moodys debt ceiling downplayed oct. 6, 2013
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Moody's echoes the GOP party line on the Debt Ceiling. Acts like prioritizing payment of interest, over standard government services, is no big deal.TRANSCRIPT
MOODYS.COM
7 OCTOBER 2013
NEWS & ANALYSIS Corporates 2
» Merck's Research & Development-Focused Restructuring Is Credit Positive
» Abengoa Gains an Investor in Its Solar Power Plant, a Credit Positive
» Portugal Telecom and Oi Merger Will Reduce Leverage and Improve Cash Flow
» IOI’s Acquisition of Oil Palm Plantation Is Credit Negative
Infrastructure 8
» Dutch Regulator's Reduction to Energy Network Returns Is Credit Negative
» DONG Energy Will Get Credit Positive DKK11 Billion Equity Injection
» KEPCO Will Resume Transmission Tower Construction, a Credit Positive
Banks 13 » Wells Fargo Resolves Freddie Mac's Repurchase Demands, a
Well-Timed Credit Positive » Bank of America Merges Merrill Lynch Holding Company into
Its Own, a Credit Negative for Merrill Bondholders » US Banks Improve Efficiency by Growing Deposits While
Closing Branches » Iceland's Budget Includes Housing Financing Fund Capital
Injection » Vietnam Asset Management Company's First Asset Carve-Out
Is Credit Positive for Banks
Insurers 22 » Aviva Sells US Life and Annuities Business at Higher
Consideration than First Announced » China’s P&C Insurers Will Benefit from Shanghai Free Trade
Zone
Sovereigns 24
» Mongolian Parliament Approves New Investment Law, a Credit Positive
US Public Finance 25 » Maryland and Virginia Local Governments Are Exposed to
Federal Government Shutdown
CREDIT IN DEPTH United States Government 27
We answer frequently asked questions about the US government shutdown and debt limit: How does the government shutdown affect US creditworthiness? Will the government default after 17 October if the debt limit is not raised? What is the pattern of US interest payments after 17 October? Why are only interest payments potentially affected and not principal? Is the situation worse now than it was in 2011, the last time that the debt limit was an issue? Could the government take other steps to finance itself without increasing debt?
RATINGS & RESEARCH Rating Changes 32
Last week, we downgraded Petroleo Brasileiro, Endurance Specialty Holdings, MONY Life Insurance of America, Mony Life Insurance, Athens Greece, and Puerto Rico Sales Tax Financing Corp., and upgraded United Rental (North America), Power Sector Assets & Liabilities Management, Reliance Rail Finance, Sandy Creek Energy, BDO Unibank, Bank of the Philippine Islands, Land Bank of the Philippines, Metropolitan Bank & Trust, the Philippines, and Catholic Health East (Pennsylvania), among other rating actions.
Research Highlights 40
Last week, we published on BP, Japanese condominium developers, US healthcare, Peruvian fishing, US speculative-grade corporations, European chemical, European auto parts, US soft beverages, global technology hardware and software, Centrais Eletricas Brasileiras, the banking systems of Cyprus, Sweden and central Europe, Gulf Cooperative Council insurers, US monetary tightening, Asia-Pacific Economic Cooperation member sovereigns, the European Financial Stability Facility, a peer comparison of Nordic countries, African Development Bank, Azerbaijan, PTA Bank, Ireland, Kuwait, Egypt, US states, CLOs, Asian structured products, and Russian MBS, among other reports.
RECENTLY IN CREDIT OUTLOOK
» Articles in Last Thursday’s Credit Outlook 46 » Go to Last Thursday’s Credit Outlook
NEWS & ANALYSIS Credit implications of current events
2 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
Corporates
Merck’s Research & Development-Focused Restructuring Is Credit Positive Merck & Co. (guaranteed debt A1 stable) on Tuesday said it would cut 8,500 positions as part of a larger restructuring designed to produce $2.5 billion in annual cost savings by the end of 2015. These cuts, together with previously announced reductions, bring the decline in Merck’s total workforce to 20%. We estimate savings from the restructuring will boost Merck’s after-tax operating cash flow by some 15%, all other factors being equal, a credit positive.
The savings, which will first require pre-tax cash outlays of $1.7-$2.0 billion for severance and other costs, will come mostly from marketing and administrative expenses, which totaled $12.8 million in 2012, as well as research & development (R&D) expenses, which totaled $8.2 billion last year.
Merck also plans to increase its focus on 10 core geographic markets and on R&D candidates that show the most commercial promise. At the same time, it plans to out-license late-stage pipeline programs that are not aligned with its strategy.
Merck’s decision to undertake a major restructuring comes as both the company and the pharmaceutical industry face ongoing pricing pressure, particularly in Europe, and slower adoption of new products by patients and physicians. For example, Merck’s large Januvia/Janumet franchise, which accounted for 13% of 2013 sales through 30 June, has produced double-digit growth for several years running, but competing diabetes drugs and treatments now threaten the franchise’s growth.
Merck is also exposed to upcoming patent expirations, including through its partnership with AstraZeneca PLC (A2 stable) in the acid reflux drug Nexium, which provides $1.2 billion of revenue for Merck. Nexium’s patent expires in May 2014, but between 1 March and 30 April 2014, AstraZeneca has the option to buy Merck’s interest in the partnership.
Euro area regulators also recently approved a biosimilar version of Remicade, a biotechnology drug for rheumatoid arthritis and Crohn’s disease that Merck jointly markets with Johnson & Johnson (Aaa stable). Sales of Remicade will not be substantially affected, however, until February 2015 because of patent protection in most key markets. Even at that point, Remicade will face less sales erosion than traditional products.
Nonetheless, Merck will be challenged to grow its overall top line without significant new product launches. Delays in products like anesthesia-reversal drug sugammadex and osteoporosis drug odanacatib have also raised the importance of the newer products advancing through the company’s pipeline, such as the anti-PD-1 cancer program and the BACE inhibitor for Azheimer’s disease. Positive clinical data from these programs will improve the likelihood that Merck will be able to sustain its positive top-line growth.
Michael Levesque, CFA Senior Vice President +1.212.553.4093 [email protected]
NEWS & ANALYSIS Credit implications of current events
3 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
Abengoa Gains an Investor in Its Solar Power Plant, a Credit Positive On 2 October, Abengoa S.A. (B2 stable), a vertically integrated environmental and energy group, announced that media conglomerate Liberty Interactive LLC (Ba3 stable) will invest $300 million in its concentrating solar power plant, Solana, located in Arizona. The investment reduces Abengoa’s equity investment in Solana and frees up capital to trim debt, a credit positive for the Spain-based company.
The transaction increases our confidence that Abengoa is sticking to its recently announced goal of reducing reported net corporate leverage (excluding concession activities) to around 3.0x for 2013 and 2.5x beginning in 2014, from 3.2x at 30 June 2013, by disposing of €1.5 billion of assets. The company also says it will cap its equity investments in new projects and maintain corporate capex below €450 million starting in 2014, which would support positive corporate free cash flow generation in 2014.
Pro forma of the transaction, reported net corporate leverage will likely decline modestly to around 3.0x debt/EBITDA, based on June’s last-12-months corporate EBITDA of €753 million. We expect that Abengoa’s consolidated free cash flow (including concession activities) will remain negative throughout this year (it was negative €770 million in the first half), although it is materially better than the negative €3.4 billion free cash flow in 2012. We expect balanced corporate free cash flow generation in 2013 on a reported basis, which is defined as EBITDA minus corporate capex.
Abengoa’s credit metrics are currently at the low end of the range for a B2 rating. A more solid rating positioning requires further evidence that Abengoa can achieve its targeted debt reduction and will not use asset-disposal proceeds to fund future growth of its concession portfolio. Abengoa’s rating will also reflect our assessment of the company’s balance of mature and profitable assets versus new investments after major asset disposals.
Abengoa’s leverage is high both on a corporate and consolidated basis, including the concession activities (consolidated adjusted net debt/EBITDA was 8.0x, reported gross corporate debt/EBITDA, 6.8x and reported net corporate debt/EBITDA, 3.2x, at 30 June). The Solana project was consolidated through the equity method in June 2013 after adoption of International Financial Reporting Standards 10. Related non-recourse debt will likely be re-consolidated in the coming quarters as Solana begins operations. We assume that Abengoa can reduce consolidated adjusted net debt/EBITDA to below 8.0x in the next 6-12 months.
Abengoa will maintain a controlling interest in Solana and responsibility for the plant’s operation and management. The total investment in Solana amounts to around $2 billion, and the US Department of Energy and the Federal Energy Regulatory Commission have provided financial guarantees of around $1.5 billion.
Abengoa’s increased focus on debt reduction is also necessary in light of its syndicated loan financial covenant, which tightens its net corporate debt/EBITDA to 2.5x from 31 December 2014 from 3.0x presently. In addition, the high leverage has resulted in increased vulnerability to a deterioration in operating performance and cash flow generation at any of its major divisions. A continuous need to refinance debt maturities also exposes Abengoa to risks regarding the markets’ ability to absorb these requirements.
Kathrin Heitmann Assistant Vice President - Analyst +49.69.70730.789 [email protected]
NEWS & ANALYSIS Credit implications of current events
4 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
Portugal Telecom and Oi Merger Will Reduce Leverage and Improve Cash Flow Last Wednesday, Portugal Telecom SGPS, S.A. (PT, Ba2 review for upgrade) and Brazilian telecom group Oi S.A. (Baa3 negative) announced they will merge into a single Brazilian incorporated entity. The merger is credit positive for both companies, although more positive for PT than Oi, because the resulting entity will be financially stronger. A simpler organizational structure at Oi will allow for improved corporate governance and lower dividend payments, while PT bondholders will have less exposure to Portugal’s sovereign and macroeconomic risks.
The combined group will benefit from an expected capital increase of BRL7-BRL8 billion (€2.3--€2.6 billion, or $3.2-$3.6 billion), of which BRL2 billion is committed so far, which will reduce debt at Oi’s current holding company and its operating company. PT will contribute its assets to the combined company and in exchange PT shareholders will get up to a 38% equity stake in the new combined entity.
We estimate that the pro forma total adjusted debt/EBITDA of the combined group will be around 4.0x, compared with 4.4x for Oi for the 12 months ended 30 June and 5.7x for PT at the end of 2012 (see exhibit). Our estimate assumes annualized synergies of BRL400 million that will largely come from tax and procurement savings, and that the company will maintain a cash balance of BRL4.0 billion and repay debt with excess cash plus BRL2.5 billion of the capital increase.
Oi-Portugal Telecom Merger Pro Forma Key Financial Metrics
Oi S.A. BRL Millions
PT Group Excluding Brazil
BRL Millions Adjustments BRL Millions
Combined Group BRL Millions
Revenues BRL28,548 BRL9,255
BRL37,803
Adjusted EBITDA 10,331 3,903 400 14,634
EBITDA Margin 36.2% 42.2%
38.7%
Total Adjusted Debt 45,679 22,125 -9,552 58,252
Cash + Cash Equivalent 2,943 7,848
10,791
Net Adjusted Debt 42,736 14,277
47,461
Total Adjusted Debt/EBITDA 4.4x 5.7x
4.0x
Net Adjusted Debt / EBITDA 4.1x 3.7x
3.2x
Note: Financials as of last 12 months to 30 June for Oi and 2012 for PT Group.
Source: Moody’s
The combined company will also benefit from increased size, scale and geographic diversification, although we consider Portugal and Africa to be higher-risk markets than Brazil. The merger offers tax benefits and some operating efficiencies, and with planned cost reductions, the combined entity should be in a better position to offset a decline in revenues at its fixed-line telephony business.
