Before MF Global went bankrupt due to European sovereign exposure, the smart money was that Austria's Erste would be "it." After all, recall from our October 10 post "that Erste disclosed some major losses on its €5.2 billion CDS portfolio, consisting of "EUR 2.4 billion related to financial institution exposures, and EUR 2.8 billion related sovereign exposures". Why is this a surprise? UK-based financial advisory Autonomous explains: "The fact that Erste had a sovereign CDS portfolio which was not marked-to-market has left many investors scratching their heads. As a reminder the EBA stress test data showed Erste to have zero sovereign CDS exposure within its sovereign mix compared to the €2.8bn it now appears to have ‘fessed up’ to (taking a cumulative €460m hit). They also have €2.4bn exposure to banks via writing of CDS. The bulk is non-PIIGS but banks spreads have moved in the same manner as sovereigns (albeit wider and more volatile)." And there you have it: the bogeyman that everyone has been warning about, yet nobody has seen, CDS written (as in sold) in bulk against other sovereigns and other banks which up until now were only mythical, as they, to quote the EBA (which had Dexia as its safest bank) simply did not exist. Oh, they exist all right, and what they do is create a toxic spiral of accentuating losses whenever the risk situation deteriorates, creating positive feedback loops of ever increasing losses until the next Dexia appears... and then the next... and the next. Expect the market to latch on to this dramatic revelation like a rabid pitbull once the hopium high from today's EURUSD short covering squeeze wears off." Of course, the market ignored this loud warning bell, and next hting you know MF was under. This time it won't be so easy, especially since Moody's just announced it is about to downgrade Erste precisely for this reason. This move also explains why the market is suddenly rife with rumors of a broad Austria downgrade.
Frankfurt am Main, November 04, 2011 -- Moody's Investors Service has today placed on review for downgrade Erste Group Bank AG's (Erste) standalone bank financial strength rating (BFSR) of C- (mapping to Baa1 on the long-term scale) and the A1 long-term debt and deposit ratings. Consequently, several subordinated and junior subordinated debt ratings were placed on review for downgrade. The P-1 short-term rating was affirmed. A full list of affected ratings is listed at the end of this press release.
The review for downgrade on the BFSR follows the bank's report of a major loss that partly stems from previously undisclosed credit default swap (CDS) exposures. Accordingly, the review will focus on Erste's risk management, internal controls and financial transparency as well as the risk-adjusted profit generating capacity of its business model. The review for downgrade of the A1 long-term ratings follows the review on the BFSR.
As part of the re-assessment of the C- BFSR, a lower mapping of the standalone credit strength to Baa2 from Baa1 is likely, while a move of the BFSR below the C- range cannot be ruled out entirely. Consequently, the rating agency notes that a one-notch downgrade of the long-term debt and deposit ratings is the most likely outcome of the rating review.
The decision to review Erste's C- BFSR for downgrade was prompted by Moody's concerns about the bank's risk appetite as well as its related risk-management policies, internal controls and financial transparency following an announcement on 10 October 2011 of extraordinary charges leading to a net loss of EUR1.5 billion in Q3 2011. Particularly relevant is the disclosure of a EUR5.2 billion net CDS portfolio (protection sold), which appears to be unrelated to Erste's core business operations and had previously been recognised at cost, rather than at fair value. Erste also announced the harmonisation of IT tools requiring the restatement of certain income-recognition accounting, raising questions about the uniform application of appropriate risk-management tools as well as financial transparency on a group-wide basis.
Both changes may mean that earlier qualitative assumptions that Moody's had assumed are no longer consistent with the C- BFSR and the Baa1 standalone credit assessment.
At the same time, Moody's acknowledges the bank's announcement -- during its Q3 2011 earnings call -- that it has reduced its net CDS exposure to EUR300 million as of 27 October 2011 through various measures such as novation, close-outs and -- to a much lesser extent -- hedges. It is Moody's understanding that these actions have effectively reduced the contingent liability relating to these derivatives contracts and related earnings volatility. However, the restatement of the CDS exposures had a negative impact of approximately EUR460 million after tax. This, combined with the other extraordinary charges (predominantly goodwill write-offs for its Hungarian and Romanian businesses), required the bank to postpone the planned repayment of EUR1.2 billion in government-provided participation capital. This could limit the bank's strategic and financial flexibility for a longer period than Moody's previously expected. In the absence of previously anticipated meaningful profit generation for the full-year 2011, Erste's 7.4% core Tier 1 capital ratio (excluding government participation capital) as per 30 September 2011 is weak compared with other banks' capital ratios rated at the C- BFSR level. In Moody's view, the comparative weakness increases the pressure on Erste to make a rapid return to its earlier earnings-generation capacity to bolster its regulatory capital levels.
Erste's A1 long-term ratings currently benefit from the very high support assumptions as a systemically relevant bank in Austria which results in three notches of uplift from the bank's Baa1 standalone credit strength. Accordingly, the long-term rating is expected to move in tandem with Erste's standalone risk assessment.
WHAT COULD CHANGE THE RATING UP/DOWN
There is currently no upward rating pressure as expressed by the review for downgrade.
In addition to the factors described above, the bank's BFSR could come under downward rating pressure due to (1) a stalled economic recovery in Eastern Europe resulting in additional substantial credit charges, beyond levels anticipated by Moody's, (2) an extended period of weak earnings and hence lower internal capital generation, and (3) weakened capitalisation levels as a result of strong asset growth in Eastern Europe.
The bank's long-term ratings could come under downward pressure in case of a weakening in its intrinsic financial strength, as well as adverse changes in the systemic support assumptions currently factored into Erste's ratings. However, Moody's does not consider this likely at present.