Banking crises generally lead to high losses for depositors. Since governments often feel obliged to cover part of these losses, there is a strong political interest to minimize the risk of bank failure through regulation. The basic idea is that regulatory authorities act on behalf of the depositors. But the goal of bank regulators is not only to protect depositors, but also to provide a stable environment for banks to operate in. In order to be allowed to take deposits, any authorized bank has to hold adequate capital. Generally, capital requirements depend on the size and type of risk associated with a bank’s assets. In order to calculate the amount of capital that has to be held the bank’s business has to be split up between its term lending and deposittaking activities, classified as the “banking book,” and its trading activities, or the “trading book.” While the capital requirements for the banking book are laid out by the Basel Capital Accord, the Amendment to the Capital Accord sets out the guidelines for the trading book.
November 10, 2009
Political interest to minimize the risk of loan failure
November 9, 2009
A cushion for depositors and creditors
Banks generally have to hold adequate capital against all risks that arise from their business. This capital is intended to provide a cushion for depositors and creditors, if the bank is confronted with unexpected losses. Thus, the probability that a bank is not able to repay its liabilities is minimized. Since 1988, the Basel Capital Accord defines the minimum capital requirements for all banks. The agreement was put forward by the Basel Committee on Banking Supervision, an organization founded in 1974, following the severe crises of Bankhaus Herstatt in Germany and Franklin National Bank in the US to improve cooperation between bank supervisors. With the adoption of the Basel Capital Accord in a directive, the EU has created the basis to transform the guidelines into national law. Therefore, the capital requirements for banks are very similar across Europe. Essentially, they reflect the rules of the Basel Capital Accord, requiring banks to hold at least 4 percent of core capital and 8 percent of total capital against risk-weighted assets. In practice, however, most commercial banks target a Tier 1 ratio in the range of 8–9 percent. Still other banks carry even higher Tier 1 ratios, reflecting a steady earnings stream, hidden reserves, and a conservative dividend policy. Total capital consists of Tier 1 capital and Tier 2 capital, whereas the latter one is eligible only up to 100 percent of Tier 1 capital. Hence, the amount of Tier 1 capital determines the maximum total capital of a bank. Tier 2 capital consists of Upper Tier 2 and Lower Tier 2.
November 8, 2009
The generation of revenues and cash flows with credit
While the focus of industrial and utility companies is primarily on the generation of revenues and cash flows, for financial institutions the management of assets is of paramount importance. Traditionally, banks’ income statements and asset composition have been the primary focus of attention when assessing their credit strength. However, the high complexity of businesses and financial products has shifted the focus towards risk management. Off-balance sheet items and funding issues have become more important, therefore common metrics of credit risk are not able to reflect the complete risk profile of a bank. We would argue that the analysis of banks requires a completely different research process compared to industrial companies.
The importance of the banking sector results from the services it provides for the economy. In commercial banking, the main business is deposit taking and lending. According to Greenbaum and Thakor (1995) the role of commercial banks involves transformations with regard to duration, divisibility, risk, numeraire currency and liquidity. Additionally, they provide transaction and payment services as well as services related to securities accounts. Investment banks act as financial intermediaries in a broader sense, as they promote the efficiency of financial markets through underwriting, issuance and distribution of securities.
November 7, 2009
A chance of keeping the operative credit going
If one assumes that there is a chance of keeping the operative business going a valuation on the basis of sales multiples or EBITDA multiples is appropriate. In this case EBITDA is multiplied by an average market multiple and again all senior debt is subtracted before dividing the remaining value by the total amount of outstanding bonds.
The discounted cash flow analysis also assumes that the company is a going concern and the computed value serves as a starting point to estimate the value of outstanding bonds. These three methods will result in three different company values and, hence, should be weighted according to the confidence in the information used in them. A ratio smaller than 1 implies that not all claims of bondholders can be served by the company if bankruptcy occurs at the time of evaluation.
November 6, 2009
The valuation of a distressed credit
The valuation of a distressed company should be done according to the following methods:
- Liquidation value
- Sales multiples and EBITDA multiples
- Discounted cash flow analysis.
In liquidation valuation, it is assumed that the underlying business is not viable and will be liquidated in parts. The analyst has to assign the most likely realizable values to accounts receivables, inventory and PP&E. Generally it happens through a haircut to the book value of those positions.The liquidation often takes a long time to execute and in many cases all cash positions as well as all debt obligations are not disclosed immediately. From the liquidation value we have to deduct all debt which ranks ahead of corporate bonds and then divide the remaining value by the total amount of outstanding bonds.