PT successfully turned around its fixed-line business in Portugal, and its experience with fiber and 4G deployment and cutting costs to offset revenue pressures should help Oi produce higher revenues, cash generation and margins in Brazil. The challenge will be to generate enough growth in Brazil to offset the decline we expect in revenue and EBITDA in Portugal during the next few years.
Low penetration of telecom services in Brazil offers a good growth opportunity. Oi has 18.5 million residential customers, most of whom are still using traditional fixed-line telephony services. As in the rest of Latin America, penetration of broadband Internet and pay-TV services is low in Brazil, and thus the
Carlos Winzer Senior Vice President +34.91.768.8238 [email protected]
Soummo Mukherjee Vice President - Senior Credit Officer +55.11.3043.7341 [email protected]
NEWS & ANALYSIS Credit implications of current events
5 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
combined entity has significant cross-selling opportunities to increase the number of services per client and generate higher revenue and EBITDA growth. However, Brazil remains a very competitive market.
The deal will also put the merged entity in a better position to generate positive free cash flow after 2015, in part because of a change in the shareholder remuneration strategy. Oi’s high dividend payout to service debt at its holding companies has been a key credit weakness, given the company’s already high leverage for the Baa3 rating category and its material negative free cash flow. With the plan to use about BRL4.5 billion of the deal’s minimum BRL7.0 billion cash capital increase to fully repay current debt at Oi’s pure holding company, Telemar, and two other Telemar holding companies, AG Telecom and LF Tel, all but about BRL500 million of Oi’s dividend commitments would be eliminated.
NEWS & ANALYSIS Credit implications of current events
6 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
IOI’s Acquisition of Oil Palm Plantation Is Credit Negative Last Wednesday, IOI Corporation Berhad (IOI, Baa2 stable) announced that its wholly owned subsidiary, IOI Plantation Sendirian Berhad (unrated), had acquired a 39.55% stake in Unico-Desa Plantations Berhad (Unico, unrated) for MYR396.63 million ($124 million) and is making a mandatory takeover offer for the remaining shares of Unico at the same offer price of MYR1.17 per Unico share (i.e., MYR606.2 million, or $189 million) for the remaining 60.45% stake.
The cash acquisition will diminish IOI’s existing cash positions, a credit negative. The total acquisition cost, including the remaining 60.45% stake, is approximately MYR1 billion ($313 million), plus net debt of MYR15 million ($5 million). IOI reported MYR2.9 billion of cash and cash equivalents at the end of June, although it will receive about MYR1.6 billion from the proposed demerger of its property businesses later this year.
The cash consideration for the Unico acquisition will likely push IOI’s net debt/EBITDA ratio beyond our downward rating trigger of 1.5x by the end of the fiscal year ending June 2014 after deconsolidating the EBITDA of its property business. We previously expected IOI to maintain its net debt/EBITDA ratio at around 1.0x-1.5x after the property spinoff and in particular, to keep higher levels of cash on hand in the run-up to the redemption of its $500 million (MYR1.6 billion) US dollar-denominated notes in March 2015.
The exhibit below shows IOI’s pro-forma credit metrics for the fiscal year ended June 2013 for two scenarios – a 39.55% acquisition of Unico or a 100% acquisition of Unico – and the rising net debt/EBITDA ratios after the proposed acquisition.
IOI Corporation Berhad’s Pro Forma Results from Unico Acquisition, MYR Millions
FY2013 (excluding property
segments) FY2013 Pro Forma After 39.55% Acquisition of Unico (minimum)
FY2013 Pro Forma After 100% Acquisition of Unico (maximum)
Revenue MYR12,199 MYR12,199 MYR12,366
Cash and Cash Equivalents 4,599 4,202 3,619
Total Debt 7,399 7,399 7,452
EBITDA 1,796 1,796 1,844
Interest Expense 282 282 284
Debt/EBITDA 4.1x 4.1x 4.0x
Net Debt/EBITDA 1.6x 1.8x 2.1x
EBITDA Interest 6.4x 6.4x 6.5x
Sources: Moody’s Financial Metrics, Moody’s estimates
We view IOI’s large cash balance as a key rating driver following the disposal of its property businesses, because IOI will keep the majority of the existing group debt. However it will be operating with a smaller income and asset base consisting solely of its plantation operations, resulting in higher gross debt leverage of 4.1x in fiscal 2013 (versus 3.5x in fiscal 2012) and weaker EBITDA interest coverage of 6.4x (versus 13.8x in fiscal 2012) after reclassifying the property segments as discontinued operations.
The company is also left with reduced business diversity and is wholly exposed to the cyclicality of crude palm oil (CPO) prices. Furthermore, the proposed purchase price for Unico works out to about
Dylan Yeo Associate Analyst +65.6398.8317 [email protected]
Alan Greene Vice President - Senior Credit Officer +65.6398.8318 [email protected]
NEWS & ANALYSIS Credit implications of current events
7 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
MYR79,000 per hectare (ha), which equates to approximately seven years’ worth of sales at a CPO price of $700 per tonne.
Unico’s 12,700 ha of oil palm plantations in Sabah, East Malaysia, will expand IOI’s plantation operations and provides synergies given the land’s proximity to existing IOI estates. IOI reported 161,754 ha of planted area at the end of June, of which 102,354 ha are oil palm plantations in East Malaysia.
Yields achieved at Unico’s plantations are already close to the levels of IOI’s plantations, leaving little scope for IOI’s management team to extract better results. Unico reported fresh fruit bunch (FFB) yield of 23.80 tonnes per ha and a CPO extraction rate of 20.33% for the fiscal year ended March 2013, compared to IOI’s FFB yield of 24.46 tonnes per ha and CPO extraction rate of 20.84% for fiscal year ended June 2013.
IOI’s plantations are aging, with a large proportion of prime and past prime trees, and the age profile will not improve materially after the acquisition because it adds less than 8% to IOI’s existing planted oil palm area. Consequently, IOI’s plantation output remains well below its CPO refining capacity and the company will continue to need significant amounts of bought-in CPO to feed its downstream activities.
NEWS & ANALYSIS Credit implications of current events
8 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
Infrastructure
Dutch Regulator’s Reduction to Energy Network Returns Is Credit Negative Last Wednesday, the Dutch energy regulator, the Authority for Consumers and Markets (ACM), announced it would reduce the allowed weighted average cost of capital (WACC) for network companies in the 2014-16 price control period to 3.6% in real terms, from 5.8%-6.2% currently. The ACM also introduced annual cost reduction targets of 2%-3% for transmission networks and 5%-7% for distribution networks.
These changes are credit negative for TenneT Holding B.V. (A3 stable), N.V. Nederlandse Gasunie (Gasunie, A2 stable), Alliander N.V. (Aa3 stable) and Enexis Holding N.V. (Aa3 stable) because lower allowed returns and more stringent efficiency targets will negatively affect revenues. However, the reduction in the allowed return will be applied on a glide path over three years, which will limit the immediate effect.
The changes will have the most significant effect on Alliander and Enexis owing to their regional concentration. Gasunie and TenneT each have operations in Germany, which reduce their exposure to the Dutch regulator’s action.
Once fully implemented, Alliander’s and Enexis’ allowed revenue will decline by 7%-10% under the new regime. In the absence of mitigating factors, funds from operations (FFO) would fall by a greater proportion at each company because the changes largely feed through to bottom-line earnings. We estimate Gasunie’s revenues will fall by around 5% per year, compared with 2012 revenues. Gasunie’s cash flows in 2012 and 2013 were subject to a one-off repayment obligation of previously collected charges, so the cash flow and revenue effect of the Dutch regulator’s action will be cushioned by that repayment obligation falling away in 2014. We expect TenneT’s revenues to decline by around 2% on average per year because of disproportionate growth in its German networks business.
ACM determines the allowed WACC by making assumptions on debt and equity costs. The reduction primarily reflects a decline in its cost of debt assumptions to 3.85% in response to falling market interest rates. Alliander and Enexis reported an embedded cost of debt of 4.32% in 2012, but both companies will benefit from their latest refinancing coupon rates of 2.25% and 1.875%, respectively. At December 2012, Gasunie’s weighted average interest cost was 4.3%, and TenneT’s was 4.1%.
However, following Gasunie’s upcoming repayment of the outstanding €1.1 billion 6% notes due this month, its cost of debt will be more in line with regulatory assumptions.
Although the tougher regulated return environment will materially reduce credit ratios until 2016, the companies’ ratings will be unaffected because we expect the ratios to be in line with our guidance for their rating categories. Nevertheless, the companies will need to implement financing and operating cost savings to mitigate the effect of the new measures.
Stefanie Voelz Assistant Vice President - Analyst +44.20.7772.5555 [email protected]
Nicholas Stevens Analyst +44.20.7772.1426 [email protected]
NEWS & ANALYSIS Credit implications of current events
9 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
DONG Energy Will Get Credit Positive DKK11 Billion Equity Injection Last Wednesday, Denmark’s DONG Energy A/S (Baa1 stable) announced that three financial institutions are poised to inject equity of DKK11 billion (€1.47 billion) into the utility before year-end. The injection is credit positive because the capital increase will reduce year-end net debt and fund a significant proportion of DONG Energy’s planned exploration & production and offshore wind investments, which would otherwise have been funded by new debt.
The proposed deal is part of DONG Energy’s financial action plan, announced in February, which included an injection of additional equity of at least DKK6-DKK8 billion. The equity injection is conditional upon the parties reaching final agreement and the investors completing due diligence, as well as shareholders’ and political and regulatory bodies’ approvals.
The equity increase will dilute the Government of Denmark’s (Aaa stable) current 80% ownership of DONG Energy to about 60%. We do not expect this to lead to a significant deterioration in DONG Energy’s government support given the government’s still sizeable stake and its generally non-interventionist attitude. The existing cross-party agreement requires the government to remain the majority shareholder in DONG Energy.
DONG Energy’s net debt at June 2013 was DKK41.7 billion (€5.6 billion) and we expect it to decline to about DKK30.0 billion (€4.0 billion) as a result of the equity injection. We expect that the equity injection will positively affect DONG Energy’s credit metrics, and will ensure that the company’s metrics will remain well within the rating guidance for its Baa1 rating for the full year to December 2013. Based on adjusted first-half 2013 numbers, the equity injection will improve the company’s key credit metrics by about one third, with funds from operations/net debt for the 12 months to first-half 2013 lifted to 20.2% from 14.9%, as shown in the exhibit. However we expect year-end metrics to be considerably stronger, based on the company’s performance so far in 2013.
DONG Energy Pro Forma Credit Profile Before and After Equity Injection
Pre-Equity Injection DKK Billions
Post Equity Injection DKK Billions
First Half 2013 Adjusted debt 55.99 55.99
First Half 2013 Cash 14.31 25.31
First Half 2013 Net Debt 41.68 30.68
First Half 2013 EBITDA 6.566
First Half 2013 Funds from Operations 6.203
First Half 2013 Retained Cash Flow 5.879
Net Debt/EBITDA 6.3x 4.6x
Funds from Operations/Net Debt 14.9% 20.2%
Retained Cash Flow/Net debt 14% 19%
What could change the rating up RCF/Net Debt greater than 25%
FFO/Net Debt greater than 30%
What could change the rating down RCF/Net Debt less than 15%
FFO/Net Debt less than 20%
Sources: Company reports, Moody’s estimates
Paul Lund Vice President - Senior Credit Officer +44.20.7772.1955 [email protected]
NEWS & ANALYSIS Credit implications of current events
10 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
We anticipate that DONG Energy will maintain its investment programme, and will not accelerate it as a result of the equity injection. DONG forecasts its net capital expenditure at DKK30 billion (€4.0 billion) for 2013-14: the equity injection should mean that DONG Energy will not have to raise additional debt until the end of 2014.
