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By M. Isi Eromosele
The ongoing European sovereign debt crisis and the European
Banking Authority (EBA’s) stress test may usher in a new era of distressed
investing aimed at Europe . This distressed investing
will be different from the classic version, which is typically triggered by major
corporations filing for bankruptcy, as happened in 2008.
The situation in Europe is an event triggered
by a sovereign debt crisis, banking liquidity and solvency crisis.
Changing European Global Finance Landscape
The financial crisis that started in the U.S.
with the sub-prime mortgage crisis and then spread into Europe
as a sovereign debt crisis has now been transformed into a banking crisis in the
European Union, affecting both its core countries as well as outlying ones.
The Bank for International Settlement’s (BIS) capital ratio
rules - Basel I, Basel
2 and 2.5 were designed and implemented to ensure that global banks could
withstand severe funding liquidity and solvency stresses.
They were meant to guarantee that banks maintained enough
capital on their balance sheets to absorb major losses that could cause
systemic problems and put all global bank son level playing field.
The current financial crisis in Europe
has exposed the weakness of the existing solvency and liquidity rules contained
within the various iterations of Basel .
European banks in aggregate have been known to have highly
levered balance sheets of around 2.8 times the total European GDP
of $17 trillion. This is compared with banks in US that have leveraged balance sheets totaling 0.8
times the US GDP of $15.1 trillion.
Not only were European banks poorly capitalized, but they
had been overly reliant on short-term wholesale funding. In addition, they had
large exposures to peripheral sovereign debt that had been historically
assigned a Risk-Weighted Asset (RWA) score of 0%.
The aggregate assets of Euro deposit-taking credit
institutions at the end of the second quarter of 2011 stood at 30.1 trillion
Euros. The European banking sector owned 687 billion Euros of sovereign debt in
the five countries - Greece, Ireland, Italy, Portugal and Spain, representing
22% of the total 31.2 trillion Euros sovereign debt outstanding by those
countries.
Against this backdrop of a worsening European sovereign
crisis, the European Banking Authority (EBA) and European Union Council agreed to a
stress test exercise in October 2011 that required banks to strengthen their
capital position by building up a temporary capital buffer against sovereign debt exposures to reflect
current market prices.
In addition, the proposal required banks to establish a
buffer such that the Core Equity Tier 1 (CET1) capital ratio reaches a level of 9% by the end
of June 2012 in order to be compliant with the European Union’s implementation of the
Basel 3 accord.
The “Tier 1” Capital Ratio is a ratio of a bank’s CET1 (the
numerator) to RWA (the denominator). The amount of any final capital shortfall
identified was based on valuations as of the end of September 2011.
The EBA’s stress test revealed that 31 European banks have a
total capital shortfall of 114.7 billion Euros.
The 24 largest European banks have to shrink their balance
sheets by at least 1.4 trillion Euros of RWA. How will banks achieve that target?
Banks will have to sell assets in the amount of 0.5 to 3.0 trillion (10% of
total gross assets across the affected banks).
Among the larger banks, about 30 percent of the balance
sheet reduction will be through LMEs, 44 percent through increasing retained
earnings and another 26% through assets sale and RWA reductions.
Another potential issue on balance sheets that is not
highlighted by the EBA is the level of non-performing loans (NPL) held. Across
14 major European banks, there is an estimated 388 billion Euros worth of NPLs.
How Banks Could Resolve Their Shortfalls
Banks have a number of options for improving their CET1
Ratio, including:
- Issuing new shares
- Growing retained earnings
- Performing liability management exercises (LME)
- Allowing loans to run off and limiting new loan originations
- Optimizing and changing the risk profile of certain assets
- Deleveraging by selling capital intensive and non-euro denominated assets, including securities and non-core businesses
Distressed Asset Sale
The potential buyers of banks’ balance sheet assets, both
performing and non-performing expect to acquire these assets at discounted or
distressed prices. To date, the sale of assets from European banks at
distressed prices has been more of a trickle than a flood.
There has been a significant difference between the book
value of assets held on balance sheets and the discounts banks are willing to
endure to sell these assets. This is due in part, to the fact that selling
assets at significant discounts to book value will create even more losses and
reduce CET1 capital further
However, if banks become forced sellers of assets, buyers
would benefit from acquiring these assets at steep discounts to their
underlying fundamental values, thus creating the potential for the buyers to
earn much higher returns in the future.
Taking Advantage Of The Opportunities
One way of taking advantage of European dislocated and
distressed market opportunities, as well as opportunities in residential and
commercial mortgages in both US and Europe is through a
customized hedge fund of funds strategy. This type of strategy would likely
have a lock-up of two to three years, slightly longer than
typical hedge strategies but certainly shorter than private equity vehicles.
One advantage of utilizing a customized hedge fund of funds strategy
would be the potential diversification that may be achieved through this
approach. The underlying managers could be combined in such a way that they
were divergent among asset types, geography of origination, liquidity terms and
investment strategies.
With respect to asset types, taking advantage of the opportunities
mentioned would mean targeting assets that would most likely be involved in the
deleveraging process, including:
- Performing
and non-performing bank loans
- Performing,
non-performing and distressed corporate bonds
- Structured credits:
- European RMBS ,
CMBS and ABS
- US
RMBS (prime, subprime, alt-A, option ARMS)
- US
ABS (student loans, other ABS)
- CLOs, CDOs, synthetic tranche
credits
- Structured fixed income: correlations,
asset swaps, structured notes
Liquidity terms would also be a crucial diversification, and
an investor would want to spread assets across various liquidity terms, such as
a mix of:
- Short-term
liquidity: one-year lock with quarterly redemption with 60-days notice
- Intermediate-term
liquidity: two to three years of initial lock and semi-annual redemption
with 60-days notice thereafter
- Long-term liquidity: drawdown of capital within a 5-years investment term, including 3 years of investment period
Hedge Credit Strategies:
- Situational
longs and situational shorts
- Capital
structure arbitrage
- Stressed
and distressed credits
- Risk hedging and management
M. Isi Eromosele is
the President | Chief Executive Officer | Executive Creative Director of Oseme
Group - Oseme Creative | Oseme Consulting | Oseme Finance
Copyright Control ©
2012 Oseme Group
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