Defaults May Double in Europe

As banks hoard cash, companies struggle to refinance debts.

Corporate defaults may almost double in Europe as companies struggle to refinance debt and banks hoard cash borrowed from the European Central Bank or use it to buy government bonds.

Europe’s default rate may soar to 8.4 percent or more, from 4.8 percent at the end of 2011 as the recession bites and company financing dries up, according to Standard & Poor’s. Petroplus Holdings AG became the latest victim of the tough stance banks are adopting when the region’s biggest independent oil refiner said this week it will file for insolvency after losing access to $2.1 billion of credit lines.

“It’s very challenging for anyone to raise money from lenders right now,” said Andrew Cleland-Bogle, a Frankfurt- based director at corporate finance specialist DC Advisory Partners. “Combine that with increased bank capital requirements and you can see that although banks are getting money they’re very selective when it comes to lending it. 2012 is going to be a very, very tough year.”

Speculative-grade companies have to refinance about 230 billion euros ($300 billion) through 2015, according to S&P. At the same time, banks and loan funds that provided the initial funding are scrambling for capital or reaching the end of their reinvestment periods and may be unwilling to extend loans.

Banks are using the 489 billion euros they borrowed at 1 percent from the ECB under its three-year longer-term refinancing operation to scoop up government bonds yielding more than 2.5 percentage points extra instead of lending the money to companies.

Italian bonds due in three years, the maturity of the ECB loans, now yield 4.37 percent, down from 7.36 percent at the end of November. The country’s 10-year bonds have declined to 6.11 percent from 7.02 percent. Spanish three-year notes now yield 3.04 percent, down from 5.51 percent in November, while yields on 10-year bonds have fallen to 5.29 percent from 6.23 percent.

Spanish and Italian banks clearly used the funds to take advantage of “the massive gap between the cost of these funds and the yield on the government bonds” of their home countries, according to John Rathbone, head of J.C. Rathbone Associates, a London-based risk management consulting firm.


Borrowing Stigma

More than 500 lenders borrowed from the ECB at the December tender. With the stigma of turning to the central bank now gone, Huw van Steenis, an analyst at Morgan Stanley in London says lenders may borrow anything from 150 billion euros to more than 400 billion euros at the second tender next month.

Some of the money borrowed is being deposited at the ECB. The 30-day moving average of deposits there -- a figure that smoothes out variations caused by regulatory requirements -- is at a record 411 billion euros, according to the central bank.

The ECB cash failed to help Zug, Switzerland-based Petroplus. After breaching loan conditions in September, the company negotiated waivers in return for $6.3 million in fees and a 50 basis-point increase in interest margin, in a process known as amend and extend. That came after a similar agreement in July, which cost the company $2.6 million in consent fees.

Lenders’ attitudes toward amend and extend are now hardening, said David Bryan, partner at London-based turnaround firm Bryan, Mansell & Tilley LLP.

“There are a lot of zombie companies that are trapped by their debts and have no way out,” Bryan said. “The recovery isn’t really happening and there’s a high probability we’re going into a double-dip recession. For all that the banks kicked the can down the road once, the realization is dawning that they can’t just do that again.”

Companies bought by leveraged buyout firms during the boom years in the middle of the last decade are particularly vulnerable to the dearth of funding because their debt levels are higher than investors are willing to accept, said Edward Eyerman, head of leveraged finance at Fitch Ratings in London. And because banks and collateralized debt obligations are also leveraged, the problem is amplified, he said.

“For companies that have five times leverage, are in cyclical industries, exposed to anemic economies and have near- term maturities, it’s questionable how much equity value is underneath the debt,” Eyerman said. “When these highly leveraged borrowers get into trouble, the focus on what’s the right capital structure for a company within its industry to perform effectively competes with the demands of banks and CLOs to preserve the senior debt.”


‘Mild Recession’

S&P’s base case for defaults is for a 6.1 percent rate in 2012, up from 4.8 percent at the end of 2011, with a “mild recession” in the first half, according to Paul Watters, the firm’s head of corporate credit research in London. S&P estimates there’s a 40 percent chance of a “deeper recession materializing” as the sovereign crisis worsens, he said.

Average relative yields on bonds in euros rated in the B category have held wider than 10 percentage points since Nov. 23 and are now 10.32 percentage points, Bank of America Merrill Lynch’s Euro High Yield, B Rated index shows. Spreads on issues rated CCC+ and lower are wider than 22 percentage points on average, index data show.

About half of the 676 junk-rated companies followed by S&P are graded in the lower part of the B category or below, according to Watters.

Lower-rated borrowers that have a large part of their business in the nations hardest hit by the sovereign debt crisis, and which haven’t refinanced loans coming due this year and next, will “face particular difficulties,” he said.

The European Banking Authority, which found a 115 billion-euro capital shortfall in its most recent stress tests on lenders, has given banks until June to find the cash or face nationalization.

Struggling to raise the money, lenders are choosing to reduce risk-weighted assets instead. European banks, which currently have total assets of about 26.5 trillion euros, will probably reduce their balance sheets by 5.1 trillion euros in the next three to five years, according to Alberto Gallo, a strategist at Royal Bank of Scotland Group Plc in London.

“Given the large shortfall in equity capital and persistent sovereign risk, we think it will be difficult for European banks to start transferring their liquidity to the broader economy,” Gallo said.


Bloomberg News


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