The equity investors are Goldman Sachs (DKK8 billion, €1.05 billion), and Danish pension funds Arbejdmarkedets Tillǽgspension (ATP - DKK2.2 billion, €295 million) and PFA Pension Forsikringsaktieselskab (DKK800 million, €105 million). Goldman Sachs will own 19% of DONG Energy, while ATP and PFA will own 5% and 2%, respectively. The investors will have the option to sell their stakes through an IPO up until the release of DONG Energy’s 2017 financial statements, at which point the stakes can be put back to the government.
NEWS & ANALYSIS Credit implications of current events
11 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
KEPCO Will Resume Transmission Tower Construction, a Credit Positive Last Wednesday, Korea Electric Power Corporation (KEPCO, A1 stable) said it will resume construction of its 765,000-volt (kV) high-voltage transmission towers in Miryang in southeastern Korea, a credit-positive development. The towers, once completed, will allow KEPCO to transmit electricity from its two new nuclear reactors, Shin-Kori 3 and 4, which will subsequently boost the company’s cash flow and related credit metrics.
KEPCO halted construction of the 52 transmission towers in May amid protests from local residents concerned about the towers’ environmental and health effects and KEPCO’s compensation to them for the towers’ negative effect on property values. The company had to obtain consensus from the residents amid the protests, despite KEPCO’s previous completion of all necessary administrative and legal procedures.
KEPCO has already completed construction of 109 of the total 161 transmission towers, which will connect the reactors to a substation 90.5 kilometers away. The reactors have a combined capacity of 2,800 megawatts (MW), equaling around 4% of KEPCO’s total generating capacity as of 30 June. Supplying nuclear power to its customers is far less expensive than supplying electricity produced by other fuel sources, such as oil and liquefied natural gas (LNG).
KEPCO’s own power generation costs and its costs for the power purchased from independent power producers have been significantly lower for nuclear power than for power generated by LNG or oil over the past five years, as shown in the exhibit.
KEPCO’s Historical Costs of Purchased Power by Fuel Sources
Source: KEPCO
We estimate that one operating Shin-Kori reactor will increase KEPCO’s funds from operations (FFO) by KRW1 trillion to KRW1.2 trillion annually, which reflects our assumption that the generation volume from the nuclear reactors will replace the volume generated from more expensive fuel sources.
Over the next two to three years, we expect KEPCO’s FFO/debt will exceed 10% versus 8% currently and FFO/interest will increase to around 3.0x from 2.6x because of the commercial operations of the nuclear reactors and other base-load power plants, as well as a 4% tariff hike in January and a 4.9% hike in August 2012.
Commercial operation of the high-voltage transmission towers positions KEPCO to achieve high operating efficiency in power transmission from the new nuclear power plants and other plants adjacent to Korea’s
0
50
100
150
200
250
2008 2009 2010 2011 2012 1H2013
KRW
per
KW
h
Nuclear Liquefied Natural Gas Oil
Mic Kang Vice President - Senior Analyst +852.3758.1373 [email protected]
Jae Woo Lee Associate Analyst +852.3758.1530 [email protected]
NEWS & ANALYSIS Credit implications of current events
12 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
major metropolitan areas. The transmission towers currently under construction are designed to reduce power losses that result from long-distance transmission, compared to low-voltage transmission towers.
Resuming construction also reflects the government of Korea’s (Aa3 stable) strong support in resolving conflicts when KEPCO faces resistance to expanding its power capacity to address the country’s tight power supply. The government worked closely with KEPCO to help the company complete the necessary administrative procedures and to reduce opposition to the transmission towers’ construction.
Based on the government’s Sixth Basic Plan of Long-Term Electricity Supply & Demand, the government aims to achieve a reserve margin of 21% by 2015 and 30% by 2021. The current margin, which reflects the country’s percentage of generating capacity above peak demand, is less than 5%.
NEWS & ANALYSIS Credit implications of current events
13 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
Banks
Wells Fargo Resolves Freddie Mac’s Repurchase Demands, a Well-Timed Credit Positive Last Monday, Wells Fargo & Company (A2 review for downgrade) announced it had reached an agreement with Freddie Mac to resolve substantially all of its repurchase liabilities related to loans sold to the government-sponsored enterprise before 2009. The agreement is credit positive for Wells Fargo because it reduces tail risk and positions the bank to stop building its mortgage repurchase reserves at a time of declining mortgage origination revenue.1 Although the agreement results in a $780 million cash payment to Freddie Mac, Wells Fargo had fully accrued for it at 30 June.
The exhibit below highlights how the resolution comes at an opportune time. The middle line shows the recent trend in Wells Fargo’s “net gains on mortgage loan origination/sales activities,” as reported in its income statement. This is its largest source of noninterest income, accounting for as much as 25% of total fee revenue in recent periods. We can split this line item into two parts: revenue from the origination and sale of mortgages (the top line) minus mortgage repurchase provisions owing to changes in estimate and driven by factors such as credit performance and investor demand, a contra-revenue item (the bottom line).2
Decline In Wells Fargo’s Repurchase Provisions Comes at an Opportune Time
Source: Wells Fargo earnings releases
The data indicate that the drop in Wells Fargo’s quarterly repurchase provisions has been significant. Provisions resulting from changes in estimate fell to $25 million in the second quarter of this year from nearly $600 million a year earlier, and have tempered the decline in Wells Fargo’s reported revenue from mortgage loan origination and sales activities (the middle line).
Wells Fargo’s recent agreement effectively eliminates the need for additional repurchase provisions for loans sold to Freddie Mac before 2009. Moreover, recent housing market improvements, which support residential real estate credit quality, also suggest a continued low level of repurchase provisions and a declining repurchase reserve. That would mirror the declining trend in Wells Fargo’s loan-loss reserves. For
1 See US Banks Expect Lower Mortgage Revenue in the Third Quarter, 16 September 2013. 2 Wells Fargo’s quarterly mortgage repurchase provision also includes the provision expense related to each period’s loan sales. This
was not stripped out of the exhibit’s top line since it will continue.
$0.0
$0.5
$1.0
$1.5
$2.0
$2.5
$3.0
$3.5
1Q12 2Q12 3Q12 4Q12 1Q13 2Q13
$ Bi
llion
s
Net Gains on Mortgage Loan Origination/Sales Activities Mortgage Repurchase Provision Due to Change in Estimate
Gross Mortgage Loan Origination/Sales Activities Revenue
Allen Tischler Senior Vice President +1.212.553.4541 [email protected]
NEWS & ANALYSIS Credit implications of current events
14 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
example, Wells Fargo released $500 million of loan-loss reserves in the second quarter and has provided guidance that its third-quarter reserve release will be larger. In our view, rebounding housing markets explain much of the reserve release.
Notwithstanding the Freddie Mac agreement, Wells Fargo has not yet reached a similar arrangement with Fannie Mae, leaving open the possibility of additional mortgage repurchase expense. However, a similar agreement with Fannie Mae, particularly if the associated cost has already been accrued, as it was for Freddie Mac, would likewise be credit positive.
Freddie Mac reached similar agreements with other US banks to resolve repurchase claims recently, similarly reducing those banks’ future exposure. On 25 September, Citigroup, Inc. (Baa2 review direction uncertain) agreed to pay $395 million to resolve potential repurchase claims for almost all loans sold to Freddie Mac between 2000 and 2012. Like Wells Fargo, the payment was fully covered by Citigroup’s existing repurchase reserve. On 1 October, SunTrust Banks, Inc. (Baa1 stable) announced a $65 million agreement covering loans funded by Freddie Mac between 2000 and 2008. Unlike Wells Fargo and Citigroup, SunTrust’s existing reserve was not wholly adequate and it will record an incremental $15 million mortgage provision expense for the settlement in the third quarter.
NEWS & ANALYSIS Credit implications of current events
15 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
Bank of America Merges Merrill Lynch’s Holding Company into Its Own, a Credit Negative for Merrill Bondholders Last Tuesday, Merrill Lynch & Co., Inc. (ML&Co, Baa2 review direction uncertain) merged into Bank of America Corporation (BAC, Baa2 review direction uncertain). The transaction merged an intermediate-tier holding company into the group’s top-tier bank holding company, but did not affect any of Merrill Lynch’s operating subsidiaries.
The merger is credit negative for existing ML&Co bondholders since it puts those creditors, whose bonds are now a direct obligation of BAC, at greater risk of loss in the event that the US government were to utilize single point of entry receivership (SER) as a means of resolving BAC. As a large and systemically important financial institution (SIFI), BAC would likely be a candidate for resolution under SER if it was facing significant financial difficulties.
BAC acquired Merrill Lynch in January 2009, and although many of the activities and subsidiaries of Merrill Lynch have been combined with similar operations and subsidiaries of BAC, ML&Co remained a separate legal entity until now, serving as an intermediate-tier holding company over BAC’s principal broker/dealer subsidiary, Merrill Lynch Pierce Fenner & Smith. The exhibit below shows the organizational structure both before and after the merger, in simplified form.
Bank of America Corporation: Select Major Subsidiaries, Before and After Merger
Sources: Company reports, Moody’s
Were BAC to be in danger of failing, the Federal Deposit Insurance Corporation (FDIC) has the authority under certain conditions to resolve the group outside of bankruptcy. SER is the FDIC’s preferred framework for implementing this authority, known as orderly liquidation authority (OLA). Under SER, the FDIC would seize a SIFI’s top-tier holding company, and after imposing any necessary writedowns, would transfer ownership of the SIFI’s systemically important operating subsidiaries to a new bridge holding company and haircut or “bail-in” creditors of the old holding company, giving them debt and shares in the new company. The intent is to mitigate contagion risks by maintaining the operations of systemically important subsidiaries under a recapitalized bridge holding company without the use of taxpayer funds.
As of 30 June 2013 As of 1 October 2013
FIA Card Services, NA
Other Merrill Lynch
Subsidiaries
Merrill Lynch & Co., Inc.
NB Holdings Corporation
Bank of America, NA
FIA Card Services, NA
Merrill Lynch Pierce Fenner &
Smith Inc.
BAC North America Holding
Company
BANA Holding Corporation
BANA Holding Corporation
Bank of America, NA
Bank of America Corporation
Bank of America Corporation
NB Holdings Corporation
Other Merrill Lynch
Subsidiaries
Merrill Lynch Pierce Fenner &
Smith Inc.
BAC North America Holding
Company
David Fanger Senior Vice President +1.212.553.4342 [email protected]
NEWS & ANALYSIS Credit implications of current events
16 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
While hurdles remain to successfully implementing OLA and SER, both the FDIC and Federal Reserve are working to overcome them. The Federal Reserve has indicated it will soon propose that the largest systemically important US banking groups be required to maintain a certain level of debt at the top-tier holding company, which could be “bailed-in” under SER if needed. We expect that BAC will be subject to this requirement.
With the merger of ML&Co into BAC, $61 billion in long-term debt issued by ML&Co is now BAC’s direct obligation. As such, this debt will likely be eligible to help BAC meet the Fed’s debt requirement, whereas it might not have been eligible as debt of an intermediate-tier holding company. While the merger reduces the costs BAC might otherwise have incurred to meet the holding company debt requirement, and also helps reduce costs by further streamlining BAC’s corporate structure, the merger is credit negative for existing ML&Co bondholders since it puts those creditors at greater risk of loss in the event that the FDIC utilizes SER as a means of resolving BAC.
