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MOODYS.COM
18 OCTOBER 2012
NEWS & ANALYSIS Corporates 2 » ITT’s Planned Bornemann Acquisition Is Credit Positive
» Hillenbrand's Agreement to Acquire Coperion Is Credit Negative
» Norsk Hydro’s Joint Venture with Orkla for Extruded Products Is Credit Positive
» CMA CGM's Receipt of $250 Million Cash Injection Would Be Credit Positive
» Bumi and Bakrie's Breakup Is Credit Negative for Berau Coal and Bumi Resources
» Malaysia Reduces Palm Oil Tax, a Credit Positive for the Industry
Infrastructure 9 » PG&E's Pipeline Safety Regulatory Proposal Is Credit Negative
Banks 10 » Basel Committee Wants Higher Capital in Domestic
Systemically Important Banks, a Credit Positive
Sovereigns 12 » Grenada Liquidity Crisis Is Credit Negative for Eastern Caribbean
Currency Union
CREDIT IN DEPTH Additional Risks Present in New US CMBS Conduit Transaction 14
Investors in a new commercial mortgage backed securities transaction should consider several risks we highlight in our report on J.P. Morgan Chase Commercial Mortgage Securities Trust 2012-C8. Our analysis concludes that most classes of this transaction lack sufficient credit enhancement relative to the ratings four other rating agencies have assigned it.
RECENTLY IN CREDIT OUTLOOK
» Articles in last Monday’s Credit Outlook 17
» Go to last Monday’s Credit Outlook
Discover Weekly Market Outlook, our sister publication containing Moody’s Analytics’ review of market activity, financial predictions, and calendar of economic releases.
NEWS & ANALYSIS Credit implications of current events
2 MOODY’S CREDIT OUTLOOK 18 OCTOBER 2012
Corporates
ITT’s Planned Bornemann Acquisition Is Credit Positive
On Monday, ITT Corp. (Prime-3 stable) said it had agreed to purchase Joh. Heinr. Bornemann GmbH of Germany for €206 million (about $265 million) in cash. The deal would be the company’s first acquisition since it split into three public companies in fourth-quarter 2011. The Bornemann acquisition is credit positive for ITT because it will increase the company’s annual revenue by about 7% and contribute to its operating profitability and cash flows without any significant increase in debt or material diminishment in liquidity.
During its October 2011 analyst day, ITT, which manufactures a broad range of engineered products including pumps, valves, actuation devices, motion control products and interconnect devices, said its acquisition strategy would target companies generating $15-$50 million in revenue. But Bornemann, which manufactures pumps and systems for the oil and gas industry, will add approximately $150 million to ITT’s post-separation revenue run rate of about $2.2 billion. At the end of June, ITT’s cash holdings stood at $739 million (much of it located offshore) and funded debt was just $40 million. We expect ITT to have annual free cash flow of around $100 million once separation and transitional costs are completed, so the cost of the Bornemann acquisition would be about 2.5x annual free cash flow. We do not expect Bornemann to have any significant debt or pension liabilities that would be consolidated into ITT’s financials upon consummation. ITT expects the deal to close by the end of the year.
Although ITT has minimal funded debt, it has significant legacy liabilities, primarily stemming from asbestos litigation. Roughly $1.4 billion remains as a balance sheet reserve, with some $700 million of related insurance recoveries carried as an asset (both are pro forma for a settlement agreement announced on 26 September 2012), leaving net claims of roughly $700 million. ITT reassesses those measurements annually in its earnings report for the third quarter ending 30 September (its 2012 third-quarter results are due out on 31 October).
The company had previously estimated its net cash outlays for asbestos to be $225-$325 million, starting at $10-$20 million a year for the next five years before stepping up to $35-$45 million a year for the subsequent five years. ITT needs to maintain liquidity to service those liabilities, as well as to potentially fund their ultimate resolution. We believe this constrains ITT’s capacity for debt incurrence. The Bornemann transaction will utilize a portion of ITT’s liquidity, but given the company’s current limited funded indebtedness, the company retains sufficient resources and flexibility for the transaction to be a net positive credit development.
Edwin Wiest Vice President - Senior Credit Officer +1.212.553.1461 [email protected]
NEWS & ANALYSIS Credit implications of current events
3 MOODY’S CREDIT OUTLOOK 18 OCTOBER 2012
Hillenbrand’s Agreement to Acquire Coperion Is Credit Negative
On Tuesday, Hillenbrand, Inc. (Baa3 review for downgrade) said it had signed a definitive agreement to acquire Coperion GmbH (unrated) for about $530 million in cash and the assumption of certain debt and pension liabilities. The acquisition is credit negative for Hillenbrand because it will raise the industrial company’s financial leverage, reduce its liquidity and increase its exposure to the cyclical industrial capital-equipment industry.
Hillenbrand said it would fund the purchase with a combination of cash on hand and funds from its $600 million revolving credit facility, which would reduce the company’s liquidity. Pro forma debt to EBITDA would also likely rise to 3.5x from 2.0x as of 30 June.
