveraged loan exposures. On the other hand, it is likely that finance companies wouldn't fare nearly as well, partly because of their dependence on wholesale funding sources. As for the European banks, in this scenario, their sources-to-uses ratios tend to be lower than those of their U.S. counterparts, most likely due to the relatively higher reserve requirements imposed on European banks.
Overall, the majority of institutions that we reviewed had the liquidity to meet their obligations in this worst-case environment for the full six months, with the most diversified institutions being the least vulnerable. Bugie made the point that the large financial institutions that hold up best in rough markets, such as those today, are diversified not only by product market and geography, but also by funding type. "Companies that rely excessively on one type of funding—say, through MBS issuances—are vulnerable to continued changes in market sentiment," Bugie said.
Other Elements Of A Fragile Stability
According to the Standard & Poor's analysts on the call, the current correction in credit pricing—while of course painful—should ultimately be healthy for the financial sector, leading to a more differentiated, long-lasting credit pricing. In the cases of mortgage lending and the leverage loan market, for instance, there are already signs of less-aggressive lending practices.
Another example is the wider credit spreads that will make bread-and-butter commercial lending more profitable, and the resulting high volatility that should boost trading income, two forces that could compensate, in the near term, for markdowns in hung-leveraged loans, RMBS, and a slowdown in debt underwriting. Moreover, according to Azarchs, most big commercial banks will likely see stronger growth in deposits in the short-term.
As for Europe, Standard & Poor's credit analyst Michelle Brennan said that several European banks were starting to see improved access to funding, but that the trends of tightening underwriting standards and of a reining in of lending were likely to continue. "We are anticipating pressures from higher funding costs, lower levels of activity in some business lines, and a decline in asset quality from the current exceptionally good positions," said Brennan.
According to Brennan, some funding conduits in Europe are beginning to finance themselves profitably in the wholesale markets again, resulting in a decrease in the support needed for sponsoring banks—but the market is distinguishing between conduits based on such factors as asset composition, disclosure, and perceived support from banks. As with the U.S. ratings, we continue to maintain stable outlooks on the majority of Western European bank ratings.
Other Shoes To Drop Could Affect The Fragile Stability
While the Standard & Poor's analysts reiterated that ratings on financial institutions take into account their expected access to liquidity, there are several adjacent issues we are continuing to monitor. These include the firms' ability to fund new business in situations where they must also fund assets for longer than expected (such as some leveraged finance assets) or unexpectedly take assets onto the balance sheet that were previously funded separately (such as assets in securitized vehicles); weak stock prices that could lead to a rise in share repurchases; and higher funding costs due to wider credit spreads.
According to Azarchs, a number of other factors, related to both liquidity and the larger economy, could upset the fragile stability. For example, Azarchs expressed concern about the high concentration of loans to single borrowers, and the fact that 10 major banks hold 75% of the exposures to the $330 billion pipeline of leveraged loans. Speaking of more macro-type trends, Azarchs cited possibilities, such as declines in mortgage volume, increases in corporate defaults, and a return to cyclical highs in consumer-related defaults and delinquencies such as credit card borrower defaults. But she emphasized that if the current fragile stability holds, it would increase the chances for a soft landing for the economy from the current credit freeze.
Writer: Mike Brewster
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