NEWS & ANALYSIS Credit implications of current events
17 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
US Banks Improve Efficiency by Growing Deposits While Closing Branches Last Monday, the Federal Deposit Insurance Corporation (FDIC) released its annual summary of deposit data, which showed that deposits at US banks grew 5.4% in the 12 months ended 30 June, while the number of bank branches in the US declined by 1%. Notably, three of the largest banks, Citigroup Inc. (Baa2 review direction uncertain), JPMorgan Chase & Co. (A2 review for downgrade) and Wells Fargo & Company (A2 review for downgrade), grew deposits most significantly. Citigroup obtained this growth despite branch reductions. Wells Fargo grew deposits while keeping branch numbers relatively steady and JPMorgan Chase experienced both deposit and branch growth.
These trends are credit positive because US banks were able to increase deposits while they closed branches. Many banks have responded to current profitability pressures by cutting costs, including through branch network rationalization. The savings from shuttering branches, along with more efficient deposit gathering, supports bank profitability.
After a long period of branch expansion, US banks began closing branches in 2010. During the global financial crisis, bank failures spiked and many of the surviving institutions consolidated branches or scaled back their expansion plans to reduce expenses. The current low interest rate environment has undermined the value of non-interest-bearing deposits and other cheap bank deposits and has caused banks’ net interest margins to fall over the past two years. Technological advancements such as mobile and online banking have also allowed banks to serve customers outside their traditional branch networks.
The exhibit below shows branch growth (the x-axis) and deposit growth (the y-axis) for the traditional domestic US banks with assets of more than $50 billion. The size of the bubble captures the absolute change in the dollar amount of each bank’s total deposits. The banks to the left of the bold 45 degree line had a positive relationship between deposit growth and branch growth during the 12 months to 30 June, meaning the pace of deposit growth exceeded their branch growth. Many of the banks to the left of the line were able to grow deposits while closing branches. For the few banks to the right of the line there was a negative relationship between deposit growth and branch growth during the same period, meaning the pace of branch growth exceeded deposit growth.
Megan Snyder Associate Analyst +1.212.553.4986 [email protected]
NEWS & ANALYSIS Credit implications of current events
18 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
Deposit and Branch Growth of US Banks with Assets of at Least $50 Billion
Note: The size of the sphere indicates the absolute dollar amount of deposit growth. For example, JPMorgan Chase grew deposits by $87 billion and Capital One lost $4 billion of deposits. BAC = Bank of America Corporation; BBT = BB&T Corporation; COF = Capital One Financial Corporation; C = Citigroup Inc.; CMA = Comerica Incorporated; FITB = Fifth Third Bancorp; HBAN = Huntington Bancshares Incorporated; JPM = JPMorgan Chase & Co; KEY= KeyCorp; MTB = M&T Bank Corporation; PNC = PNC Financial Services Group; RF = Regions Financial Corporation; STI = SunTrust Banks, Inc.; USB = US Bancorp; WFC = Wells Fargo & Company; ZION = Zions Bancorporation Source: FDIC
Among the three institutions in negative territory, BB&T Corporation (A2 negative) is one of the few large US banks pursuing a new branch expansion strategy. Last November, the bank announced it would open 30 bank branches in Texas, 26 of which it had opened by 30 June. As is the case with expansions, it will take time for BB&T’s new branches to generate notable deposit growth. Huntington Bancshares Incorporated (Baa1 stable) is also pursuing branch expansion, but its strategy consists of closing more expensive traditional bank branches and opening new in-store branches, which typically have lower overhead costs, but also fewer deposits.
BAC
JPMWFC
STICOF
PNC
ZION
C
CMA
RF
KEY
USBFITB
MTBBBT
HBAN
-15%
-10%
-5%
0%
5%
10%
15%
-15% -10% -5% 0% 5% 10% 15%
Change in Branches
Branch Growth Greater Than Deposit Growth
Chan
ge in
Dep
osits
Deposit Growth Greater Than Branch Growth
NEWS & ANALYSIS Credit implications of current events
19 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
Iceland’s Budget Includes Housing Financing Fund Capital Injection On Tuesday, in its 2014 draft budget, the government of Iceland (Baa3 stable) announced a planned ISK4.5 billion ($37.3 million) capital injection into government-controlled mortgage lender Housing Financing Fund (HFF, Ba1 stable). Including an explicit sum for the HFF capital injection in the draft budget lends certainty to future capital support, and based on June 2013 numbers, will bring the capital ratio to 3.5% from 2.5%, a credit positive.
Since 2009, HFF has generated ISK47.6 billion of net losses on the back of ISK46.3 billion of impairments and declining pre-provision profitability.3 Coinciding with 2010 and 2012 year-end results, the Icelandic government has provided a total of ISK46 billion in capital to HFF, as shown in the exhibit below. Despite those contributions, HFF has not reached its target capital ratio of 5%, owing to operating losses. Likewise, the ISK4.5 billion allocated amount will only stabilise the capital ratio and not increase it to the targeted 5%. The low capitalisation results from a continued high level of problem loans.4
Iceland’s Housing Financing Fund’s Capital and Problem Loans
Sources: Housing Financing Fund interim and annual reports
As part of the draft budget, HFF will also receive ISK441 million in compensation for providing mortgages below market interest rates. The lender has previously received a similar level of compensation for its social role as a government-controlled mortgage lender. The sum will be booked in year-end 2013 results as part of interest income.
The draft budget includes an expectation that the government will need to provide ISK4.5 billion in capital injections annually to HFF in future years to cover expected losses and keep the capital ratio stable. Previous draft budgets have not included explicit forecasts of capital contributions.
In December, the Icelandic government is scheduled to confirm and pass the final budget for the year, and the final version may have changes. We anticipate that the ISK4.5 billion capital injection will be provided at the beginning of 2014, and expect it to be booked in year-end 2013 results.
3 See Iceland’s Working Group Proposals May Have Negative Credit Implications for New Borrowing by HFF, 25 April 2013 and
Landsvirkjun and the Housing Financing Fund: A Comparison of Icelandic Government-Guaranteed Entities, 2 April 2013. 4 Problem loans are defined as loans in payment suspension or default. Data prior to 2010 is not available on the same basis.
ISK33 Billion Capital Injection
ISK13 Billion Capital Injection
0%
3%
6%
9%
12%
15%
18%
0%
1%
2%
3%
4%
5%
6%
Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13
Total Capital Ratio - left axis Target Minimum Ratio - left axis Problem Loans/Gross Loans - right axis
Kim Bergoe Vice President - Senior Credit Officer +44.20.7772.1659 [email protected]
Daniel Forssén Associate Analyst +44.20.7772.1553 [email protected]
NEWS & ANALYSIS Credit implications of current events
20 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
Vietnam Asset Management Company’s First Asset Carve-Out Is Credit Positive for Banks On 1 October, Vietnam Asset Management Company (VAMC, unrated) agreed to take over VND2.53 trillion ($120 million) of nonperforming loans (NPLs) from Vietnam Bank for Agriculture and Rural Development (Agribank, unrated), a state-owned bank and the country’s largest lender. VAMC’s first action since its establishment in July is credit positive for Vietnam’s banks, especially the weakest institutions, which need liquidity.
The transaction provides a clear example of how the VAMC will carry out its government-mandated mission of helping to clean up the banking system’s NPLs and allays speculation about VAMC’s efficacy in providing liquidity. We expect more banks to follow Agribank’s lead in offloading problem loans from the balance sheet and obtaining additional liquidity to support growth.
However, these transactions will not help recapitalize banks because no capital is transferred to the bank in return for the assets. Therefore, VAMC falls short of addressing the most fundamental problem in Vietnam’s banking system: undercapitalized balance sheets from rising NPLs.
How VMAC Functions. Participating banks transfer their problem loans to VAMC in return for a loan from the central bank.5 Banks that transfer NPLs to VAMC will be issued a bond that can only be used as repo collateral with the central bank. Unlike an ordinary bond, there are no interest or principal cash flows associated with the VAMC bond. And because the amount of the bond amortizes 20% per year, it has no value after five years. The central bank will lend the participating bank 70% of the declining amount of the VAMC bond.
Benefiting the Weakest Banks. Unless the VAMC is enhanced to allow for real asset purchases that transfer permanent capital against NPLs, the scheme will only be materially positive for the system’s weakest banks, which face both liquidity and capital tightening. In contrast, most banks we rate are substantially undercapitalized but still flush with liquidity, with their loan-to-deposit ratio at 93% at the end of 2012, an improvement from 99% at the end of 2011.
The current slowdown in growth and rising asset-quality problems have raised counterparty risk in the system. This risk is material as, on average, approximately 25% of a bank’s assets in 2012 (35% in 2011) and 14% of its liabilities (20% in 2011) were exposed to other banks through interbank placement and borrowing activities, and holdings of other banks’ paper and account receivables. Larger and stronger banks have curtailed their interbank exposure, which has had a knock-on effect of diminishing the liquidity of smaller and weaker banks.
Although the VAMC bond transaction leaves banks with their NPL losses, these will be partly offset by the return banks can generate on liquidity accessed from the central bank.
At the end of 2012, our nine rated banks in Vietnam reported an average NPL ratio of 2.6%. However, if we include special-mention loans, which are delinquent loans (the majority of which would be reported as NPL in other systems), that ratio would be 7.5%. Yet we believe this ratio still underestimates the real economic NPLs in the banking system.6 Although the system’s lack of transparency makes it difficult to ascertain the true extent of the problem loans on the banks’ books, it is clear that the banks would be
5 See State Bank of Vietnam Circular No. 19/2013/TT-NHNN and No. 20/2013/TT-NHNN. 6 See, Key Drivers of Vietnamese Bank Rating Actions, 8 October 2012.
Falemri Rumondang Associate Analyst +65.6398.8330 [email protected]
NEWS & ANALYSIS Credit implications of current events
21 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
substantially undercapitalized if they recognized and provisioned for all their economic NPLs, as shown below.
Average Rated Vietnam Banks’ Reported and Adjusted Nonperforming Loan Ratio
Sources: Banks’ financial reports, Moody’s
3.4%
15.3%
3.8%
20.8%
3.2%
12.2%
2.4%
8.3%
1.7%
7.0%
2.6%
7.5%
0%
3%
6%
9%
12%
15%
18%
21%
Reported NPLs to Gross Loans Reported NPLs + Special Mention Loans to Gross Loans
2007 2008 2009 2010 2011 2012
NEWS & ANALYSIS Credit implications of current events
22 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
Insurers
Aviva Sells US Life and Annuities Business at Higher Consideration than First Announced On 2 October, Aviva Plc (A3 stable) announced that it has completed the sale of Aviva USA Corporation (unrated), its US life and annuities business, to Athene Holding Ltd (unrated) for cash proceeds of $2.3 billion, $0.8 billion higher than the originally announced consideration of $1.55 billion.
Selling the US operations for higher proceeds than originally announced is credit positive for Aviva because it will improve the group’s liquidity and economic capital more than expected, and completing the sale obviates execution risk.
Aviva announced last December that it had agreed to sell its US operations for cash consideration of $1.55 billion. The sale is part of the group’s plan to focus on businesses and markets in which it has lead positions and can generate attractive financial returns.
However, final proceeds depend on the statutory surplus development between the announcement of the sale and its completion. The $0.8 billion premium over the pre-announced proceeds reflects the favourable evolution of the US operations from 30 June 2012 (i.e., the balance sheet on which the original €1.55 billion valuation was based) to 30 September 2013. Aviva reported that the book value of US operations after selling costs and other adjustments improved to £523 million as of 30 June from £367 million at year-end 2012, driven mainly by retained earnings and favourable market movements. Aviva will receive transaction proceeds in cash of $2.3 billion after repayment of an external loan of Aviva USA.
