UPDATE DI SETTEMBRE

In recent weeks, we have witnessed interesting developments in the financials debt market.

Overall, the quarterly results season confirmed the health of the European banking system, in terms of profitability and fundamentals (both in terms of asset quality and regulatory capital). Net interest income on average grew by around 30% year-on-year, the cost of credit remained anchored at the levels of recent quarters, and capital continued to benefit from the organic ability to generate profits, while offering attractive returns to shareholders (RoE averaged 12% in the quarter, with peaks of 14.7% in Italy and 13% in Spain).

On capital side, according to our calculations, the average CET1 is above 15% with a capital cushion against regulatory requirements (MDA buffer) of 470 bps.

AVERAGE LEVEL OF CAPITAL PER COUNTRY AND BUFFER VS MDA REQUIREMENT

Source: Valori AM on corporate data as of 31/08/2023.

On the regulatory front, some European countries have announced new taxes on bank profits, in an attempt to transfer part of the benefit of rising rates from the banks to the community, as the return on deposits remains very low. Italy was the latest country to join the group of governments that are imposing taxes on banks in various ways (UK, Spain, Netherlands), with a 40% tax on annual growth in net interest income exceeding the 8% threshold: a measure still under discussion and which initially weakened market confidence on the equity market, but without any significant impact on the fixed income market.

Activity on the primary market, after the usual summer break, confirmed investors’ interest in the Additional Tier 1 asset class, with around $5.2bn of new issues from systemic issuers such as BBVA, ERSTE, INTESA, KBC, BNP and particularly attractive coupons (average above 8%).

The AT1 market also saw several issuers proceed with the redemption of AT1s on the first call date in recent months (Barclays, Abanca, BBVA, Caixa, HSBC), with the exception of Santander and Zürcher Kantonalbank.

AT1: NEXT CALLS

Source: Valori AM on Bloomberg data as of 12/09/2023.

On Santander, we point out that this is certainly nothing new, as it had already happened in March 2019 when the issuer opted not to call an AT1 bond (coupon 6.25%), surprising the market with this decision (given that the bank had apparently financed the redemption by issuing a new $1.2bn AT1 the previous month). The coupon was resetted  to 5.481% and the bond, with a call exercisable quarterly, was called in March 2020.

This time, unlike in the past, the market did not react negatively to the news: the bond’s coupon will rise from 5.25% to 8.20% (at current market conditions) and the quarterly call leaves the issuer with the option of a possible recall in the coming months.

PERFORMANCE BOND AT1

Source: Bloomberg, data as of 12/09/2023.

We therefore do not see any long-term effects on the price levels of Santander’s other AT1s or more generally on the AT1 market arising from this news.

On the contrary, the flow on the primary deals , the good series of recalls on the AT1 market or the buy-back offers launched in conjunction with new issues (as in the case of Intesa) have improved market sentiment. In terms of valuation, AT1s trade at a discount to the corporate high-yield market, and as the chart below shows, many instruments have not yet fully recovered from last March’s drawdown.

The resolution of the Credit Suisse case, with the forced sale of the bank to UBS by FINMA, the SNB and the Swiss Federal Council last Sunday, triggered strong selling in the AT1 segment and questions about the future and evolution of the instrument.

As part of the deal, the Swiss regulator wrote off the value of Credit Suisse’s AT1 bonds for CHF 16bn amount, instead allowing shareholders to limit the loss on their investment (UBS valued the bank at CHF 0.76 per share, 59% lower than the closing value on Friday 17 March, for a total valuation of CHF3bn).

With this decision, FINMA effectively inverted the creditor hierarchy with respect to the Basel rules, favouring shareholders at the expense of the AT1 bondholders. Although AT1s are clearly riskier than other debt instruments, they have always been and should be considered less risky than shares. But this has not happened.

The FINMA decision: some details

AT1 instruments absorb losses through three different mechanisms, chosen by the bank when the instrument is issued: nominal write-down (permanent or temporary, in case the bank becomes solvent again) or conversion into equity.

There are essentially two cases in which loss absorption is triggered:

• Contractual trigger (when capital, as measured by the CET1 ratio, falls below a certain threshold of 5.125% or 7%);
• Activation of ‘PONV’ (Point of Non Viability, i.e. when the regulator deems the bank to be close to failure). In this scenario, the participation in the losses of shareholders and bondholders is the basic prerequisite before public support can be activated.

The FINMA press release shows that Credit Suisse had not breached the capital ratios but that ” “there was a risk of the bank becoming illiquid, even if it remained solvent”. We therefore fall into the second case: FINMA, as the press release points out, linked the liquidity assistance backed by Swiss Confederation (amounting to CHF 9bn) to the impairment of AT1.

“The extraordinary state support entails a full write-off of the nominal value of all Credit Suisse’s AT1 bonds in the amount of approximately CHF 16 billion.”.