Additionally, the deal would increase Hillenbrand’s exposure to the process equipment business, demand for which fluctuates with the economy. Hillenbrand’s other business segment, the more stable deathcare-products business, will become a smaller part of its business mix. The process equipment group will be about 65% of pro forma revenue, up from around 34%. Hillenbrand’s revenue was around $960 million for the 12 months ended 30 June.
The acquisition is the latest in a series of deals transforming Hillenbrand into a company focused on the design, production and servicing of equipment and systems used in processing applications, such as food processing and crushing machinery, from one engaged primarily in manufacturing, marketing and distributing caskets. Hillenbrand moved into the process equipment business with its 2010 acquisition of K-Tron and acquired Rotex in 2011.
The casket business, although stable, has been relatively soft in recent years as the deathcare industry trends more toward cremation. As the process equipment business becomes an increasingly large component of Hillenbrand, we believe it will drive the company’s revenue growth and more than offset any volume declines in casket sales.
Coperion, based in Stuttgart, Germany, manufactures compounding, extrusion and bulk material handling equipment used in a variety of industries. The company’s revenue was about $675 million and EBITDA was $50.2 million for the 12 months ended 30 September, according to Hillenbrand.
Hillenbrand expects the deal to close in December, pending regulatory approvals and certain other conditions.
We placed Hillenbrand’s ratings on review for downgrade following the acquisition announcement owing primarily to evolving issues with the company’s capital structure. The increased borrowings under the revolver would amplify the structural subordination between the company’s senior unsecured notes, which are not guaranteed, and the senior unsecured revolving credit facility, which is guaranteed by the company’s domestic subsidiaries, unless the company is able to make all borrowings parri passu.
Nancy Meadows Vice President - Senior Analyst +1.212.553.1673 [email protected]
NEWS & ANALYSIS Credit implications of current events
4 MOODY’S CREDIT OUTLOOK 18 OCTOBER 2012
Norsk Hydro’s Joint Venture with Orkla for Extruded Products Is Credit Positive
Last Monday, aluminium producer Norsk Hydro ASA (Baa2 stable) and Orkla ASA (unrated), a Norwegian conglomerate, announced they would merge their respective extruded aluminium businesses, including their profiles, tubing and building systems, into a 50-50 joint venture called Sapa. This is credit positive for Hydro because the joint venture would effectively reduce its exposure to the poorly performing and volatile extruded products division, which accounted for 22% of its 2011 consolidated sales, but just 5.6% of its EBITDA. Additionally, it would pave the way for an exit, via an initial public offering (IPO), from the extruded aluminium sector, which suffers from its high exposure to the building and construction industry.
The companies expect the deal to close during the first half of 2013, subject to customary regulatory and antitrust approvals.
Transferring the extruded products business into a separate joint venture with another major global producer of aluminium extruded products would improve Hydro’s business and financial profile. It would create a leading downstream aluminium player, with a much broader scale and geographic diversification to compete in increasingly challenging market conditions. On a pro forma 2011 accounts basis, Sapa would have revenues of NOK47 billion ($8.2 billion) and an underlying EBITDA of nearly NOK2 billion ($350 million). It would be the market leader in Europe and North America, and a major player in the less mature and more dynamic markets of Latin America, where Hydro already has an important presence, and in Asia, where both Hydro and Orkla each have an established and growing presence.
The combination would allow both Hydro and Orkla to take more meaningful restructuring measures and to extract synergies by rationalising their product portfolios and manufacturing capacity, especially in Europe and the US, where they partially overlap. At the same time, the joint venture would have more dedicated managerial and financial resources to further expand its commercial and manufacturing presence in fast-growing emerging markets. This would be an important upside potential for each shareholder, especially for an IPO opportunity, which both partners may consider after the third anniversary of transaction closing.
The joint venture would be accounted for as an associate of both shareholders, according to the equity accounting methodology. We expect the partnership to eliminate a source of volatility in Hydro’s consolidated earnings and reduce its capital expenditure (capex) and working capital-related funding commitments since these would be equally shared with its partner and, after the initial start-up phase, would be directly funded by Sapa’s operating cash flows. Indeed, de-consolidating the extruded business would improve Hydro’s financial profile because the division is less profitable than others, with an EBITDA margin of only 3.3% in 2011 versus Hydro’s average of nearly 13%. Furthermore, the division has been characterised by high cyclicality and seasonality in its earnings, reflecting its large exposure to the building and construction and automotive end-user markets, which accounted for 38% and 17%, respectively, of the division’s sales in 2011.
Several details yet to be clarified include the timeline and nature of the expected synergies, which management estimates at NOK1 billion ($175 million), details of the restructuring plan (including associated costs and funding arrangements) and the degree of ring-fencing that may be required in the new joint venture. Hydro did not specify the extent of its support to the joint venture, but we believe some support would be required, at least during the start-up phase, as we expect large restructuring charges (at least NOK 1.5 billion) in the first two years after closing.
The joint venture would not affect Hydro’s rating, mainly owing to the limited relevance of the extruded division on overall accounts (5.6% of 2011 EBITDA).