The sale enhances the group’s economic capital position and strengthens its central liquidity more than the company originally expected. When the sale was announced, the group expected its economic capital surplus, based on its own internal model, to increase by £1.1 billion, compared with £5.3 billion at year-end 2012. We now expect the increase in the economic capital surplus to be larger than initially envisaged, in line with the additional proceeds. In addition, the sale of the US operations will reduce the group’s economic capital volatility to credit spread movements. These improvements offset the large accounting loss previously incurred (£2.4 billion at year-end 2012), which will continue to be significant despite the higher consideration received for the sale.
The sale of the US life and annuity business diminishes the geographic diversification of the group’s revenues and profits. Aviva US contributed less than 10% of group’s operating profits at year-end 2012, but the subsidiary has not paid a dividend to the group since it was acquired in 2006.
Laura Perez Martinez, CFA Analyst +44.20.7772.1602 [email protected]
NEWS & ANALYSIS Credit implications of current events
23 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
China’s P&C Insurers Will Benefit from Shanghai Free Trade Zone On 29 September, the China Insurance Regulatory Commission (CIRC), concurrent with the Shanghai municipal government’s official launch of its free trade zone, formally announced eight policy initiatives that will be applicable in the free trade zone. The initiatives include developing marine/cargo insurance, liability insurance and health insurance in the zone, and are credit positive for property and casualty (P&C) insurers because they will open up new business opportunities and help them diversify away from their strong concentration in motor policies.
Two companies with deep roots and headquarters in Shanghai stand to benefit the most: China Pacific Property Insurance Co. Ltd. (CPPIC, financial strength A1 stable) and Dazhong Insurance Co. Ltd. (unrated) both have secured approvals to open branches in the free trade zone.
We see the biggest opportunities in marine/cargo insurance and liability insurance. The free trade zone, which covers four port and airport areas in Shanghai, will offer favorable treatment for shipping companies, including higher limits on foreign ownership and preferential tax rates. These will increase the volume of cargo and trade going through the free trade zone, thereby raising related demand for cargo and liability insurance.
Growth in these two lines of business will help diversify insurers’ product portfolios and improve profitability. P&C insurers in China currently depend on motor insurance for more than 70% of their premium volume, and profitability in this line is declining because of intense competition and rising claims costs from inflation. CPPIC’s combined ratio (the ratio of losses and expenses paid to premiums earned) of motor insurance was 99.8% in the first six months of this year, which means this business was barely profitable. However, CPPIC’s cargo insurance line was far more profitable, reporting a combined ratio of around 80% for the same period.
We expect PICC Property and Casualty Co Limited (financial strength A1 stable) and Ping An Property & Casualty Insurance Company of China Ltd. (unrated), China’s largest and second-largest P&C insurers, respectively, to also benefit from this reform if they set up operations in the free trade zone, which we expect.
The CIRC’s separate announcement that it will allow foreign insurers to sell health insurance in the free trade zone without a domestic partner is also credit positive. We expect this relaxation to benefit the major foreign insurers (which until now have sold their medical coverage through joint ventures) by giving them more flexibility in operations and capital management. Among the major foreign players operating in China, we see Aetna Inc. (Baa2 stable) as a potential beneficiary from this scheme because it has already set up a representative office in China. Also likely to benefit is CIGNA Corporation (Baa2 stable), another large health insurer that currently operates Cigna & CMB Life Insurance Co. Ltd. (unrated) with China Merchants Group (unrated).
The initiatives in the free trade zone notwithstanding, we do not expect drastic and sudden change in the overall insurance regulatory regime in China. Deregulation in the insurance sector has historically been gradual and conducted within the confines of restrictions, such as requiring insurers to maintain a specified local solvency margin ratio before allowing them to engage in new business or investment channels. From a credit perspective, this cautious approach to reform helps to insulate China’s insurers from abrupt shocks related to sudden and wide-ranging changes in their operating environment.
Sally Yim Vice President - Senior Credit Officer +852.3758.1450 [email protected]
NEWS & ANALYSIS Credit implications of current events
24 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
Sovereigns
Mongolian Parliament Approves New Investment Law, a Credit Positive On 3 October, Mongolia’s (B1 stable) parliament ratified a new investment law that replaces the Foreign Investment Law and the Strategic Entities Foreign Investment Law (SEFIL).7 We view the new law’s passage as credit positive because it liberalizes and provides clarity on Mongolia’s investment regime, which had become restrictive and unpredictable and thus deterred foreign investment. The law will likely promote the development of the country’s abundant mineral resources, thereby strengthening Mongolia’s external payments position and the government’s external debt repayment capacity.
Over the past year, Mongolia’s unpredictable foreign investment regime has weakened the country’s credit quality. In May 2012, the government approved the SEFIL, which mandated that foreign private and state-owned investors undergo a rigorous approval process to acquire Mongolian companies operating in sectors of strategic importance, including minerals. SEFIL was amended in April 2013, but still did not provide complete clarity on approval criteria.
Policy unpredictability and disputes between the government and mining company Rio Tinto plc (A3 stable) over the country’s largest copper and gold mine, Oyu Tolgoi, in which Rio Tinto owns a 66% stake, have greatly undermined foreign investment. Foreign direct investment (FDI) in Mongolia declined 48% year-on-year to $1.8 billion between January and August 2013. In a bid to resolve these disputes and possibly ward off an economic crisis, lawmakers called an emergency session of parliament at the end of September, during which they discussed the new investment law.
The dominant feature of the new law is that it lessens discrimination against foreign investors. Although a final version is not yet available, media reports note that foreign state-owned entities would still require government approval if they seek a stake of more than 50%, while the threshold is 33% for entities in strategic sectors such as mining, banking or communications. However, the law eliminates a two-step registration process that was a major stumbling block of the SEFIL. It also introduces a tax stabilization certificate that guarantees stable tax treatment for investments of MNT10 billion ($6 million) or more for stipulated periods of time.
The new law marks an important step toward encouraging foreign investment in Mongolia, although immediate improvements in FDI are unlikely as investors wait for a resolution of the Oyu Tolgoi dispute. Nevertheless, a healthy foreign investment regime is essential to boost mining-sector foreign-exchange inflows to shore up the country’s external payments position. The Bank of Mongolia’s international reserves fell to $2.7 billion in August from $4.1 billion in December 2012, while external debt rose sharply, ratcheting up debt service obligations. Public sector external debt in 2012 increased to $4.7 billion from $2.2 billion in 2011 as a result a sovereign global bond issuance and borrowing by the state-owned Development Bank of Mongolia, whose plans to launch a yen-denominated bond later this year would add to the government’s debt burden.
7 See Mongolia’s New Foreign Investment Law Shows Unpredictable Investment Regime, a Credit Negative, 21 May 2012, and
Mongolia’s Delay of Oyu Tolgoi Copper Exports Is Credit Negative for the Sovereign, 27 June 2013.
Anushka Shah Analyst +65.6398.3710 [email protected]
Tom Byrne Senior Vice President +65.6398.8310 [email protected]
Cynthia Mar Associate Analyst +65.6398.8323 [email protected]
NEWS & ANALYSIS Credit implications of current events
25 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
US Public Finance
Maryland and Virginia Local Governments Are Exposed to Federal Government Shutdown The federal government shutdown that began on 1 October is credit negative for the local governments of Maryland (Aaa stable) and Virginia (Aaa stable) that comprise the Washington, DC, metro area because some government employees have been furloughed, some federal procurement contracts have been cut and other discretionary federal services and programs are closed.
An extended shutdown will negatively affect income tax revenues of counties in Maryland, while local governments in Virginia will feel the pinch of declining sales taxes, and these effects will worsen the longer the shutdown lasts. In addition, local governments in both states face the risk of reduced aid from their respective states and the possibility of the region’s economy slowing. The longest federal shutdown in US history was 21 days, beginning 16 December 1995.
About 29% of the approximately 2.8 million federal workers nationally have been furloughed, and this will be particularly troublesome for the DC metro statistical area because federal employees make up 12.6% of the area’s total employment, versus 2.1% nationally. In addition, because the shutdown curbs federal contract work, it will impair the economy of the DC metro area, which includes 11 cities and 15 counties.
Maryland counties are susceptible to declines in income tax revenue that would result from an extended government shutdown. In fiscal 2012, income taxes accounted for about 34.2% of general fund revenues of Maryland counties in the DC metro area (Exhibit 1). Cities in Maryland receive a relatively small amount of their revenues from income tax revenues.
EXHIBIT 1
Income Taxes Are a Significant Portion of Some Maryland Counties’ Revenues Issuer Income Taxes as Percent of General Fund Revenues
Montgomery County 43.5%
Frederick County 38.0%
Charles County 31.3%
Prince George's County 30.9%
Calvert County 27.1%
Source: 2012 Comprehensive annual financial reports
Maryland might reduce state aid to counties and cities in response to its own economic or financial strain caused by the shutdown. But of the three counties for which we have specific data, state aid accounted for an average of only 0.6% of their total general fund revenues. Similarly, local governments in Maryland have little reliance on direct federal transfers. For example, federal aid accounted for less than 1% of Montgomery County’s (Aaa stable) operating revenues for the fiscal year ended 30 June 2012.
Virginia local governments will likely experience modest negative effects from the shutdown. Economically sensitive revenues such as sales taxes would be most affected. However, sales taxes comprise a relatively small portion of Virginia local governments’ revenues. For example, sales tax revenues were about 6.4% of the operating revenues of Fairfax County (Aaa stable) in the fiscal year ended 30 June 2012.
Jennifer Diercksen Analyst +1.212.553.4346 [email protected]
NEWS & ANALYSIS Credit implications of current events
26 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
However, Virginia might reduce state aid to local governments to alleviate economic and financial strains on the state caused by the shutdown. Based on available data, state aid on average accounts for a sizable 10.4% of total revenues of DC metro area cities in Virginia and 10.9% for area counties. As with Maryland local governments, Virginia’s cities and counties receive only a small portion of revenues directly from the federal government. For example, direct federal aid totals only 2.3% of Loudoun County’s (Aaa stable) operating revenues.
Despite the risks, most DC metro area local governments have strong credit fundamentals that will help them withstand a prolonged government shutdown. These strengths include large tax bases, high wealth levels and solid reserves (Exhibit 2). The average full value of the region’s taxable real estate is $8.2 billion for cities and $59.3 billion for counties, which is well above the national median of $1.1 billion for cities and $7 billion for counties. DC area local governments’ reserves average a robust 22.9% of operating revenues. Moreover, property taxes make up about half of local governments’ revenues, which is notable because property taxes are not sensitive to short-term economic events and therefore will not be discernibly affected by the shutdown.
