McKinsey has an interesting background paper on Commercial Real Estate finance (subscription required). One startling finding is that the European industry as a whole did not cover its cost of capital even in the good times of 2006-2007.
Eight large European banks took part in the initial survey; several others granted supplementary interviews. Collectively, McKinsey estimates that these two groups comprise about 40 percent of the CRE loans outstanding on balance sheets across Europe. The survey spanned 2006 and 2007, the final two years of the property boom, providing a clear picture of how the industry performs in good years.
“Our research has produced two key findings. First, the industry as a whole does not return its cost of capital (defined as equity) even in the best of times, let alone over the business cycle. Put another way, the “profits” recorded in good times are in fact economic losses to equity holders; worse, they fail to provide a cushion for the significant losses that come in industry downturns.”
In McKinsey’s view, the primary culprit is poor deal selection and, more specifically, a failure to adequately price the underlying risks. Other factors include a lack of revenue diversification and cost inefficiency.
Because of these dynamics, we expect that even after the current crisis has faded, the CRE finance industry will continue to destroy value.
That said, some CRE lenders do in fact generate returns exceeding their cost of capital. Top-performing lenders have developed a thoughtful approach to their business, choosing their customers with care, concentrating on the markets they know best, and taking a deliberate view of the many risks inherent in property markets. Furthermore, they have kept their businesses at a manageable size, moving countercyclically to reduce volumes.
A new discussion paper from the Bank of England looks at the concept of increasing capital requirements on banks during market bubbles and reducing them in times of weak economic conditions when banks are typically reluctant to lend.
Excerpts from The role of macroprudential policy (free pdf download)
This discussion paper examines whether it would be practical to dampen cyclical overexuberance through a regime of capital surcharges on top of prevailing microprudential capital ratios. These surcharges could be applied to headline capital requirements or at a more disaggregated level (through so-called ‘risk weights’ on particular types of exposure). The sectoral approach might allow policy to be better targeted at pockets of emerging exuberance, but would also entail greater complexity. The appropriate level of disaggregation for setting capital surcharges would need to be considered carefully.
Increasing capital requirements in a credit boom would generate greater systemic self-insurance for the system as a whole and, at the margin, act as a restraint on overly exuberant lending.
Crucially, this mechanism could also operate in reverse: lowering capital requirements in a bust might provide an incentive for banks to lend and reduce the likelihood of a collective contraction of credit exacerbating the downturn and increasing banks’ losses.
Separately from seeking to address changes in risks through the credit cycle, capital surcharges could also be set across firms so as broadly to reflect their individual contribution to systemic risk. For example, as the FSA have discussed, surcharges could be levied based on factors such as banks’ size, connectivity and complexity. This would lower the probability of those institutions failing and so provide some extra systemic insurance. It would also provide incentives for those firms to alter their balance sheet structure to lower the systemic impact of their failure.
A big practical question is whether a macroprudential regime with aims of the kind described above could be made operational. Capital surcharges would need to be calibrated. That would ultimately require judgement, drawing on analysis, market intelligence and modelling. This discussion paper summarises, by way of illustration, a few of the indicators, quantitative and qualitative, that with further work could become useful inputs. They would largely be about the macroeconomy, and the financial system as a whole and the interaction between them.
It seems unlikely that macroprudential instruments could be set wholly according to fixed rules. Judgement may be needed to make robust policy choices. That would call for assessments of the resilience of the system, credit conditions, sectoral indebtedness and systemic spillovers — all of which vary over time and according to circumstances. All available evidence would need to be weighed, and policymakers would themselves need to adapt as they learn about the effects of their instruments on behaviour.
But it would be important that constraints were placed on a macroprudential regime to ensure transparency, accountability and some predictability. That would call for clarity around the objectives of macroprudential policy, the framework for decision-making, and the policy decisions themselves. It also suggests the need for robust accountability mechanisms. Such a macroprudential regime of ‘constrained discretion’ would share some similarities with macroeconomic policy frameworks.
Another important issue would be the degree of international co-operation. To be wholly effective, a macroprudential regime might require significant international co-ordination. But, even in its absence, appropriate macroprudential instruments might still be able to strengthen the resilience of the domestic banking sector.