Gianmarco Migliavacca Vice President - Senior Analyst +44.20.7772.5217 [email protected]
NEWS & ANALYSIS Credit implications of current events
5 MOODY’S CREDIT OUTLOOK 18 OCTOBER 2012
CMA CGM’s Receipt of $250 Million Cash Injection Would Be Credit Positive
Last Tuesday, CMA CGM SA (B3 review for downgrade), said it had agreed in principle to sell a 10% stake in exchange for $250 million from French strategic investment fund Fond Stratégique d’Investissment (FSI, unrated) and the Turkish conglomerate Yildirim Group (unrated). The $250 million cash injection is credit positive for CMA CGM, the world’s third-largest container shipping company, because it will strengthen its liquidity and bolster its renegotiations with its banks over its financial covenants.
Under the memorandum of understanding, FSI has agreed to invest $150 million in CMA CGM in the form of bonds redeemable in shares, giving it the right to a 6% stake in CMA CGM upon conversion. Yildirim, meanwhile, will subscribe to $100 million of bonds redeemable in shares under an existing agreement, giving it the right to a 4% stake in CMA CGM upon conversion. The conversion date for both deals is the later of either the date of any initial public offering or December 2020.
The arrangements will provide CMA CGM with funds that it can use to meet its debt repayments and cover its moderate capital expenditure (capex) requirements. CMA CGM has been renegotiating its financial covenants with its banks since March and we think the transaction will likely help the company in those discussions.
The agreement is the latest showing of support from Yildirim. In 2011, Yildirim invested $500 million in CMA CGM in the form of bonds redeemable in shares that on 31 December 2015 will automatically redeem into preferred shares equal to 20% of CMA CGM’s capital. The emergence of FSI, a fund backed by the French state, as a shareholder will provide additional confidence to CMA CGM’s existing stakeholders.
A collapse in world trade flows in 2009 dealt a heavy blow to the container shipping industry, and CMA CGM was no exception. CMA CGM’s revenue fell 30% to $10.5 billion and reported negative EBITDA of $626 million in 2009. After a temporary recovery in 2010, CMA CGM’s financial profile deteriorated again in 2011 because of weak freight rates. The company’s EBITDA began to recover in 2012 as freight rates rose in the first two quarters of the year. We expect the third quarter to be positive, while the fourth quarter remains uncertain and will depend on the operators’ ability to reduce the supply of vessels on the water to face a declining demand in the sector. CMA CGM’s has high leverage, with a debt/EBITDA ratio of 9.9x on an adjusted basis for the 12 months ended 30 June.
Federica Carollo Associate Analyst +44.20.7772.1944 [email protected]
Marco Vetulli Vice President - Senior Credit Officer +39.02.914.81.123 [email protected]
NEWS & ANALYSIS Credit implications of current events
6 MOODY’S CREDIT OUTLOOK 18 OCTOBER 2012
Bumi and Bakrie’s Breakup Is Credit Negative for Berau Coal and Bumi Resources
On 10 October, Bakrie Group1 offered to exchange its 23.8% shareholding in Bumi Plc (unrated) for an equivalent value of Bumi Resources Tbk (P.T.) (B1 negative) shares. At the same time, Bakrie Group made a conditional proposal to acquire Bumi Plc’s remaining 18.9% shareholding in Bumi Resources before Christmas, and a conditional proposal to make a cash offer for Bumi Plc’s 84.7% shareholding in Berau Coal Energy Tbk (P.T.) (B1 stable) within the next six months. If the exchange and contingent offers are accepted, it would be credit negative for Berau Coal Energy and, to a lesser extent, Bumi Resources.
London Stock Exchange-listed Bumi Plc was a coal venture founded last summer by London-based financier Nathaniel Rothschild. The exhibit below shows the shareholding structure of Bumi Plc and its subsidiaries Bumi Resources and Berau Coal Energy, including their operating coal mining entities, PT Kaltim Prima Coal (unrated), PT Arutmin Indonesia (unrated) and Berau Coal (unrated), and diversified miner Bumi Resources Minerals (unrated).
Bumi Plc Organization Chart
Note: As of 30 June 2012. *Bakrie Group and Borneo Lumbung’s shareholdings are held through a joint venture, whose voting interest in Bumi Plc is limited at 30%. The balance of the shares is held as suspended voting ordinary shares, which are shares with no voting rights. Source: Bumi Plc, Moody’s estimates.
The offer comes amid the ongoing dispute between two of Bumi Plc’s major shareholders, Mr. Rothschild and Bakrie Group, which began in November 2011 after Mr. Rothschild issued a public letter about corporate governance concerns at Bumi Resources. Recently, Mr. Rothschild resigned from Bumi Plc’s board, citing a loss of confidence in the chairman and the board.
Bumi Plc would need 75% of its shareholders to accept Bakrie Group’s exchange and contingent offer, but that is complicated by the ongoing independent investigation into allegations of financial and “other irregularities” at Bumi Resources.
1 Bakrie Group refers to PT Bakrie and Brothers Tbk (unrated) and Long Haul Holdings (unrated), which are affiliated to
Indonesia’s Bakrie family.