November 5, 2009
A successful turnaround with payday loans
Companies which are likely to achieve a successful turnaround will have the following attributes:
- Balance sheet restructuring through, for example, a rights issue or convertibles
- Rebalancing of debt instruments towards more long-term debt
- The equity price recovers and keeps a positive trend
- New sources for working capital are available
- Operating income is generated during restructuring
- Sales growth is positive and the operating margins are at least constant (remember that in the short term, restructuring efforts will cause operational dislocation)
- Administrative costs and production costs can be kept under control
- Streamlining of operations
- The focus remains on the core business and noncore assets are sold successfully (increase liquidity in the short term, but may be leverageneutral
or negative) - Downsizing of business through workforce reduction
- Top-line growth and a controlled geographic expansion
- Cash flows are generated by different business units
- The business plan is flexible, for example, CAPEX program can be scaled back or postponed
- Loss-making businesses are sold first in order to stop the drain on cash flow.
November 4, 2009
It is difficult to identify all credit variables
It is difficult to identify all variables, which lead to the default of a specific company. The monitoring of the company’s ratings is not a good way because the rating agencies tend to react with a lag of sometimes a couple of months when the financial situation of a company deteriorates. Aand BBB companies can reach the spread levels normally seen at the CCC level. Some points, which might be an indication for upcoming financial distress are as follows:
- A new accounting firm or banking relationship is in place
- Amanagement conflict escalates and is discussed publicly
- Members from top management leave on short notice
- The banks cancel or reduce credit lines
- The budget for R&D is capped
- Alarge depreciation of assets takes place
- The financial ratios deteriorate over a period of 6–36 months before the default occurs
- The equity price has a negative trend.
November 3, 2009
The risk of an imminent loan rating downgrade
Especially lower investment grade (A-BBB) companies that have the risk of an imminent rating downgrade due to negative industry trends and firmspecific problems should include this clause in the covenant package. In the case of a downgrade the bond investors would receive a higher coupon payment (e.g. 25 bp per notch and rating agency). This way the companies can demonstrate their commitment to the current rating and the bondholder gets a fair compensation in the case of a downgrade. Options pricing theory is applied to compute the value of the coupon step-ups and the swap spread is adjusted accordingly. The coupon step-ups are increasingly important in industries with a negative rating trend like, for example, the European Telecoms in 2001/02. The spread differential between the bond with a coupon step-up and the credit curve of the issuer without step-ups is equal to the market value of the coupon step-up. The market value is computed with a binomial model by assuming historical or subjective ratings migration expectations.
November 2, 2009
Breaching one of the credit covenants
If a company is in danger of breaching one of their covenants or has to renegotiate a bank facility in order to stay in accordance with existing covenants, the credit spreads will widen immediately because major problems are anticipated in the future. Use of proceeds from bond offering: Another important point which should be considered in the evaluation of a new bond issue is the use of proceeds, because for bond investors there is a major difference between, for example, the refinancing of outstanding debt (bonds and bank debt), CAPEX, general corporate purposes, acquisition financing or the financing of a share buyback program. A transfer of wealth from bondholders to shareholders can occur. It is important to analyze the driving force behind a new bond offering. The use of proceeds will be determined by a company’s needs in the first place but will also fluctuate with general economic conditions.
November 1, 2009
Optional redemption of credit
The issuer may redeem all or part of the notes at a specified price and time. This means that, for example, a company issues a bond with 10-year maturity and has the option to call the bond after 5 years. This option represents value to the issuer because depending on future interest rates and the required risk premium a company might considerably reduce financing costs by calling the outstanding bonds. Furthermore, most high-yield bonds have an equity claw-back clause in their indenture. This means that an issuer may redeem up to 35 percent of the aggregate principal amount of notes with the net proceeds of public equity offerings at the redemption price set in the indenture.
Change-of-control: The change-of-control event occurs when, for example, a merger or acquisition leads to a change in the ownership structure.
In most cases the bondholders have a put option.
Negative pledge: The negative pledge restricts the issuers from using some or all of their assets as a guarantee for other indebtedness.
Cross default: The cross default clause is a mechanism which links the credit quality of one bond to other securities issued by the same parent company. In the case of an issuer’s bond default, a default will be triggered at all other bonds and loans within the capital structure.
Carve outs: Carve outs weaken the protection of bondholders. They represent exceptions for actions previously forbidden by the covenants.