One week ago, in a valiant attempt to defend the stock price of struggling commodity trading titan Glencore, one of the company's biggest cheerleaders, Sanford Bernstein's analyst Paul Gait (who has a GLEN price target of 450p) appeared on CNBC in what promptly devolved into a great example of just how confused equity analysts are when it comes to analyzing highly complex debt-laden balance sheets.
In the clip below, starting about 2:30 in, CNBC's Brian Sullivan gets into a heated spat with Gait over precisely how much debt Glencore really has, with one saying $45 billion the other claiming it is a whopping $100 billion.
The reason for Gait's confusion is that he simplistically looked at the net debt reported on Glencore's books... just as Ivan Glasenberg intended.
However, since Glencore - like Lehman - is first and foremost a trading operation, one also has to add in all the stated derivative exposure (something we did ten days ago), in addition to all the unfunded liabilities, off balance sheet debt, bank commitments and so forth, to get a true representation of just how big, or rather massive, Glencore's true risk is to its countless counterparties.
Conveniently for the likes of equity analysts such as Gait and countless others who still have GLEN stock at a "buy" rating, Bank of America has done an extensive analysis breaking down Glencore's true gross exposure. Here is the punchline:
We consider different approaches to Glencore’s debt. Credit agencies, such as S&P, start with “normal” net debt, i.e. gross debt less cash and then deduct some share (80% in the case of S&P of “RMIs” – Readily Marketable Inventories. These are considered to be “cash like” inventories (working capital) in the marketing business. At the last results, RMIs were about US$17.7 bn. Giving full credit for RMIs plus a pro-forma for the equity raise and interim dividend we derive a “Glencore Adjusted Net Debt” of c. US$28 bn.
On the other hand, from discussions with our banks team, we believe the banks industry (and ultimately regulators) may look at the number i.e. gross lines available (even if undrawn) + letters of credit with no credit for inventories held. On this basis, we estimate gross exposure (bonds, revolver, secured lending, letters of credit) at c. $100 bn. With bonds at around $36 bn, this would still leave $64 bn to the banks’ account (assuming they don’t own bonds).
Charted, here is why Sullivan and his $100 billion number was spot on, and why Glencore's banks suddenly realize the company has more gross exposure than its has total assets!
BofA lays out the stunning, if only for equity analysts, details:
Over US$100bn in estimated gross exposures to Glencore
We estimate the financial system's exposure to Glencore at over US$100bn, and believe a significant majority is unsecured. The group's strong reputation meant that the buildup of these exposures went largely without comment. However, the recent widening in GLEN debt spreads indicates the exposure is now coming into investor focus.
Debt broadly spread
GLEN debt breaks down as US$35bn in bonds, US$9bn in bank borrowings, US$8bn in available drawings and US$1bn in secured borrowing. We then estimate that the group has US$50bn in committed lines against which it can draw letters of credit with which to finance its trading inventories. Based on public filings, we believe that the banks may have limited capacity to reduce even the undrawn portion of these lines until 2017. GLEN have publicly stated its financing is largely locked in - but we believe that this may not provide comfort to risk-averse bank shareholders and supervisors.
Concentration and convexity: potential stress testing ahead
GLEN had an unencumbered asset base of over US$90bn in property, plant, equipment and inventories at the half year. However, for bank investors and regulators, after the crisis, gross nominal exposure is a key metric – including committed facilities. We believe many banks may now be more carefully reviewing their exposure to the commodities complex. Glencore’s banks span the globe, with 60 in a recent financing. Glencore has stated it has locked its financing in for an extended period, but a desire to hedge would be powerful at the banks, as likely that regulators will include commodity and energy exposures in the next stress tests as it is a stated area of focus. These stress tests typically take gross exposures and assume elevated loss-given-default - a potential 5x capital uplift. A system positioned one-way on a credit has historically tended to keep spreads high; implying rising debt costs which are likely to put pressure on credit quality: convexity is alive and well.
Furthermore, as we reported last night, while banks have so far been willing to throw good money after bad, this is about to change:
Bond market spreads imply a non-investment grade rating
The group's bond spreads imply a rating in the single-B range and a rollover cost of funding >200bp above the cost of debt outstanding. We believe banks’ gross margins on their exposures are below the Glencore group’s average funding cost, with drawn financing at spreads around 50bps and undrawn lines materially below this. The cost of hedging exposure is currently over 600bps. Thus, the P&L dynamics for banks are difficult; this implies to us that banks may increase challenge the business model of commodity traders; this implies to us that banks may increase the cost of and reduce the availability of credit to commodity traders, thus challenging their business model.
Bank shareholder pressure on disclosure and exposure
We believe bank shareholders may pressure managements to reduce exposures, if not because of potential loss then at least because of likely capital consumption under stress. In our view, current disclosures by the banks are inadequate to provide clarity. It is not possible to estimate unsecured exposures, nor to understand if individual short term loans may be a part of a long-term irrevocable commitment as in the case of Glencore, based on publicly available disclosure..
