So far, the market has focused on write-downs related to mortgage securities and other structured credit products. Given that UBS analysts estimate total losses for banks and brokers to reach about USD 296bln, the 241bln of write-downs so far announced leads us to expect only limited further write-downs over the coming quarters. However, this does not mean that the credit crisis is over.
Indeed, UBS analysts think the credit crisis is about to enter a second phase. Many large banks have improved their liquidity positions and managed to raise capital to partially rebuild their capital ratios following large writedowns.
So far, banks have raised a total of around USD 150bln in capital, according to UBS calculations. UBS analysts think it may take the banking industry several years to fully
rebuild capital levels through earnings retention (namely, dividend cuts) and by selling non-core assets.
Why further problems lie ahead
UBS note that loans held on banks’ balance sheets have not been considered in the announced write-downs. While securities are valued according to market prices, it is the banks themselves who determine expected loan losses and set provisions for them. Banks have already increased their provisions for loan losses and UBS expect to see provisions on consumer loans and commercial mortgages to exceed long-term average rates over the next year or two.
Banks have now tightened their lending standards and many have announced plans to reduce their lending books, which will primarily affect borrowers of weaker credit quality. Small and medium-sized enterprises (SMEs) in particular may face severe funding and refinancing challenges as the cost of credit surges. As credit becomes less
available, higher default rates by consumers and SMEs should be expected, which in turn weighs on banks’ earnings as loan losses accelerate.
In UBS’ view, credit risk premiums on banks’ bonds are significantly above levels justified by their probability of default. With the banks’ now proven ability to raise capital, and the commitment of governments and central banks to support the banking sector, UBS analysts are confident that no major bank will default. However, they still see substantial default risk for smaller financial institutions that do not have a significant deposit base and are not deemed to be of great economic importance.
A conservative…
UBS analysts think this is the time to buy senior bonds of large banks and brokers and to hold those instruments until maturity. Among debt instruments issued by banks, hybrid bonds are the most subordinated and consequently most risky investments.
Hybrid bonds are partly or fully considered as equity capital for regulatory and accounting purposes. As a consequence, these complex instruments contain several contractual provisions that may lead to losses of coupon payments and principal, irrespective of an actual default of the issuer. The most common type, called fixed-to-floating, shares the following characteristics: No stated maturity date (perpetual
maturity). A fixed coupon for a defined time period of three to ten years, followed by a floating rate coupon calculated with a predefined risk premium over a money market rate, for example, 3-month Libor. On the payment date of the final fixed coupon, the issuer can choose to redeem the bond at a pre-defined price, usually 100%.
These bonds are traditionally offered to institutional investors and according to a market convention they are called at the first call date. Only in a few instances have banks failed to call these bonds: in the Japanese banking crisis of 1999 and recently at a smaller Italian bank. UBS think large banks cannot afford to miss the first call, as doing so would raise doubts about their ability to refinance and could severely hamper their ability to obtain new funding.
