Insurance stocks were hit hard on Monday amid concerns about their holdings of sovereign debt. But what about the banks, how exposed are they to government paper, eurozone and otherwise.
Here, via JPMorgan, is something of an answer.
Unfortunately, it is not possible to get specific country details because the banks don’t provide that level of granular data. (The above is aggregate data disclosed in half year 2009 balance sheets).
Nonetheless, we can see that RBS has the largest holding of eurozone paper. Also worth noting is the fact that 60 per cent of RBS’ government securities are held on its trading book, according to JPMorgan.
As for HSBC, its large holding of ‘Other’ government paper can be explained by the fact that its local subsidiary companies – outside of the UK, US and Asia – deploy commercial surpluses in short-term sovereign paper.
Now, for JPMorgan, specific company exposures to eurozone debt is not something investors should be overly concerned about – the bank reckons the risk of a default is low. However, there is something to be concerned about – higher funding costs from an increase in UK sovereign risk.
Given the implicit and explicit guarantees to the banking sector, a widening of the sovereign spread would have a direct impact on banking profitability. In the table below we show the change in CDS for the UK since the 1st January and also since the recent low in September 09. We have highlighted the potential impact of a permanent 20bps move in terms of funding costs. Note we are assuming the full movement in UK sovereign is reflected in funding costs and that the whole book is refinanced. If this is more of a short term issue, then this will impact banks with shorter duration funding more disproportionately.
Once again, RBS comes off worst.
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As for the insurers and their large holdings of government paper, Morgan Stanley reckons they can withstand the mark-to-market volatility as they can hold sovereign debt to maturity; policyholders may also share losses and current solvency rules contain offsets that reduce the impact of market movements.
Due to the long-term nature of their liabilities, most insurers will be able to hold their sovereign debt to maturity, in our view. The mark-to-market of sovereign debt in the portfolio will pass through insurers’ shareholder equity, to the extent that it is accounted for under the ‘fair value’ or ‘available for sale’ IFRS accounting buckets. However, regardless of the accounting treatment, we believe most insurers will be able to hold these bonds to maturity, ultimately benefitting from the pull to par.
Life insurance liabilities are long-term in nature, and have recently shown resilience against a ‘run on the bank’ risk. Even in non-life insurance portfolios, the degree of matching the duration of bonds to the duration of liabilities is high, resulting in a low liquidity risk from the need to sell bonds before maturity, below par, to meet claims payments.
The fundamental risk to the insurance sector, of course, comes from a default, something which Morgan Stanley like JPMorgan thinks is unlikely.
And in any case, gearing is low. Certainly nowhere near enough to force insurers to fresh capital, a concern which seems to have driven Monday’s sell off.
Our macro economists’ view is that it is extremely unlikely that we will see sovereign defaults from any Eurozone member or other developed country. There are many levers governments can and will pull if necessary to head off default, such as tax rises and asset sales. However, investor nervousness is understandable given news headlines and the insurance sector’s material exposure to sovereign risk – a direct result of defensive investment strategies. Our thesis is that: i) the insurance industry is well placed to ride out sovereign market volatility; and ii) direct gearing to the countries deemed most ‘at risk’ is low.
We believe direct gearing to the sovereign debt of Greece, Ireland, Portugal and Spain is low. Detailed sovereign exposure data is currently lacking – insurers have generally not produced granular information as investors were not focused on the issue – market updates being hampered by closed periods. However, we have made some estimates of exposure based on data available. Overall, we estimate largely single-digit gearing to tangible equity for most companies to each country.
Related link:
Défãult rísk – FT Alphaville