23.8% * 23.8% * 10% 10% 32%
29.2% 84.7%
70% 65% 87% 90%
Borneo Lumbung
Berau Coal Energy
Berau CoalKaltim Prima CoalArutmin Indonesia Bumi Resources Minerals
Bumi Resources
Bumi Plc
PublicNathaniel RothschildRecapital GroupBakrie Group
Simon Wong Vice President - Senior Analyst +65.6398.8322 [email protected]
Dylan Yeo Associate Analyst +65.6398.8317 [email protected]
NEWS & ANALYSIS Credit implications of current events
7 MOODY’S CREDIT OUTLOOK 18 OCTOBER 2012
Bakrie Group’s acquisition of Berau Coal Energy would likely trigger the change of control clause in Berau Coal Energy’s bonds, adversely affecting the company’s liquidity and refinancing risk. Based on the current price of its outstanding bonds, Berau Coal Energy would likely have to repay $505 million when the bonds are puttable upon change of control. Considering Berau Coal Energy’s cash on hand of $522 million at 30 June and ongoing capex, it is unlikely to build adequate cash on hand to meet the bond repayment. Berau Coal Energy’s current rating considers its large cash holding, which allows it to tide through the weakened operating environment. A significant decline in cash on hand would result in negative credit and rating pressure.
Bumi Resources could be negatively affected by the ongoing independent investigation into allegations of financial and other irregularities, corporate governance practices, and uncertainty arising from the potential change of shareholders.
We revised Bumi Resources’ outlook to negative on 25 September to reflect the risk that the lingering corporate governance issues will affect its ability to refinance its scheduled loan maturities of over $300 million in 2013. Furthermore, because Bumi Plc is publicly traded, losing it as a direct shareholder could increase corporate governance concerns at Bumi Resources and BCE because transparency would likely decrease without Bumi Plc’s oversight and compliance with financial reporting and corporate governance standards of the London Stock Exchange.
NEWS & ANALYSIS Credit implications of current events
8 MOODY’S CREDIT OUTLOOK 18 OCTOBER 2012
Malaysia Reduces Palm Oil Tax, a Credit Positive for the Industry
On Friday, Malaysia (A3 stable) announced long-awaited rate reductions in its crude palm oil (CPO) export tax. The reduced rates take effect in January 2013 and counter the changes that Indonesia (Baa3 stable) made to its CPO tax arrangements in October 2011, a credit positive for the domestic industry.
Until the new rates go into effect, we expect downward price pressure on CPO as storage capacity fills and forces stockpile sales. We expect market conditions to return to normal by mid-2013.
Indonesia changed its CPO export taxes in 2011, trimming the top rate on CPO to 22.5% from 25% and moved the nil tax threshold to $750 per tonne from $700 per tonne. More importantly, in a desire to stimulate domestic, downstream value addition, the tax rate on refined products was broadly halved, cutting the top rate for refined palm oil (RBDPO) to 10% from 23%.
From January 2013, Malaysia’s tax rate on CPO exports will be 4.5%-8.5% of the price, down from its current rate of 22%-23% of the price. Malaysia has no tax on exports of processed palm oil. At the same time, the annual tax-free export allowance of CPO (increased to 5.5 million tonnes in 2012) will be removed.
Since refined palm oil exports are untaxed, the new tax regime narrows the difference in Malaysia’s export tax between CPO and refined palm oil to the new CPO tax rate, 4.5%-8.5%. Assuming that the domestic CPO price equals the exported CPO price net of the export tax (although local demand-supply balance between refinery capacities and plantation outputs can affect prices significantly), domestic refining is encouraged by a larger tax differential. The tax differential will now be around 300 basis points greater in Indonesia than Malaysia, thus encouraging great refining in Indonesia. With Indonesia’s CPO tax of 10.5% and refined palm oil tax of 2%, the difference in tax rates is 8.5%. With Malaysia’s CPO tax at 5.5% and no refined palm oil tax, the difference in tax rates is 5.5%. While the refining tax advantage remains with Indonesia, some customers, for the cost of a few dollars, prefer to deal with the more established Malaysian refiners, which may also provide logistical benefits and savings such as shorter shipping distances.
The Malaysian palm oil sector has had a tough year. Changes to Indonesia’s palm oil export tax regime immediately put Malaysian downstream processors at a disadvantage to their Indonesian counterparts such as Musim Mas (unrated). This pressure, coupled with lower demand from Europe, led to reduced plant utilization and negative refining margins for some Malaysian processors, such as FELDA (unrated) and Sime Darby (unrated). Wilmar International (unrated), the world’s largest processor of palm oil, currently has 64% of its refining capacity in Indonesia, the remainder in Malaysia. The yield of Malaysian plantations has also been slightly weaker this year. IOI Corporation Berhad
We expect Malaysia’s output of palm oil in 2012 to reach 18.4 million tonnes. Peak production of palm oil usually occurs between June and October, but owing to the lower CPO prices so far this year, stock levels in Malaysia have been running at higher levels than usual. Stocks of all palm oil products climbed to a record 2.45 million tonnes at the end of September from 2.11 million tonnes a month earlier. Domestic storage capacity is 5.2 million tonnes, but the raw product has a comparatively short shelf life, making the inventory growth a risk.