EXHIBIT 2
DC-Metro Area Local Governments Have Large Tax Bases and Solid Reserves
Issuer General Obligation Rating Full Value of Taxable Real
Estate $ Billions Reserves as Percent of
Revenue
Bowie, MD Aaa $5.9 83.5%
Frederick, MD Aa2 $6.4 41.6%
Calvert County, MD Aa1 $13.4 28.1%
Fredericksburg, VA Aa2 $4.0 24.6%
Prince George's County, MD Aaa $85.7 24.4%
Falls Church, VA Aa1 $3.3 23.5%
Stafford County, VA Aa2 $13.7 22.3%
Frederick County, MD Aa1 $26.3 22.2%
Manassas, VA Aa1 $3.8 22.1%
Arlington County, VA Aaa $64.4 21.4%
Prince William County, VA Aaa $41.7 19.0%
Loudoun County, VA Aaa $62.3 18.5%
Spotsylvania County, VA Aa2 $14.6 17.9%
Fairfax, VA Aaa $5.2 16.8%
Rockville, MD Aaa $11.8 16.4%
Fairfax County, VA Aaa $194.8 15.3%
Charles County, MD Aa1 $17.7 14.7%
Alexandria, VA Aaa $32.6 14.6%
Manassas Park, VA A3 $1.2 13.2%
Fauquier County, VA Aa1 $11.0 11.9%
Montgomery County, MD Aaa $165.9 9.2%
Source: 2012 Comprehensive annual financial reports
CREDIT IN DEPTH Detailed analysis of an important topic
27 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
United States Government Shutdown and Debt Limit: Answers to Frequently Asked Questions Two separate issues now affect the near-term outlook for US government finances: the government shutdown and the debt limit. The government shutdown began 1 October and resulted from Congressional inaction to authorize spending through either a budget or a continuing resolution. The US government (Aaa stable) reached its statutory debt limit of $16.7 trillion on 19 May. Since then, the US Treasury has used “extraordinary measures” to raise funds and pay government expenditures. Treasury estimates that it will exhaust those measures on 17 October and government expenditures will have to be reduced.
Below, we address key questions stemming from the US government shutdown and the failure to raise the debt limit.
» How does the government shutdown affect US creditworthiness? The shutdown has no effect on the government’s ability to pay interest and principal on its debt obligations, and therefore does not directly affect the government’s creditworthiness. The shutdown prohibits discretionary spending, but not mandatory spending or debt service, such as interest and principal on Treasury securities, which the US government will continue to be able to pay.
» Will the government default after 17 October if the debt limit is not raised? We believe the government would continue to pay interest and principal on its debt even in the event that the debt limit is not raised, leaving its creditworthiness intact. The debt limit restricts government expenditures to the amount of its incoming revenues; it does not prohibit the government from servicing its debt. There is no direct connection between the debt limit (actually the exhaustion of the Treasury’s extraordinary measures to raise funds) and a default.
» What is the pattern of US interest payments after 17 October? Interest payments on Treasury bonds and notes are due twice monthly, on the 15th and the last day of every month. After 17 October, the first interest payment date is 31 October, when a relatively small $5.9 billion is due, and the next is 15 November, when $30.9 billion is due.
» Why are only interest payments potentially affected and not principal? The statutory debt limit is a limit on the amount of debt outstanding. As debt matures, it can be refinanced with new Treasury issuance without affecting the total amount of debt (principal). Interest, by contrast, is an expenditure and could be included among the expenses that the Treasury could decide not to pay.
» Is the situation worse now than it was in 2011, the last time that the debt limit was an issue? No. The budget deficit was considerably larger in 2011 than it is currently, so the magnitude of the necessary spending cuts needed after 17 October is lower now than it was then.
» Could the government take other steps to finance itself without increasing debt? Although we consider it unlikely, the government could pursue a variety of options to finance itself, from asset-backed sales or swaps of gold reserves or other assets to invoking the 14th Amendment. Congress could also decide to repeat its prior suspension of the debt limit while further negotiations take place.
Detailed Discussion
How does the government shutdown affect US creditworthiness?
The US government shutdown on 1 October resulted from Congressional inaction to authorize spending through either a budget or a continuing resolution. It prohibits discretionary spending, which includes most day-to-day operations of the government. However, mandatory spending, which includes major social
Steven A. Hess Senior Vice President +1.212.553.4741 [email protected]
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28 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
programs such Social Security, Medicare, Medicaid and income support programs can continue normally during the government shutdown. Importantly, the shutdown does not affect the payment of debt service on Treasury securities, so the government’s creditworthiness is not directly affected.
Since 2011, a series of continuing resolutions have authorized government spending because no budgets have been passed. Discretionary spending amounts to about 38% of the government’s non-interest spending, but the shutdown has numerous exceptions for activities considered essential. Therefore, the reduction to total government non-interest spending for the duration of the shutdown could be considerably less than the 38% figure would imply.
If the shutdown lasts for an extended period, it could have economic effects that would eventually affect government revenues, but lower expenditures would also continue, so that budget deficits would likely decline. If short-lived, the economic and revenue consequences of the shutdown will be minimal.
Congress’ failure to raise the statutory debt limit presents a theoretically larger threat to the government’s ability to service its debt.
Will the government default after 17 October if the debt limit is not raised?
There is no direct connection between the debt limit, which was reached last May, and a default. On 17 October, however, the government is expected to have less revenue and cash on hand than committed expenses, so some bills may not be paid. If that occurs, the government will have to prioritize among its expenditures. We continue to believe that the government will prioritize its debt payments.
No interest payments are due until 31 October, when $5.9 billion in interest is to be paid. Thus, a Treasury bond default is not technically possible until that date. Moreover, given that the amount that needs to be paid is relatively small, a default is also extremely unlikely.
According to the Treasury Secretary Jack Lew, the Treasury’s extraordinary measures to finance government spending (since the $16.7 trillion debt limit was reached in May) will be exhausted sometime around 17 October. The Congressional Budget Office (CBO) estimates the date between 22 October and the end of the month.
When the extraordinary measures are exhausted, the government’s expenditures will be limited to the amount of incoming revenues, since it is not authorized to increase its stock of debt. These revenues change day to day. During September, for example, the daily receipts of the Treasury varied from $5.8 billion to $152.0 billion, averaging $55.4 billion daily. Daily expenditures also show considerable variation, from $9.9 billion to $147.2 billion and averaged $52.3 billion. The excess of revenue over expenditure meant that, on a cash basis, the government recorded a surplus for the month of September. This results mainly from the schedule of corporate tax payments; the government also recorded a surplus in September 2012.
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29 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
EXHIBIT 1
Daily US Treasury Cash Balance During September 2013
Source: US Treasury, Moody’s
However, if the debt limit is not raised by November, the government will face the prospect of a month when revenues fall short of scheduled expenditures by a significant margin. In November 2012, expenditures were more than double revenues, resulting in a $172 billion cash deficit.
Given that the Treasury will exhaust extraordinary measures to raise funds in the second half of October, November is the first month the government will have to select which obligations it will meet if the debt limit is not raised. The government has not indicated which obligations it would meet in such a scenario. If the shutdown is still in effect by the start of November, discretionary spending will be severely limited, so that some of the choices will have already been made. If the shutdown has been lifted by the start of November, then the rationing of payments will be at the discretion of Treasury and the Office of Management of Budget. In our view the government is very likely to manage to prioritize interest payments. The reputational cost of a US government default is too great and both political parties in the United States have stated they are against a government default.
What is the pattern of US interest payments after 17 October?
Interest payments on Treasury bonds and notes are due twice monthly, on the 15th and the last day of every month. For 31 October, the $5.9 billion in interest payable is a relatively small amount. However, on 15 November, interest totaling $31 billion is due. This, plus the $6 billion payment due at the end of November, would be equivalent to about 18% of our estimate of the government’s revenues for the month. Therefore, if the government gives priority to paying interest, as we believe it will, it will have sufficient resources to do so.
-$160
-$120
-$80
-$40
$0
$40
$80
$120
$160
$ Bi
llion
s
Deposits Withdrawals Balance
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30 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
EXHIBIT 2
US Federal Government Interest Payments Due in Fourth-Quarter 2013
Amount of Principal
Affected $ Billions
Principal/ Total Debt Outstanding (excluding
T-Bills) $ Billions Interest Payments $ Billion
Interest Payments/
Revenue
October 15th $418 4.2% $1.8
3.7% 31st $773 7.8% $5.9
November 15th $1,768 17.8% $30.9
18.9% 30th $776 7.8% $5.6
December 15th $196 2.0% $0.5
2.0% 31st $776 7.8% $6.1
Source: US Treasury, CBO, Moody’s
Why are only interest payments potentially affected and not principal?
The statutory debt limit is a limit on the amount of debt outstanding. As debt matures, it can be refinanced without affecting the total amount of debt. Interest, however, is an expenditure and is potentially affected in the process of cutting expenditures. The ability to refinance is, of course, dependent on market confidence. As the global reserve currency and financial market benchmark, it is very unlikely that the US will lose market access, since the debt limit question does not affect its long-term debt-servicing capacity. However, yields on Treasury securities may well rise in coming weeks if there is no increase in the debt limit.
Is the situation worse now than in 2011, the last time that the debt limit was an issue?
No. By comparison, the budget deficit (the amount of spending financed by borrowing) was considerably larger in 2011 than it is currently, so that the magnitude of the necessary spending cuts is now lower than it was then. This is shown in Exhibit 3. In July 2011, we placed the US government bond rating on review for downgrade because the probability of a missed interest payment on Treasury bonds was rising, but still low. At the time, we believed that the government would continue to service its debt even if the debt limit were not raised.
EXHIBIT 3
US Federal Government Deficit as Percent of Total Expenditures
Source: US Treasury, CBO, Moody’s
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
2007 2008 2009 2010 2011 2012 2013E 2014F
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Can the government take other steps to finance itself without increasing debt?
The government could take a number of steps to finance itself without recourse to borrowing. We believe these are unlikely to be implemented, but they include:
» Sales/swaps of gold. The US has 261.5 million ounces of gold. At current market prices, this is valued at over $300 billion
» Minting coins in large denominations that would be deposited with the federal reserve in exchange for cash
» Asset-based lease-backs, sales or swaps involving property or other assets
» In addition, some commentators believe that the administration could continue to borrow by invoking the 14th Amendment to the constitution, which states that no one shall question the validity of US debt. It is unclear whether the courts would deem this action constitutional
» Finally, Congress could, as it did earlier this year, suspend the debt limit while further negotiations occur. This seems unlikely in the current political conjuncture, but a precedent has been set
RATING CHANGES Significant rating actions taken the week ending 4 October 2013
32 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
Corporates
Anadarko Petroleum Corporation Outlook Change
23 Mar ’12 30 Sep ‘13
Senior Unsecured Rating Baa3 Baa3
Outlook Stable Positive
Anadarko's strong operating performance and improving financial position triggered the change in outlook. Legal contingencies related to litigation with Tronox and residual liabilities related to Macondo are unlikely to affect Anadarko’s leverage metrics because they will be covered by the company’s cash balances.
AB Volvo Outlook Change
24 Jul ’09 1 Oct ‘13
Long-Term Issuer Rating Baa2 Baa2
Short-Term Issuer Rating P-2 P-2
Outlook Stable Negative
The change in outlook reflects Volvo’s deteriorating financial performance over the past four quarters. Demand softness in key markets makes it unlikely that financial metrics will improve enough to stay in the Baa2 rating category.
Petroleo Brasileiro S.A. - PETROBRAS Downgrade
17 Dec ’12 3 Oct ‘13
Long Term Issuer Rating A3 Baa1
Outlook Negative Negative
The downgrade reflects Petrobras’s high financial leverage and the expectation that the company will continue to have large negative cash flow over the next few years as it pursues its capital spending program.
SGPS, S.A. Review for Upgrade
13 Apr ’12 3 Oct ‘13
Corporate Family Rating Ba2 Ba2
Outlook Negative Review for Upgrade
The rating action is triggered by Portugal Telecom’s announced proposal that it will combine its business with that of Oi S.A. to form a new corporate structure. The combined entity will benefit from a minimum BRL 7 billion (€2.3 billion) to as much as BRL 8 billion (€2.7 billion) capital increase and a shareholder restructuring at Oi. The rating review will focus on the execution of the proposed transaction.
RATING CHANGES Significant rating actions taken the week ending 4 October 2013
33 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
United Rentals (North America), Inc. Upgrade
25 Jun ’13 30 Sep ‘13
Corporate Family Rating B2 B1
Outlook Positive Stable
Improvement in United Rentals’ operating margins, EBITDA margins, leverage and interest coverage, and the resulting improvement in credit quality triggered the upgrade. The company is on track to reduce leverage to its target range of 2.5 to 3.5 over the next 12-18 months. We expect United Rental to also maintain an adequate liquidity profile over that timeframe.
