July 2014 - Credit - Oops, BES...

Signs of HY indigestion

We have always highlighted the importance of primary markets as a key gauge of investor risk appetite, a crucial driver of price discovery and a bellwether for the market outlook in European credit. In this respect, we are concerned by the signals that we have received from the HY new issue market in the past couple of months. Despite ca. €28bn of bonds issued in June and July alone and absorbed by investors, only 9 of the 67 transactions launched are currently trading above their reoffer price in the secondary market. Combined with a selloff of many HY bonds by 2 to 5 points over the same period and some nasty credit surprises such as the UK food manufacturer Boparan or Portugal-based bank BES, this negative momentum in the primary market likely induced significant losses in many European credit portfolios and should encourage a more cautious investor behavior during the summer lull.

BES: a unique situation…

We have said for a while that the broad picture for European credit markets remains favorable – with abundant liquidity, improving fundamentals and low default rates – but that idiosyncratic risk assessment and credit selection are key to navigate the current market environment. We consider the Portugal-based Espirito Santo Group (GES) situation as a case in point worth analyzing in detail.

GES is a privately owned conglomerate built over almost 150 years by the Espirito Santo family. The group has interests in several sectors such as tourism, real estate, banking services and insurance. The group corporate structure is complex and opaque. Espirito Santo International S.A. (ESI) is the Luxembourg-based holding company of the group. ESI does not own any hard assets but holds 100% of Rio Forte Investments S.A., which itself concentrates all the assets of the group, including 49.26% of the Espirito Santo Financial Group (ESFG). ESFG is a Luxembourg-listed company encompassing the financial activities of the group, such as the private bank Banque Privée Espirito Santo, the insurance company Tranquilidade and a 20.1% stake in Banco Espirito Santo (BES), the second largest Portuguese bank by assets.

Today, the three holding companies – ESI, Rio Forte and ESFG – have filed for protection from creditors in Luxembourg (Régime de gestion controlée) while BES is under resolution by the Portuguese banking regulator. In this saga, it all started at the ESI level. With limited access to capital markets after the 2011 peripheral sovereign crisis, ESI sold debt to one of the money market investment funds managed by BES, with very limited disclosure and based on potentially fraudulent asset valuations. By the end of 2013, ESI and Rio Forte had also issued €3.6bn of debt to investors, of which €2.1bn was placed to BES retail customers. While not strictly illegal, the Bank of Portugal ordered an external audit of ESI’s 2013 annual accounts and ESFG was forced to set a €700m provision to cover potential losses suffered by BES retail customers invested in ESI debt instruments.

In early 2014, ESI replaced some of its retail financing by issuing commercial paper to institutional investors, the highest profile one being Portugal Telecom which bought €897m of Rio Forte commercial paper. It also issued debt purchased by other group subsidiaries, such as ESFG and BES. In the end, ESFG exposure to ESI and Rio Forte increased from €1.37bn at the end of 2013 to €2.35bn at the end of June 2014. Over the same period of time, BES exposure to ESFG and Rio Forte increased from €400m to €1.2bn!

At the time, BES underlying exposures to ESI and Rio Forte, the web of intertwined debt within GES and the appalling group corporate governance were largely ignored – overlooked? – by the market. However, last June BES issued €1bn of new shares to strengthen its solvency ahead of the ECB’s Comprehensive Assessment. In the transaction prospectus, BES warned investors that due to accounting irregularities, ESI was in a serious financial condition, which could have an adverse impact on BES reputation and the market price of its shares. Although the rights issue was successfully completed, investors started to pay attention to the situation of ESI, Rio Forte and other GES entities.

In July, ESI and Rio Forte announced that they were unable to repay their commercial paper maturing the same month and filed for protection from creditors in Luxembourg. ESFG, being materially exposed to these 2 entities had no choice but to do the same. In a little more than a month, ESFG senior bonds went from par to 18 cents while subordinated instruments were quoted in the mid-single digit range from 98 on June 26.

This was not the end of the story. On July 30, BES announced a €4.2bn provision – mostly to cover its exposure to GES entities, including new ones – and published a €3.6bn record loss for H1 2014. As a result, BES Core Tier 1 ratio dropped to 5%, i.e. below the Bank of Portugal’s 7% minimum regulatory requirement, implying a €3bn capital shortfall to reach the 10% Tier 1 ratio that is now seen as the new standard for European banks.

… but a template outcome

With a stock price in free fall, credit spreads at record wides and rumors spreading all over the market, the Portuguese government had no other choice than intervention. On the night of August 3, it announced the transfer of all BES “general activity and assets” – aka. the clean assets and operations – as well its deposits and unsubordinated debt into a newly-created regulated institution named Novo Banco. €4.9bn of new capital is allocated to Novo Banco by the Resolution Fund – created in 2012 in the context of the EU new banking regulation – via a loan from the Portuguese State. In the meantime, all problematic assets – in particular loans to other entities of GES – stay with the equity and the ca. €1.2bn of subordinated debt in the former BES with very low recovery expectation – if any. In the end, depositors and senior creditors of the bank remain protected, while its shareholders and subordinated creditors will be bailed-in. Little wonder that BES senior bonds recovered from their 90-95 lows to levels above par, while its subordinated bonds now trade between single digit and mid-10’s. At the holding companies level, all creditors – senior and subordinated – and shareholders will likely incur severe losses and all debt instruments now trade single digit.

In our view, such outcome seems very consistent with the new resolution regime governing the European banking sector post the financial crisis as the EU regulation requires a mandatory burden sharing of shareholders and subordinated creditors in case of state aid for a banking institution since 1 August 2013. However, one important feature will be added to this resolution toolkit going forward. From 2016, the banking regulator will have the ability to force losses on senior creditors – once shareholders and subordinated creditors have been written down via the enforcement of bail-in legislation. No doubt that senior credit risk may need to reprice in the next few quarters.