(Baa1 negative) has, for example, produced 8% less palm oil for the year to September 2012 than in the same year-ago period. At the same time, CPO prices are down over 8% year on year for the first nine months of 2012.
We believe the tax changes are credit neutral for IOI with its European refineries losing their advantage but with better onshore refining margins. For Golden Agri-Resources (Ba2 stable) and Bakrie Sumatera Plantations (Caa2 stable), the tax change does not help their downstream expansion plans in Indonesia.
Alan Greene Vice President - Senior Credit Officer +65.6398.8318 [email protected]
NEWS & ANALYSIS Credit implications of current events
9 MOODY’S CREDIT OUTLOOK 18 OCTOBER 2012
Infrastructure
PG&E’s Pipeline Safety Regulatory Proposal Is Credit Negative
Last Friday, the California Public Utilities Commission (CPUC) issued a proposed decision that, if enacted, would prevent Pacific Gas and Electric Company (PG&E, A3 stable) from recovering roughly $1 billion of its $2.18 billion expenditure on its pipeline modernization program and a pipeline records integration program. The CPUC also proposed a 6.05% return on equity (ROE) on the recoverable portion of the investment for five years, as compared with the current ROE of 11.35%. Both aspects of the proposal are credit negative for PG&E.
How adverse the credit effects are will largely depend on how much of the unrecoverable costs, which also include yet-to-be-determined fines, are financed with equity as opposed to debt. The company’s recent actions suggest a commitment to allocate the burden largely onto shareholders, mitigating the effect on credit quality.
The CPUC’s administrative law judge (ALJ) proposed decision follows PG&E’s August 2011 filing with the CPUC of its pipeline safety enhancement plan (PSEP) to address several pipeline deficiencies that led to the San Bruno, California, natural gas pipeline explosion more than two years ago. In the filing, PG&E forecast that its total plan-related costs over the first phase of the PSEP would approximate $2.18 billion, including $750 million in operating expenses and $1.4 billion in capital expenditures.
Of the $750 million in operating expenses, PG&E did not seek recovery of its 2011 related expenses of around $220.7 million. The company does not have a regulatory mechanism that allows recovery of its 2012 estimated $231.1 million of expenses. Of the remaining $300 million of future PSEP operating expense, the ALJ proposed decision contemplates recovery of 56%, or $166.6 million, according to an 8-K that PG&E filed on Monday.
The two primary areas of disallowance for the capital expenditure portion are recovery of the capital costs associated with the company’s pipeline records integration program, and the capital costs for potential contingencies concerning the plan. We are not surprised that the proposed decision would exclude recovery of PG&E’s planned records-integration program given the substantial criticism of the company for past record keeping. However, the authorized ROE that will accompany the recoverable portion of the company’s capital investment was more of a surprise, because the proposed authorized ROE is equivalent to the company’s current cost of debt for the first five years of depreciable life.
While ALJ-proposed decisions in California often differ materially from the final decision, the existence and timing of this proposed decision and its stark differentiation from the company’s request, along with the negative public sentiment toward PG&E around the San Bruno incident, increases the probability that the final CPUC decision will end up similar to the proposed decision. The total effect on PG&E’s credit quality would depend upon the final details of the PSEP decision, the size of the expected fine, and most importantly, the manner in which the company intends to finance these future obligations.
Toby Shea Vice President - Senior Analyst +1.212.553.1779 [email protected]
A.J. Sabatelle Senior Vice President +1.212.553.4136 [email protected]
NEWS & ANALYSIS Credit implications of current events
10 MOODY’S CREDIT OUTLOOK 18 OCTOBER 2012
Banks
Basel Committee Wants Higher Capital in Domestic Systemically Important Banks, a Credit Positive
On 11 October, the Basel Committee on Banking Regulation (BC) published its final framework on domestic systemically important banks (D-SIBs).2 The BC recommends that starting in 2016, national regulators require institutions whose failure would pose systemic risks in their jurisdiction to hold more core equity Tier 1 capital than the minimum required in the forthcoming Basel III framework, a credit positive for D-SIB creditors.
We view the BC’s framework as an important complement to its existing recommendations on global systemically important banks (G-SIBs). 3 However, the ultimate scope, consistency and capital add-on for D-SIBs remain unspecified.
The BC proposes that national regulators classify D-SIBs in their jurisdictions and define additional capital requirements for them. Delegating key decisions to national regulators makes sense because a small, highly concentrated banking system has different criteria than a larger, more fragmented one. At the same time, however, delegating classification to national regulators risks uneven implementation, with the potential for regulatory arbitrage by banks.
The BC’s process of public peer reviews limit this risk. Supervisors will have to publish the list of D-SIBs in their jurisdictions along with specific capital requirements for those institutions, and their underlying methodology. This transparency will create peer pressure for regulators and allow investors to enforce market discipline by penalizing banks in regulatory regimes deemed less strict.
