Here’s the Moody’s report that is making waves in financial media circles on Tuesday morning.
The basic premise: The average maturities of new debt issuance by Moody’s-rated banks around the world fell from 7.2 years to 4.7 years over the last five years — the shortest average maturity on record. In graphic terms, that looks like this:
That means banks will face maturing debt of $10,000bn between now and the end of 2015, or $7,000bn by the end of 2012, according to Moody’s.
Now, a debt profile skewed towards short-term maturities can make a bank more vulnerable to market volatility (increases in official interest rates and/or swings in investor confidence) which rather helps explain why banks got into it in the first place. Here’s Moody’s:
Before the crisis, banks tended to issue two to three times more new debt than what came to maturity during a given year, highlighting the rapid asset growth that occurred across banks and systems in recent years and their active management of liabilities to lower funding costs. The trend towards shorter debt maturities reflected banks’ increasing confidence in their market access as well as the availability of alternative funding channels, notably through the use of securitization. It also appears that, presumably for similar reasons, banks have increasingly relied on instruments with option features (step-up, call or put options) that expose the issuer to periodic changes — the risk being an increase — in the rate they pay on their own debt (for the purpose of our graph, we have generally referred to these instruments as medium-term notes, or MTN).
As the above should suggest, the danger here is that investors don’t return in time for banks to refinance their shorter term debt. Uncharacteristically perhaps, Moody’s is actually concerned here. At the very least, the ratings agency says the banks will experience a step-up in funding costs:
Driven by either internal risk management or regulatory considerations, we expect that affected banks will want to extend their debt maturity profiles by replacing some of their short-term debt instruments and MTN-like instruments with new, longer term wholesale debt in the coming months and years. However, spreads on long-term corporate debt are already substantially wider than short-term debt currently, and it is probable that rates will rise in the future when considering the historically low interest rates currently prevailing and some other forces that may also push up rates, such as the imminent exit of government support to the financial sector and the fact that these governments will also compete with banks for debt raising in order to finance their large deficits. Therefore, funding costs would increase from the mere fact of moving out on the yield curve, with the risk of funding costs being pushed up further by the rising tide of benchmark rates.
And just to get really wonky — here’s a demonstration of that increased funding cost:
Suppose, a Baa-rated bank had issued short-term debt under an Aaa-rated government guarantee programme and had been paying a coupon of about 1.3 per cent. It would need to pay a 7.75 per cent coupon for issuing a 10-year bond on its own today — a 645bp increase. The same move by a Ba-rated bank would result in a 929bp increase. Considering that the issuance of Aaa-rated government-backed unsecured debt for banks globally (ex-US) is up 23 per cent, while issuance without government backing is down 22 per cent — you can get a sense of just how much money banks have actually been saving due to the guarantee programmes.
Those government-guarantee programmes around the world will of course expire in coming years. At the same time you will also probably get a wind-down of central bank asset purchases and further regulatory pressure on banks’ capital — all of which means significant upward pressure on banks’ funding costs, at a time when many will still be dealing with copious amounts of bad debt, according to Moody’s.
In other words, the banks don’t just have an asset problem — they also have a looming liability problem.
Back to Moody’s:
Investors have returned to the market in 2009, providing significant amounts of funds, but this should not be confused with a return to a normal operating environment. We believe that the “thawing” of debt and equity markets was largely driven by calculated, opportunistic risk-taking in the context of the extraordinary support provided by government programs and very low short-term interest rates. We would therefore not describe the investor resurrection as a return to strong financial fundamentals in the markets.
In fact, we expect that credit-related losses to continue to cause damage to banks’ financials. In our view, losses are still on a rising trend, mainly because of the delay that exists between the end of a recession and a fall-off in provisions and actual charge-offs.
To use the US banking system as an example, banks have not provisioned for the full amounts of loan and securities losses that we believe they will incur over the coming year, which we expect to reach $470 billion in credit costs by the end of 2010. Approximately only one quarter of this has been recognized to date and we expect earnings to be insufficient to offset these costs during that period, resulting in many banks being unprofitable.
The risk premium on bank debt is unlikely to fall in such a poor credit quality context. If anything, it may actually increase, especially for long-term debt which already commands a significantly higher premium. Additionally, a close look at recent results reported by banks in various systems reveals that asset quality prospects for both consumer and commercial credits remain bleak.
Therefore, credit costs should continue to put banks’ earnings and profitability under considerable pressure, which might cause investors to seek additional risk premia, as governments gradually exit from the direct support they have so far provided. In other words, we see weaknesses on both sides of the balance sheet, and we are concerned that the risks associated with both assets and liabilities may fuel each other, cause losses and undermine investor confidence.
Moody’s — we didn’t know you could be so (bank) bearish.