Universal Health Services, Inc. Outlook Change
18 Nov ’10 3 Oct ‘13
Corporate Family Rating Ba2 Ba2
Outlook Stable Positive
The outlook change reflects our expectation that strong growth in the behavioral segment will offset the difficult operating environment in the acute care business in the near term. Benefits to the acute care segment from the Affordable Care Act expected to begin in 2014, therefore, will be incremental to the faster pace of growth provided by the behavioral segment. We also expect that cash used for acquisitions and investments in growth initiatives will add to EBITDA and improve overall margins.
RATING CHANGES Significant rating actions taken the week ending 4 October 2013
34 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
Infrastructure
Power Sector Assets & Liabilities Management Corporation (PSALM) Upgrade
29 Oct ‘12 3 Oct ‘13
Senior Unsecured Bond Rating Ba1 Baa3
Issuer Rating Ba1 Baa3
CFR (Corporate Family Rating) Ba1 Withdrawn
Outlook Stable Positive
The action follows our upgrade of the Philippine government's long-term foreign-currency and local-currency ratings to Baa3 with a positive outlook also on 3 October 2013. The government has provided unconditional and irrevocable guarantees for debt issued by PSALM and transferred from National Power Corporation,
Reliance Rail Finance Pty Ltd. (RRF) Upgrade
14 Dec ‘10 3 Oct ‘13
Senior Secured Rating B3 B2
Subordinated Debt Rating Caa2 Caa1
Outlook Negative Positive
The upgrade reflects Reliance Rail's improved funding position, following the final scheduled drawdown under its bank facilities to fund the completion of the Waratah trains project, which is being delivered under a public private partnerships framework. RRF is the funding vehicle for Reliance Rail, which in turn is the consortium appointed to manufacture and maintain 78 new trains for Sydney Trains, whose obligations under the project are backed by the State of New South Wales (Aaa stable).
Sandy Creek Energy Associates (SCEA) Upgrade
8 May ‘12 2 Oct ‘13
Senior Secured Term/Construction Loan
B1 Ba3
Outlook Negative Stable
The rating action largely reflects the successful repair of plant components damaged in a boiler incident in late 2011, and marginally improved conditions in the ERCOT North merchant energy market. Sandy Creek Energy Associates, LP owns 64% of Sandy Creek Energy Station, a 945 MW single unit pulverized coal-fired power generating facility in Riesel, Texas.
RATING CHANGES Significant rating actions taken the week ending 4 October 2013
35 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
Financial Institutions
Brazilian financial institutions Outlook Changes
3 Oct ‘13
We have changed to stable, from positive, the outlooks on the standalone bank financial strength ratings of three Brazilian financial institutions, the outlooks on the long-term global local currency deposit, issuer, and debt ratings of eight financial institutions, and the outlooks on the long-term global foreign currency deposit, senior and subordinated debt ratings of 10 financial institutions and their respective foreign branches. The outlook changes are based primarily on our outlook change on Brazil's Baa2 sovereign credit rating also to stable from positive. We also changed the outlooks on the local currency issuer and debt ratings of several entities related to the banks, in line with the outlook of these entities respective to their parents’ bank ratings.
Four Philippine Banks Upgraded to investment grade Upgrade
3 Oct ‘13
The rating actions are in line with the upgrade of the Philippines sovereign's bond ratings to Baa3 from Ba1. The improved sovereign rating is reflected in an improved operation environment for the Philippine banking system, which includes robust growth, strong domestic consumption and well-anchored inflation. The improved creditworthiness of the Philippine government also means a stronger capacity to support the country’s banks in a potential crisis.
AG Insurance Outlook Change
15 Jul ‘09 2 Oct ‘13
Long-Term Rating A2 A2
Outlook Negative Stable
The outlook change reflects AG’s ability to maintain a leading market position in Belgium as well as a good level of capitalisation, the de-risking of its investment portfolio since 2010 and the improvement in its profitability.
Ally Financial Inc. Review for Upgrade
25 Feb ‘13 2 Oct ‘13
Long-Term Rating B1 B1 (Review for Upgrade)
We view the uncertainty over the extent of Ally's contingent exposures to bankrupt subsidiary Residential Capital LLC (ResCap) as reduced, leading to the review. Other considerations include the improvement we expect in the quality of Ally's capital, and Ally's efforts to strengthen financial performance.
RATING CHANGES Significant rating actions taken the week ending 4 October 2013
36 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
Caixa Economica Montepio Geral Review for Downgrade
28 Mar ‘12 2 Oct ‘13
Long Term Debt and Deposit Ratings Ba3 Ba3 (Review for Downgrade)
The review for downgrade has been triggered by our concern over the rising pressure on Montepio's standalone credit profile, as evidenced by a significant rise in non-performing loans and weakened earnings. We believe that the continuing weakness of the Portuguese economy is likely to exert further pressure on the bank' asset quality and profitability.
Chubb do Brasil Companhia de Seguros Outlook Change
29 Oct ‘12 3 Oct ‘13
Long-Term Rating Baa1 Baa1
Outlook Positive Stable
The outlook change is based primarily on our outlook change on Brazil's Baa2 sovereign credit rating also to stable from positive.
Endurance Specialty Holdings Ltd. Downgrade
29 Mar ‘12 2 Oct ‘13
Long-Term Rating Baa1 Baa2
Insurance Financial Strength Rating A2 A3
The downgrade results from a deterioration in the company's credit profile over the past couple of years, including higher financial and operational leverage, as well as muted profitability that has been suppressed by catastrophe losses. While the company is performing better in 2013 and has meaningfully reduced its catastrophe risk exposure to levels more in line with its peers, we view Endurance's overall credit profile to be more appropriately positioned at A3 for insurance financial strength at the current time.
MONY Life Insurance Company of America (MLOA) Downgrade
11 Apr ‘13 2 Oct ‘13
Insurance Financial Strength Rating Aa3 A1
The rating action follows the closing of the sale of MONY Life Insurance Company (MONY) to an operating subsidiary of Protective Life Corporation and the coinsurance of certain inforce business of MLOA, for approximately $1.06 billion. The downgrade of MLOA reflects one notch (instead of the previous two notches) of implicit support given the sale of MONY, the new role of MLOA within the group and the anticipated diminished contribution of the US business to the group's earnings relative to historical levels given the transaction.
RATING CHANGES Significant rating actions taken the week ending 4 October 2013
37 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
MONY Life Insurance Company (MONY) Downgrade
11 Apr ‘13 2 Oct ‘13
Insurance Financial Strength Rating Aa3 A2
Surplus Notes A2 (hyb) Baa1 (hyb)
The rating downgrade follows the announcement that a subsidiary of Protective Life Corporation (PLIC) has completed the transaction by which it has purchased MONY and coinsured certain inforce business of its formerly wholly-owned subsidiary, MONY Life Insurance Company of America (MLOA), for approximately $1.06 billion from AXA Financial, Inc. MONY's rating and outlook are aligned with those of PLIC because MONY will be integrated in the Protective family of companies as has been done with previously acquired entities.
RATING CHANGES Significant rating actions taken the week ending 4 October 2013
38 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
Sovereigns
Brazil Outlook Changed
20 Jun ‘11 2 Oct ‘13
Gov Currency Rating Baa2 Baa2
Foreign Currency Deposit Ceiling Baa2 Baa2
Foreign Currency Bond Ceiling Baa1 Baa1
Local Currency Deposit Ceiling A1 A1
Local Currency Bond Ceiling A1 A1
Outlook Positive Stable
The change to a stable outlook was based on three considerations:
» Key credit metrics are deteriorating, especially Brazil's government debt-to-GDP and the investment-to-GDP ratios, which are weaker than those of other sovereigns in Baa rating category.
» Evidence that the economy is going through an extended low-growth period given expectations that GDP will increase at annual rates of just over 2% in 2013 and 2014.
» The deterioration in reporting quality of the government accounts, as well as continued Treasury borrowings to support increased lending by public banks.
Philippines Upgrade
25 Jul ‘13 3 Oct ‘13
Gov Currency Rating Ba1 Baa3
Foreign Currency Deposit Ceiling Ba1 Baa3
Foreign Currency Bond Ceiling Baa2 Baa1
Local Currency Deposit Ceiling A2 A2
Local Currency Bond Ceiling A2 A2
Outlook Review for Upgrade Positive
We had placed the ratings on review for upgrade because of the country's robust economic performance, ongoing fiscal and debt consolidation, and political stability and improved governance. These trends have continued. In addition, the stability of the Philippines' funding conditions during the recent bout of market volatility in emerging markets points to the country's relative lack of vulnerability to external financial shocks, such as those arising from anticipated tapering by the US Federal Reserve of its quantitative easing policy.
RATING CHANGES Significant rating actions taken the week ending 4 October 2013
39 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
Sub-sovereigns
City of Athens (Greece) Downgrade
3 Aug ‘11 1 Oct ‘13
Issuer rating Caa3 C
Outlook Developing No Outlook
The downgrade is driven by evidence of default after the recent disclosure of accrued penalty interest resulting from a missed payment on a €29.5 million bullet loan. The city's rating is now aligned with the Greek sovereign rating,
US Public Finance
Catholic Health East, PA Upgrade
5 Dec ‘12 3 Oct ‘13
Revenue Bonds A2 Aa2
Outlook Negative Negative
CHE is now part of CHE Trinity, Inc., and the rating upgrade and negative outlook are based on our analysis of CHE Trinity. CHE Trinity is one of the nation's largest multi-state health systems that has expanded into 21 states, with operating revenues for fiscal year 2014 likely to be just shy of $14 billion.
Puerto Rico Sales Tax Financing Corp. (COFINA) Downgrade
18 Jul ‘12 3 Oct ‘13
Sales Tax Revenue Bonds Aa3 A2
Outlook Negative Negative
As we downgraded COFINA’s bonds, we also affirmed the general obligation (GO) rating of the Commonwealth of Puerto Rico at Baa3. Our downgrade of COFINA’s senior lien bonds reflects persistent and cumulative effects of the weak economy of the Commonwealth of Puerto Rico, our reassessment of the close and enduring linkages that exist between the commonwealth's fundamental credit position and that of the sales tax bonds, and strong linkages between a government's GO and special tax ratings, with special tax ratings rarely exceeding GO ratings.
RESEARCH HIGHLIGHTS Notable research published the week ending 4 October 2013
40 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
Corporates
Integrated Oil: BP Still Risks Big Claims as Macondo Proceedings Enter Second Phase BP’s credit quality could be compromised by the amount of penalties related to the April 2010 Macondo oil spill. A moderate penalty under the US Clean Water Act would not have an impact on BP’s credit, but severe penalties coupled with rising costs from the Plaintiffs’ Steering Committee could affect its A2 stable rating.
Japan: Olympic Games in Tokyo Are Credit Positive for Condominium Developers The announcement that Tokyo will host the 2020 Olympic Games is credit positive for condominium developers in the city, including rated Mitsubishi Estate Co., Ltd and Mitsui Fudosan Co., Ltd. Condo sales in the Tokyo Bay Zone will accelerate and sales prices will increase because government development of quality residential apartments will increase demand for housing in the area, while land prices there will also climb.
Moody's Healthcare Quarterly This edition examines what various levels of enrollment in the Affordable Care Act’s exchanges would mean for credit in six healthcare subsectors. Specifically, we look at the credit implications of enrollment on health insurers, for-profit hospitals, not-for-profit hospitals, pharmaceutical companies, the pharmacy-benefit management sector and medical device manufacturers.