Extra capital buffers intend to reduce the risk of a D-SIB’s failure and the risk of broader systemic consequences of such a failure, including the cost to taxpayers from a government bailout. They also create an incentive for large banks to reduce their asset size and systemic relevance to avoid the D-SIB designation or at least minimize the capital surcharge.
If D-SIBs feel compelled to take outsize risks in an effort to bolster profits and stabilize returns on capital, even higher required capital won’t necessarily safeguard them. D-SIBs may also try to minimize the surcharge through regulatory arbitrage, which would leave investors with greater and less transparent risks.
Many of the largest banks in each jurisdiction – beyond the 29 bank already designated as G-SIBs – are likely to be designated D-SIBs. To preserve a level playing field, the BC recommends that the capital add-ons to D-SIBs and G-SIBs be decided upon in a coordinated way. This makes it likely, in our view, that rules for D-SIBs will be similar in many countries to the staggered surplus between 0% and 2.5% (3.5% for banks that grow too fast) on top of Basel III, depending on a bank’s systemic relevance.
One important difference between the BC’s new framework for D-SIBs and its existing rules for G-SIBs is the absence of calls for specific resolution regimes for the D-SIBs, a key component of the BC’s
2 See the Basel Committee’s press release, 11 October 2012. The final framework is similar to an earlier consultative document,
see Basel Committee Principles for Domestic Systemically Important Banks Are Credit Positive for Large Domestic Banks, 9 July 2012.
3 See G-SIFI Capital Surcharge Is Credit Positive for the 29 Banks But Resolution Framework Could Offset That Benefit, 14 November 2011.
Alain Laurin Senior Vice President +33.1.5330.1059 [email protected]
Tobias Moerschen, CFA Vice President - Research +1.212.553.2891 [email protected]
NEWS & ANALYSIS Credit implications of current events
11 MOODY’S CREDIT OUTLOOK 18 OCTOBER 2012
framework for G-SIBs. An effective resolution regime for all systemically important banks would reduce the likelihood of government support for such banks, which offsets the positive credit implications of the BC’s G-SIB framework and led us to reduce our assumptions about government support for banks in several countries.
NEWS & ANALYSIS Credit implications of current events
12 MOODY’S CREDIT OUTLOOK 18 OCTOBER 2012
Sovereigns
Grenada Liquidity Crisis Is Credit Negative for Eastern Caribbean Currency Union
Last Friday, the government of Grenada (unrated) avoided default by making a late coupon payment on its US dollar denominated $193 million 20-year bond due in 2025. However, the delayed payment highlights the government’s liquidity crisis and the likelihood that Grenada’s foreign currency debt will be restructured as financing pressures continue to mount over the next two to three years. The liquidity crisis leading to the late coupon payment is credit negative for Grenada and elevates the risk of distress spilling over to its peers in the Eastern Caribbean Currency Union (ECCU).
Grenada is among the most indebted countries in the Caribbean: central government debt exceeds 105% of GDP. In addition to the debt overhang, the government’s liquidity is severely constrained. Grenada also missed payments to bilateral creditors earlier this year and has had difficulty paying public sector wages. The International Monetary Fund (IMF) projects the fiscal deficit will widen to 5.7% of GDP by 2013 from 4.7% of GDP in 2011.
Grenada has exhausted its options – including volatile multilateral and bilateral grants – for meeting this year’s financing needs, which has diminished the government’s ability to service its debt.
Grenada is not the first or only ECCU country in fiscal distress: St. Kitts (unrated) defaulted on its debt in 2011, and Antigua (unrated) restructured its debt in 2010. Both countries have active IMF stand-by programs and all ECCU members rely on emergency IMF credit facilities.
As the exhibits below show, government debt in the ECCU remains elevated, with the regional average debt equaling 94% of GDP, and some countries’ debt levels on par with distressed euro area sovereigns.
EXHIBIT 1
Debt/GDP in the Eastern Caribbean Currency Union
2000 2005 2012
Antigua and Barbuda 108% 95% 98%
Dominica 71% 83% 72%
Grenada 41% 88% 105%
St. Kitts and Nevis 98% 160% 145%
St. Lucia 40% 63% 79%
St. Vincent and the Grenadines 59% 66% 68%
Source: Moody’s, IMF World Economic Outlook (October 2012).
Edward Al-Hussainy Assistant Vice President - Analyst +1.212.553.4840 [email protected]
NEWS & ANALYSIS Credit implications of current events
13 MOODY’S CREDIT OUTLOOK 18 OCTOBER 2012
EXHIBIT 2
ECCU Debt/GDP versus Stressed Euro Area Sovereigns
Source: Moody’s, IMF World Economic Outlook (October 2012).
Grenada shares a common currency (pegged to the US dollar) with five other sovereigns as part of the ECCU. The bloc has a combined GDP of only $5.6 billion and has had a prolonged recession driven by depressed tourism and foreign investment since 2008. The IMF projects ECCU growth this year of 0.7%, up from a decline of 1.1% in 2011, but significantly below its projections for the rest of the Caribbean (2.8%) and Latin America (3.2%).