Worse, since it is not just Glencore that the banks are exposed to but very likely the rest of the commodity trading space, their gross exposure blows up to a simply stunning number:
For the banks, of course, Glencore may not be their only exposure in the commodity trading space. We consider that other vehicles such as Trafigura, Vitol and Gunvor may feature on bank balance sheets as well ($100 bn x 4?)
Call it half a trillion dollars in very highly levered exposure to commodities: an asset class that has been crushed in the past year. Which explains BofA's next point:
According to our Credit analyst, Navann Ty, GLEN’s 5y CDS tightened by 85bp yesterday to c. 640 bps. GLENLN CDS is 70bp wider to MTNA (ArcelorMittal), which is rated Ba1/BB. Trying to extrapolate to an implied credit rating is difficult as we don’t think that there are many IG-rated credits trading at the same level. Bottom line - there appears to be a lot of demand for default protection.
All of the above should be well-known to our readers. However, the below exchange between the BofA equity analyst and the company's bank analyst is a must read to gain some further insight on Glencore which is increasingly - and belatedly - seen as the fulcrum entity in what may be the watershed event for any wholesale commodity-trading indudstry collapse, and why the company is, as we first called it, in danger of becoming the commodity sector' "Lehman", a name we first gave Glencore two weeks ago and which appears to have stuck.
What are the similarities that you observe between GLEN and your experience/analysis of other financial companies during the 2008 Global Financial Crisis (GFC)? What is the roadmap for a situation like this to unwind?
Alistair Ryan (AR): One key similarity I see is the financial structure of the company in time and space. Glencore’s highly leveraged financial structure has not been stress tested in its current form through a full cycle. Ultimately it appears that there is a time mismatch between the duration of its funding (short) and the time to realize the value of (some) of its assets (e.g. the industrial assets). The large notional size of its outstanding debts (US$50 bn+) is also unusual. We observed similarly mismatched capital structures during the GFC in consumer finance companies (e.g. Countrywide, Household) & public broker dealers (e.g. LEH).
Can you give some examples of situations that ended well/less badly? What were the actions taken by company managements?
If we look at Banks as a counterpoint through the GFC, they were, in general much more financially resilient. The institutions which came under pressure and/or failed during the GFC had large nominal amounts of short term debt. Take HSBC. HSBC bought “Household”, the largest consumer finance company. We believe because of HSBC’s relatively low leverage, and the fact that they undertook a $17 bn rights issue, they were able to absorb the losses resulting from their ownership of Household.
As an interesting aside, and again speaking to the financing duration mismatch issue, while HSBC took US$22 bn in write-downs related to mark to market losses onstructured credit (sub-prime), in subsequent years, the company has written back around $21 bn of these losses. We might think about a parallel here with the duration mismatch of short term debt funding and some of GLEN’s more marginal industrial/mining assets which might be “out of the money” today but where value could be realized if the assets are held for the longer term.
Can you give some examples of situations that ended badly? What were the pitfalls?
If we consider the example of UBS, during the GFC found itself in the unfortunate situation of needing to do 4 share issuances support its balance sheet and ultimately sold down the assets that were causing the problems. While this combination did fix the problem at that time, it meant that the company didn’t benefit when the value of the distressed assets recovered. (As an aside, we note GLEN’s 9.99% issue may be of concern due to the fact this is the maximum permissible size that can be undertaken without shareholder approval or a prospectus). During the GFC we came to see similarly sized issues as not always adequate.
A key problem then is the combination of short term funding and market moves in the price of assets which could impact the ability to raise funds either through equity raises and / or asset sales.
Speaking in general terms, we think that some management teams may have been overly confident in terms of their ongoing access to funding. They may also have underestimated the severity of market moves and the extent to which these market moves might make their funding structures unsustainable in less liquid environments. Financial companies tended to have few covenants meaning there wasn’t an actionable indication of a problem under the debt terms until it was time to refinance. At Enron, by contrast, the company used funding structures which were dependent on its investment grade rating so that, effectively, 2 days after the company was downgraded to junk, it was “done”.
We do note the dependence of some business models on the feedback loop of market confidence into the cost of debt which can then ultimately impact the viability of the business. For example, if the cost of debt doubled at a commodity trading company, to what extent is the business model impacted?
We also find it interesting that other commodity trading houses such as ADM & Bunge use relatively lower levels of financial leverage.
What are the problems for GLEN with a potential downgrade to ratings 1 notch (BBB-). What about a two notch downgrade to Junk?
As a rough rule of thumb, we’d think about a 1 notch change in rating being equivalent to a 50% change in a bank’s appetite for exposure to a company. With the pressure we’ve seen on Glencore’s yields & CDS we’d expect that some banks could be looking to reduce their exposure to Glencore and would be looking to hedge existing exposures (for example through the CDS market). This would include undrawn lines. With Glencore presently financing at about Libor + 40 bps but the CDS at 800 bps, having a line out to Glencore has significant “negative carry” implications.
Size matters when it comes to the size of debt issuance. Glencore is a large absolute issuer with >$50 bn in outstanding debt in various forms. What this means, in our view, is that the credit may be quite large in many banks’ portfolios already. As such, the ability of some banks/investors to take additional exposure to Glencore may be limited. We consider the example of RBS vs. HSBC. RBS “maxed out” many credit counterparties including in the short-term wholesale market during the GFC.