Peruvian Fishing Companies Poised for Earnings Recovery The earnings of Peruvian fishing companies will be strengthened by an increase in the government’s anchovy harvesting quota. The recovery in anchovy stocks in Peruvian waters will likely lead to another quota increase later this year, spurring a recovery in revenues and margins in the fishing industry in the third quarter of 2013.
US Speculative-Grade Corporations Refunding Risk and Needs Update: Rising Rates Would Have Modest Effect on Interest Expense of Lower-Rated Companies Our review of 19 of the largest debt issuers rated B3 negative and below indicates that rising rates would have a modest effect on interest expense in the near term. Rising rates would affect companies with more variable debt first, but even companies without variable rate debt would be affected long term when they refinance existing obligations or issue new debt.
European Chemicals: Pension Obligations Pressure Credit Metrics But 2013 Should Bring Some Relief In 2012 we made a €30 billion adjustment to debt for the 10 largest European companies we rate in our Global Chemical Industry methodology. Pension obligations account for more than 70% of that adjustment and changed what would have been a 6% decrease in debt since 2008 to a rise of over 5%. However, higher long-term interest rates should alleviate the pressure on credit metrics in 2013.
RESEARCH HIGHLIGHTS Notable research published the week ending 4 October 2013
41 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
European Automotive Parts Suppliers: Light at the End of the Tunnel as European Car Sales Touch Bottom We are changing our outlook to stable from negative based on signs that European light vehicle sales have reached a trough. The ensuing recovery should mitigate protracted weakness in the euro area and the pressure international expansion places on free cash flow.
US Soft Beverage Industry: Coca-Cola Remains the Industry Powerhouse A comparison of US soft beverage rivals The Coca-Cola Company, PepsiCo, Inc., Dr Pepper SnappleGroup, Inc. and Cott Corporation shows that Coke holds a dominant position on nearly every measure. Its strong, global bottler networks drive its lead in market share and financial strength.
Global Technology Hardware and Software: Supply Chain Revenue Would be Pressured by Potential BlackBerry Handset Exit A scenario in which BlackBerry Ltd. exits the smartphone handset market would be credit negative for its major manufacturing partner, Jabil Circuit Inc., and distributor, Brightstar Inc., but would not affect either of those company’s ratings. With Jabil looking to end its manufacturing relationship with BlackBerry and BlackBerry’s reporting a $965 million net loss in the second quarter, we believe the probability that BlackBerry will quit the handset market is growing.
Infrastructure
Centrais Eletricas Brasileiras SA – ELETROBRAS: Frequently Asked Questions on the Credit Negative Effects of the Renewal of Concessions Ahead of their Expiration We assess the credit negative effects of the renewal of concessions ahead of their expiration. In December 2012, ELETROBRAS accepted the federal government’s offer to accelerate the renewal of certain generation and transmission concessions ahead of their scheduled expiration dates between 2015 and 2017. As a result, we foresee a significant reduction in the company’s annual revenues.
RESEARCH HIGHLIGHTS Notable research published the week ending 4 October 2013
42 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
Financial Institutions
Cyprus Banking System Outlook Our outlook on the Cypriot banking system remains negative, unchanged since 2009. The financial crisis in Cyprus has triggered a deep and prolonged economic recession that will further strain the already highly stressed operating environment. The outlook reflects the formidable challenges facing the banks, namely acute asset quality deterioration, continued concerns over their solvency, and intense funding and liquidity pressures.
Sweden Banking System Outlook The stable outlook mainly reflects the supportive operating environment, with strong economic growth relative to peers over the next 12-18 months, and our expectation that asset quality will remain strong in the low interest rate environment. In addition, the authorities and regulator are in the process of addressing Sweden’s increased household indebtedness and banks’ short-term funding reliance on foreign currency.
Central European Banking Systems: Limited Market Funding Reliance and Continued Growth Trends Imply Resilience to Fed Tapering Banking systems in the CEE countries are likely to prove resilient to the market volatility affecting emerging-market countries. As export oriented economies, the CEE countries are principally driven by the resumption of growth in the EU. Fed tapering alone is unlikely to have a major impact on the liquidity and asset quality, and thus on the overall creditworthiness, of the CEE banking systems.
GCC Insurance Industry – Markets Continue to Evolve, Rapid Premium Growth Expected The Gulf Cooperation Council (GCC) remains a small insurance region from a global perspective, collectively accounting for less than 0.4%of global insurance premiums. However, the region has been one of the fastest growing, with average annual revenue growth of 16.8% over the past six years, and we expect significant further growth over the near-to-medium term.
RESEARCH HIGHLIGHTS Notable research published the week ending 4 October 2013
43 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
Sovereigns
Credit Consequences of US Monetary Tightening The precise impact for countries will depend on their financial and economic linkages with the US, and how domestic policymakers respond.
Sovereign Ratings in APEC and Global Economic Challenges In the five years since the onset of the global financial crisis, the performance of the sovereign ratings of the members of the Asia-Pacific Economic Cooperation (APEC) has in general been of stability and strength. Looking ahead, APEC sovereigns are facing several new challenges. The slow pace of recovery in the advanced economies is constraining demand for the region’s exports, a key source of corporate profitability and employment as well as income growth.
European Financial Stability Facility The provisional (P)Aa1 long-term and (P)Prime-1 short-term ratings (negative outlook) assigned to the debt issuance programme of the European Financial Stability Facility is based on its contractual elements, including the irrevocable and unconditional guarantees by the euro area member states, as well as their creditworthiness and firm commitment to the EFSF.
Denmark, Finland, Norway and Sweden: Peer Comparison The Aaa ratings and stable outlook of the four main Nordic countries – Denmark, Finland, Norway and Sweden – are driven by a number of shared credit strengths and challenges. Their strengths include robust government balance sheets, strong institutional frameworks and a sustained economic resilience relative to most other Aaa-rated peers. However, this economic resilience masks highly indebted private sectors and high house prices, which could inhibit private consumption going forward.
African Development Bank We rate the African Development Bank Aaa/Prime-1, with a stable outlook. The bank’s ratings reflect a combination of its intrinsic financial strength, prudent financial management and policies and very strong shareholder support. These strengths offset the fairly low average credit quality of AfDB’s loan portfolio, a result of the bank’s challenging regional operating environment.
Azerbaijan Credit Analysis Azerbaijan’s Baa3 foreign and local-currency government bond ratings are supported by low government debt, sustained fiscal surpluses and a strong net creditor position. However, the ratings also capture Azerbaijan’s over-reliance on the oil sector, very low institutional strength, and the low credibility and effectiveness of policies.
PTA Bank The Ba1 rating of the Eastern and Southern African Trade and Development Bank, a multilateral development bank, reflects the combination of the bank's intrinsic financial strength and shareholder support.
RESEARCH HIGHLIGHTS Notable research published the week ending 4 October 2013
44 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
US Fed Tapering Effects Likely to be Relatively Limited and Temporary Industrialized and developing countries alike will experience temporary volatility in their growth trajectories, exchange rates and asset prices as the US economy continues to recover and the Fed eventually reduces its substantial monetary support to the US economy. The move toward normalization of monetary policy in the US will have a relatively limited and temporary impact for both developed and developing economies, while developing countries receiving significant amounts of capital inflows are vulnerable to capital flow reversals.
Moody's Sovereign Monitor - Focus on APEC Ahead of our participation in the APEC CEO Summit in Indonesia, this compendium brings together recent research underscoring our assessment of the sovereign creditworthiness of APEC’s member countries amid changing global economic conditions.
Ireland Credit Analysis Ireland’s credit profile is underpinned by the underlying dynamism of its economy, which remains attractive to foreign direct investment although the pace of robust economic growth registered in the pre-crisis period is unlikely to return. Although the rapid and steep climb in Ireland’s debt metrics over the past six years appears to have reached its zenith, significant challenges remain as the government continues the consolidation of public finances in line with the EU’s fiscal pact.
Kuwait Credit Analysis Kuwait’s very high levels of economic and fiscal strength support its Aa2 sovereign ratings, with a stable outlook. However, Kuwait’s high dependence on volatile oil exports causes wide fluctuations in economic performance.
Egypt Credit Analysis Egypt’s Caa1 sovereign rating reflects the country’s considerable economic and political dislocation, stemming from the January 2011 revolution. The widening of the fiscal deficit to 13.8% of GDP in the fiscal year ending 30 June 2013 from 8.3% in fiscal year 2010 is a credit negative development.
US Public Finance
Rating Changes for the 50 States from 1973 Our quarterly identifies changes in state general obligation and issuer ratings and outlooks. Currently, we have positive outlooks for two states, as well as negative outlooks for five states and for the Commonwealth of Puerto Rico.
RESEARCH HIGHLIGHTS Notable research published the week ending 4 October 2013
45 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
Structured Finance
CLO Interest We discuss the poorly defined rules that govern covenant matrices that create credit risk as CLO managers use covenant matrices to limit portfolio trading risk. Also in this issue: manager consolidation trend reverses in the US and slows in Europe amid new issuance, and the bankruptcy of Energy Future Holdings has a limited impact on CLOs.
Structured Thinking: Asia Pacific The latest newsletter contains articles on how having the Olympics in Tokyo is credit positive for condominium developers; the rising number of used condos is credit positive for Japanese investment-purpose condo loans RMBS; in Korea indexed property valuations mitigate risk for investors in KHFC covered bonds, and in Singapore the rules on credit card and unsecured credit are credit positive for ABS.
Impact of Legislative Amendments on Russian Onshore MBS Amendments to the Russian mortgage-backed security law that came into effect in January 2013 limit the risk associated with a number of relevant laws and are credit positive overall for domestic RMBS. Prior to these amendments, we assumed that an issuer with a negative net asset ratio would be self-liquidated and its assets would be sold. But the amendments prohibit voluntary issuer self-liquidation.
RECENTLY IN CREDIT OUTLOOK Select any article below to go to last Thursday’s Credit Outlook on moodys.com
46 MOODY’S CREDIT OUTLOOK 7 OCTOBER 2013
NEWS & ANALYSIS Corporates 2 » J.C. Penney Sells Shares to Boost Liquidity » Exova’s Acquisition of Defiance Testing & Engineering Services Is
Credit Positive » Alrosa’s Sale of Oil and Gas Assets to Rosneft Is Credit Positive
for Alrosa » New World Resources’ Disposal of Its Coke Business Is
Credit Positive » Metsa Board’s Divestment of Its Treasury Unit Is Credit Positive
Banks 7 » Royal Bank of Scotland’s Forced Sale of Branches Is Credit
Negative for Bondholders » Japanese Regulator Orders Mizuho Bank to Cease Lending to
Organized Crime
Insurers 9 » Colombia’s New Highway Infrastructure Initiative Would Be
Credit Positive for Insurers
Sovereigns 10 » Japan’s Decision to Proceed with Consumption Tax Increase Is
Credit Positive » Italy’s Political Instability Is Credit Negative Despite Confidence Vote
CREDIT IN DEPTH US RMBS Structures 13
Structural features common in pre-crisis transactions are re-emerging in new US residential mortgage-backed securitizations. Super senior support bonds, exchangeable securities, principal-only bonds and pool interest-only bonds can increase risks to senior bonds in the event of very high mortgage losses. They pose analytical challenges because their risk profiles are affected by absolute levels of losses and prepayments as well as timing.
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EDITORS PRODUCTION ASSOCIATE News & Analysis: Elisa Herr, Jay Sherman and Bronwyn Collie
David Dombrovskis
Ratings & Research: Robert Cox Final Production: Barry Hing