Grenada’s US dollar 2025 bond, which is the result of a distressed debt exchange completed in 2005, equals about 21.6% of government debt, of which more than 70% is denominated in foreign currency. While we see an increased likelihood that the government’s foreign currency debt will be restructured, a default on Grenada’s local currency obligations is less likely.
Local currency bonds and treasury bills are issued (and traded) on the ECCU’s Regional Government Securities Market (RGSM) and held by a captive base of domestic institutional investors. If Grenada defaults, funding costs in the regional market are likely to increase, elevating rollover risk. A sovereign default in this market will also have systemic repercussions for the financial sector, spilling onto government balance sheets in the ECCU through elevated fiscal liabilities.
98%
72%
105%
145%
79%68%
171%
118%126%
119%
91%
Antigua and Barbuda
Dominica Grenada St. Kitts and Nevis
St. Lucia St. Vincent and the
Grenadines
Greece Ireland Italy Portugal Spain
ECCU Euro Area
CREDIT IN DEPTH Detailed analysis of an important topic
14 MOODY’S CREDIT OUTLOOK 18 OCTOBER 2012
US CMBS: J.P. Morgan Chase Commercial Mortgage Securities Trust 2012-C8 Under-Enhanced Relative to Assigned Ratings
Biggest Deficiency for Low Investment Grade Classes
EXECUTIVE SUMMARY
J.P. Morgan Chase Commercial Mortgage Securities Trust 2012-C8, a US commercial mortgage-backed securities (CMBS) conduit transaction we did not rate, will likely close on or about 18 October. Based on our review of publicly available information, including the preliminary prospectus dated September 2012 and the presale reports of the rating agencies that rated the transaction, all principal and interest (P&I) classes of this transaction (with the exception of Classes A-1, A-2, A-3 and A-SB) lack sufficient credit enhancement relative to the ratings four other rating agencies assigned.
The biggest deficiency in enhancement occurs at the lower end of the investment-grade spectrum. Classes D and E, the two lowest investment grade classes, would most likely merit ratings two notches below the assigned ratings, with Class E falling into speculative grade. For these classes, we would assign ratings consistent with those assigned by other agencies only if credit enhancement were substantially higher.
In addition, we disagree in particular with the analysis, as presented in Standard & Poor’s presale report of six loans that constitute 17% of the pool balance. Four of those loans are retail properties in secondary or tertiary markets, with high tenant concentrations and upcoming lease expirations.
Finally, in our opinion, the use of low cap rates by Standard & Poor’s and other market participants in valuing the properties in the pool is shortsighted in an environment of historically low interest rates, and underestimates the refinance risk of loans that mature in 10 years.
OPINIONS ON ASSET RISK DIVERGE
Our assessment of risk factors differed from the approach of other rating agencies. In our view, the enhancement levels in the subordinate classes of this transaction are inadequate and inconsistent with the transaction’s credit profile.
The major risk factors that we judge to be inconsistent with published subordination levels are as follows:
» Loan concentration: The top 10 loans constitute 58.5% of pool balance, and the effective average loan size is approximately 5% using the Herfindahl index. This level of concentration can result in a high degree of performance volatility and, for those classes that experience a default, a high severity.
» Loan leverage: The weighted average Moody’s LTV of the pool is above average for CMBS 2.0.
» LTV dispersion: Approximately one quarter of the pool has very high leverage, in excess of 110% LTV on a Moody’s stressed basis. Top markets can mitigate the risk of high leverage, but no such top markets are represented in this transaction.
» Small markets: The collateral pool contains no properties in the top six capital-attracting cities. In smaller markets, replacement tenants and liquidity are harder to come by, and loss severities for defaulted loans are materially higher than for those in larger markets.
» Interest-only terms: 25.8% of loans have partial term interest-only, and 5.5% have full term interest-only, reducing the loan level amortization available to mitigate the above average leverage.
Tad Philipp Senior Vice President - Director CMBS Research +1.212.553.1992 [email protected]
Nick Levidy Managing Director - Structured Finance +1.212.553.4595 [email protected]
CREDIT IN DEPTH Detailed analysis of an important topic
15 MOODY’S CREDIT OUTLOOK 18 OCTOBER 2012
OPINIONS ON MOST SUBORDINATE CLASSES DIFFER
While the presale reports published by other rating agencies identified most of these credit risks, they did not draw the same conclusions as we did regarding the effect of the risks on the bonds, particularly with respect to Class E, the most subordinate rated class the other agencies designated as investment grade. Given its size of less than 3% of the pool balance in relation to a highly concentrated loan pool of uneven quality, we believe that Class E has a higher than investment-grade risk of default, as well as a higher than investment-grade risk of loss given default. The default of only one or two average size loans after the depletion of credit enhancement could lead to 100% severity on the class. We address the risks associated with such small subordinate classes by only rating classes that are sufficiently thick or that have a higher level of protection from the first dollar of loss, or both.