By applying the writedown only on the AT1s, FINMA has thus distorted the creditor hierarchy, causing a major shock in the markets and with implications that we believe are negative not only for Swiss AT1s, but in the long term for the entire architecture of Swiss resolution.

It is no coincidence that, the following day, both the ECB and the Bank of England[1] wasted no time in reiterating, via an official press release, the creditor hierarchy and that, for institutions under their supervision, equity is always written down before AT1s.

Five considerations

1. The European BRRD (the Directive regulating bank resolutions in the EU) clearly stated that if a bank is deemed ‘unviable’, the authorities may impose losses on AT1 and T2 holders. However, unlike in Switzerland, in the EU and the UK it is explicitly stated that if authorities decide to impose losses on AT1/T2, they must first write down equity, thus respecting the creditor hierarchy.
2. The devaluation of Credit Suisse’s AT1s highlights the riskiness of the instrument and the possibility that the regulator may impose losses on its holders, so an increase in the premium required by investors to subscribe AT1s can be expected in the future.
3. As of June ’22, the Tier 1 capital of European banks amounted to about €200bn (on average about 200 bps in terms of RWA). Although banks could be pushed to gradually replace some of these instruments with equity, we think it is difficult to assume a complete replacement, as the market would hardly absorb capital increases of this size. Moreover, even if the market had the capacity to do so, capital increases of this size would have a significant dilutive effect on shareholder returns with a net reduction in the RoE and thus the attractiveness of the industry.

4. The mechanism of permanent write-down of AT1s is essentially active only in Switzerland, since in Europe about 50% of the AT1s issues provide for a temporary nominal write-down and the remaining 50% for conversion into equity, which is slightly positive from the point of view of the recovery rate.

5. Since the scheme adopted in Switzerland for Credit Suisse cannot be replicated in the EU, we do not believe that there will be permanent damage to the AT1 market in Europe.

1. Shares of Silicon Valley Bank (SVB) plummeted 60 percent yesterday after the company announced a series of strategic actions to change its balance sheet structure while launching a $2.5bn total capital increase.
2. SVB has some peculiarities. The bank’s main clientele are California tech start-ups (which then use the bank to deposit funds received from venture capitalists). SVB has thus grown significantly in recent years, expanding the size of its liabilities (deposits have more than tripled in the past 4 years, from $55bn to $186bbn).
3. However, the sensitivity of SVB’s assets to increases in interest rates has been structurally lower than that of its liabilities, so the bank is seeing an inflation in the cost of deposits (on the liabilities side) on the one hand, not offset by an increase in profitability of assets. In the March 9 statement, the bank’s management warned that it “expects interest rates to continue to rise, Venture Capital markets to continue to be under pressure, and customers to burn cash.”

4. Therefore, SVB is trying to change its asset structure to make it more flexible if rates rise. How? SVB sold about $21bn of US Treasury and Agency securities (average yield of 1.79%), to buy short-term US-Treasury bonds at higher rates (about 5%), thus recording a loss of about $1.8bn. To cover the loss, the bank then launched a $2.5bn total capital.
5. This move underscores how recent rate hike policies have exacerbated the fragility of certain market segments, causing losses to crystallize by having to value mark-to-market assets.

6. In summary, Silicon Valley Bank shows a number of peculiarities:

– It is a regional bank with a specific clientels (start-ups, venture capital, California tech, which is penalized by the current market environment)

– It has a particular balance sheet structure (high percentage of business deposits with high sensitivity to rate increases , but low relative to its assets);

7. After losing 60% yesterday, the stock is losing about 60 percent today in pre-market in the wake of fears related to the possibility that customers may decide to withdraw deposits at the bank triggering a liquidity crisis. The fears were heightened after the Founders Fund, Peter Thiel’s Venture Capital, recommended withdrawing money from the bank’s accounts.
8. We are closely monitoring the development of the situation, although the contagion risk for large US banks would seem limited, but regional/smaller banks may show greater vulnerabilities.
9. In Europe, banks are highly regulated entities by European institutions, and banking fundamentals are solid, as confirmed by the latest quarterly reports recently released. Today’s event does not change the positive assessment of the sector’s solidity both from an equity perspective and with regard to subordinated bank bonds.
10. In U.S., it will be interesting to assess the Fed’s next moves: on the one hand, further tightening could exacerbate the risk of a systemic event; on the other hand, a slowdown in tightening could be interpreted as a symptom of some fragility in the U.S. financial sector.

New record for anti-inflation government bond, 3.6 billion subscribed on first day of placement. In this article in La Stampa, Paolo Barbieri, Head of Fixed Income at Valori Asset Management, explains how the forecast is to end the year around the 6/7% average Italian inflation rate and how this implies a very aggressive descent in the second half of the year. This means that the revaluation of the Foi could be more subdued than in past months, and therefore return expectations may not be met.

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