We also consider the relative size of the markets for investment grade and high yield debt in Europe. Investment grade is about $1.6 trillion. High yield is about US$330 bn. These markets are anticipatory, of course, but to the extent that a large issuer were to be downgraded from IG to junk, we’d expect to see some indigestion as markets adjust to new balances.
What is the feedback loop into the banking system from financial stress at Glencore? What does our experiences of 2008 tell us?
The key feature of financial markets in early 2008 was that it had been a long time since something bad had happened. As such “tail risks” were underpriced and we saw an extended period of “easy money”. More and more leverage came into the financial system at different levels. The layers of leverage meant that once the market turned (and the key one here was the US housing market), and recovery proved difficult.
We also note that, as financial institutions came under pressure in 2008, 2009, several companies released quite general statements reaffirming the strong state of affairs in the business. While these statements may have been true in terms of operations, they didn’t reflect the sea-change in the financing environment and the potential negative marks to which the companies were exposed. As such, we read Glencore’s statement of 29th September 2015 with interest and caution: “Glencore has taken proactive steps to position our company to withstand current commodity market conditions. Our business remains operationally and financially robust – we have positive cash flow, good liquidity and absolutely no solvency issues. …”
How might stress tests evolve to include exposure to commodity traders? What is the likely outcome of this?
Bank stress tests are inevitably “topical” i.e. focused on the issues of the day. Take the concept of RMI (“readily marketable inventories”). It hasn’t been tested through an economic cycle. To the extent that we saw a dislocation in commodity markets (say caused by falling commodity prices), this might cause several financial institutions to reexamine commodities / contracts that initially appeared to be cash-like. Then, recovery assumptions might be called into question with the realization value for those commodities as key. To the extent that we saw systemic distress in the GFC with several financial institutions as forced liquidators in a distressed market, liquidity became a real issue and losses were greater than financial models might have suggested. As such, based on our experience, we could hypothesize that a stress test might require an approximate 30/40% haircut on assumed commodity prices.
UK, US & Swiss bank regulators are likely to be focused on this issue in the next round of stress tests (starting in January). In the US we are starting to see the fall-out from the US energy junk-bond situation. In the UK, HSBC and Standard Chartered have big exposures to emerging markets, particularly China. In Switzerland, we believe that both UBS & CS would have exposures to most of the commodity trading houses so Glencore, but also the privately held commodity trading companies such as Trafigura & Gunvor.
How should we think about bank exposure to Glencore and commodity traders in general? Overall, what do you think about this situation?
I’m concerned. The company has cash on hand of around $3 bn at its last results. Yes liquidity is $10 bn including credit lines [JF: latest from company is c. $13 bn post the rights issue]. However, to the extent the company chooses to fully draw those credit lines, a scenario that could emerge is that of this being a stepping stone to lines potentially not being renewed.
If we look at the risks on counterparties, we think that UBS might not be in a position to “take” a $1 bn loss on funds outstanding to Glencore, if such losses were required. CS might not be in a position to “take” a $1 bn loss on funds outstanding to Glencore, if such losses were required. If we think about it from a game theory point of view, there is the danger of a “rush for the exit” in terms of bank exposure to GLEN. As such, credit departments must, we believe, be thinking about how others in the market will consider the risk.
Bottom line, given that CDS in the range of 600-800 and yields on some bonds are now 7% plus, we believe it seems unlikely that a financial institution would look to actively increase its exposure to Glencore, and potentially, to the wider commodity trading space. This scenario would suggest that, while a liquidity squeeze for the wider space may not be imminent, it cannot be ruled out over the next 12-18 months. Again, we are thinking about how risk officers will be planning for the next round of stress tests. To us, part of the latter may mean reducing exposure to commodity traders. We acknowledge that some relationship banks would likely continue to “back” the relationship but whether this will be the norm for the c. 70 banks with whom Glencore has a relationship is uncertain.
Finally, here is BofA's punchline:
- Comparisons are being made with some financially leveraged companies during the 2008 Global Financial Crisis (GFC).
- If credit is downgraded, banks could lower their exposure to Glencore both in terms of RCFs & LCs.
- The high yield market is small and, our credit strategist thinks we might initially see temporary dislocations in a scenario in which GLEN were downgraded to junk.
- Bank stress tests could start to include commodity trader distress. This could lead to less availability and more expensive bank funding of traders.
And just like that not only is Glencore confirmed to be systemically important (something we knew when we exposed an "academic" hack's paid report to guarantee that commodity traders were not a systemic risk, confirming they are preicsely that) but suddenly - now that this warning is "out there" and even the most clueless credit, and equity, analyst who is stuck holding billions in losses to GLEN will have no excuse to say they "had no idea" - the negative convexity of bank exposure means that all those very banks which have $100 billion in exposure to the giant commodity trading company will quietly do their best to hedge their exposure, ostensbilty by buying default protection adding even more stress to Glencore's "shadow" funding channels, in the process unleashing the very same chain of events that ultimately led to Lehman's downfall.
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It appears the credit markets are well aware of the systemic risks that Glencore poses...