SIX LOANS STAND OUT
While each rating agency formed its credit opinion of the collateral pool using its own criteria, one of the agencies rating the transaction, Standard & Poor’s, appears to have assigned no credit enhancement at the low investment grade level to six loans ranging in size from $6.2 million to $125 million. Not a single one of these loans, based on our analysis, merits investment grade consideration, whether on a standalone or a diversified pool basis. While they do have below average leverage relative to the remainder of the pool, the Moody’s LTV for each of these loans is well into speculative grade. These loans, listed below, total $197.6 million and constitute 17% of the $1,136.6 million pool balance, sufficient in and of itself to lead to a credit enhancement deficiency of approximately 1% at Class E.
EXHIBIT 1
Loans Assigned No Credit Enhancement at Low IG by Standard and Poor’s
Loan Property Name Type
Loan Balance ($mm)
% of Pool
Moody’s LTV (%) City State
1 Battlefield Mall Retail 125.0 11.0 Low 80’s Springfield MO
16 Fairway Marketplace Retail 23.4 2.1 High 70’s Pasadena TX
17 Shops at Moore Retail 21.3 1.9 Mid 80’s Moore OK
25 Centre Point Com. Retail 14.4 1.3 High 80’s Bradenton FL
39 Chenal Commons Retail 7.3 0.6 Mid 70’s Little Rock AR
41 Forest Meadows Manuf. Housing
6.2 0.5 Mid 80’s Sandston VA
The five largest loans receiving no enhancement are secured by retail properties. The retail sector is undergoing significant transition, with store closings and re-sizings owing to factors including the rapid growth of online shopping. Their location in secondary or tertiary markets, combined with their generally high levels of tenant concentration and impending lease expirations, generate a high level of volatility of income and value and, in the event of default, a potentially high severity. With no investment grade credit enhancement for such loans, Class E bears the full risk of these loans defaulting.
In our approach, only a loan with a very low probability of default during its life is worthy of even the lowest investment grade assessment, which is not the case for any of the above-referenced loans. We rarely consider small loans on non-credit tenant, triple net leased properties to have sufficient market stature and recovery prospects to merit an investment grade rating. Smaller loans, particularly those with single tenants or secured by retail properties in secondary markets, demonstrated well-above-average loss severity in the recent downturn.
CREDIT IN DEPTH Detailed analysis of an important topic
16 MOODY’S CREDIT OUTLOOK 18 OCTOBER 2012
REFINANCE RISK IS UNDERESTIMATED
The recent use by some market participants and adoption by Standard & Poor’s of lower, more market-based cap rates is extraordinarily risky in this environment of historically low interest rates because doing so fails to fully recognize refinancing risk. Much of the credit risk in commercial real estate lending consists of the potential for default at loan maturity, and this risk is particularly acute right now. The risk of default during the term of the loan is relatively low for many new loans with today’s ultra-low loan coupons because property cash flows can easily cover debt service. However, refinance risk will increase substantially when interest rates revert to normalized levels. While current market capitalization rates are appropriate for analyzing the credit of a loan maturing in 10 days, they are not appropriate to analyze the risk of one maturing in 10 years.
APPENDIX I – JPMCC 2012-C8 SUMMARY OF CERTIFICATES EXHIBIT 2
Summary of Certificates*
Class Initial Class Certificate
Balance or Notional Amount Approx. Initial
Credit Support Expected Ratings
(S&P/Fitch/DBRS/KBRA)
A-1 $ 76,634,000 30.00% AAA(sf)/AAA(sf)/AAA(sf)/AAA(sf)
A-2 189,227,000 30.00% AAA(sf)/AAA(sf)/AAA(sf)/AAA(sf)
A-3 426,122,000 30.00% AAA(sf)/AAA(sf)/AAA(sf)/AAA(sf)
A-SB 103,623,000 30.00% AAA(sf)/AAA(sf)/AAA(sf)/AAA(sf)
X-A 897,898,000 N/A AAA(sf)/AAA(sf)/AAA(sf)/AAA(sf)
X-B 238,681,989 N/A NR/NR/AAA(sf)/AAA(sf)
A-S 102,292,000 21.00% AAA(sf)/AAA(sf)/AAA(sf)/AAA(sf)
B 56,829,000 16.00% AA(sf)/AA(sf)/AA(sf)/AA(sf)
C 44,043,000 12.13% A(sf)/A(sf)/A(sf)/A(sf)
EC 203,164,000 12.13% A(sf)/A(sf)/A(sf)/A(sf)
D 35,518,000 9.00% BBB+(sf)/BBB+(sf)/BBB (high)(sf)/BBB+(sf)
E 32,676,000 6.13% BBB-(sf)/BBB-(sf)/BBB (low)(sf)/BBB-(sf)
F 15,628,000 4.75% BB(sf)/BB(sf)/BB(sf)/BB(sf)
G 17,049,000 3.25% BB-(sf)/B(sf)/B(sf)/B(sf)
NR 36,938,989 0.00% NR/NR/NR/NR
*Source: Preliminary prospectus dated September 2012.
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17 MOODY’S CREDIT OUTLOOK 18 OCTOBER 2012
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