Standard & Poor’s today updated and corrected some of the results of its first global comparison of banks’ risk-adjusted capital adequacy, first published Nov 23. The affected bans are Allied Irish Banks (to 4.7% from 5.0%) , Bank of America (6.5% from 5.8%) , Danske Bank (6.1% from 5.4%), and UBS (2.4% from 2.2%). S&P said the changes “result from new material information that we have now received. We recalculated the estimated RAC ratio for Rabobank (to 8.3% from 7.8%) due to a computational error. Receipt of new information and a computational error has resulted in a new estimated RAC ratio for BBVA.” (to 6.3% from 5.4% )
S&P also provided additional information about a number of banks: “Our report prompted a lot of interest about the impact of recent capital initiatives by banks on their RAC ratios and, consequently, we are now providing further supplemental information for banks that have announced substantial capital measures since (the cutoff date) of June 30, 2009. These banks are Citigroup, Intesa, Mizuho, Standard Chartered, and UBS.”
S&P said using Tier 1 or leverage ratios for direct comparisons of banks’ relative capital positions can be misleading both at the national and the international levels.
“We found that the average estimated RAC ratio for large international banks was 6.7% as of June 30, 2009, more than three percentage points below their average Tier 1 ratios. As we generate more RAC ratios, the results to date appear to confirm our view that capital is a rating weakness for a majority of banks in our sample.” S&P set a benchmark of 8% as desirable.
The RAC results also illustrate our qualitative opinion that the Tier 1 and leverage ratios are not sufficient to come up with an informed view about individual banks’ capital adequacy.
For details on the RACF, see Methodology And Assumptions: Risk-Adjusted Capital Framework For Financial Institutions (Premium), published April 21, 2009.
“We are, however, also seeing a clear improvement in banks’ risk-adjusted capital positions, compared with the level in 2007. Beyond fulfilling the short-term goals of alleviating market pressure, responding to the uncertain economic environment, and addressing strategic considerations, banks appear to have started to prepare for a future structural increase in regulatory capital requirements as well. Capital raising, conversion of hybrids into common equity, asset disposals, and reduction in risk assets have allowed a number of banks to significantly increase their capital ratios in the past 18 months.”
After the revisions are taken into account, HSBC remained the top-ranked bank as of June 30 with a ratio of 9.2%. Goldman Sachs (8.2%) and Morgan Stanley (8.1%) rounded out the top quintile.
Mizuho Financial Group (2.0%) remained the lowest ranked followed by Citigroup (2.1%) and UBS (2.4%). However, Citigroup’s RAC pro-forma RAC would have increased to 6.1% from 5.9% if its subsequent capital increases were taken into account.
For the full results see S&P Ratio Highlights Disparate Capital Strength Among The World’s Biggest Banks.(Premium)
Guest Post by Oxford Analytica
The OECD yesterday forecast world growth of 3.4% in 2010. The OECD’s baseline forecast projects a world in which the US household savings rate is unchanged from 2009 and consumer growth picks up by 1.3%. As global trade growth recovers, some reversion to pre-crisis current account dynamics is on the cards. This reversion is only partial, and would not materialise at all under plausible alternatives to the baseline scenario.
Reversion to mean? On the back of recovering global trade, patterns of current accounts in 2010 recall pre-crisis norms:
- The US current account deteriorates by 0.4 percentage point of GDP, on the back of stronger domestic demand growth and an overall real GDP growth rate of 2.5%.
- The euro-area current account expands by half a percentage point of euro-area GDP, consistent with anaemic real GDP growth of 0.9%.
- Japan’s current account expands by 0.3 percentage point of GDP, with real GDP growth of 1.8%.
Underlying change. Three of the four ‘BRIC’ economies (Brazil, Russia, India and China) are projected to provide a larger contribution to net global demand in 2010:
- Brazil and India are projected to run larger current account deficits.
- China’s surplus is projected to shrink for the second year in a row.
The OECD’s collective current account deficit is projected to expand by 13 billion dollars (mostly on a US deterioration) while the non-OECD’s collective current account surplus (excluding the Middle East and Africa) shrinks by 96 billion dollars.
De-coupled or re-coupled?
In line with a variety of current forecasts, the OECD’s baseline scenario portrays a world in which recovering trade and demand growth is not postulated on a sharp US rebound.
This is evidence that the poorly named ‘de-coupling’ phenomenon is coming to fruition. The thesis does not posit a de-globalised world, but one in which growth in final demand is less OECD-centric. This process is at hand, with risks both to the downside and upside:
- Liquidity panic. A sharp reversal in the dollar in 2010 would test the ability of emerging markets to withstand a whipsaw of capital flows (and asset prices) arising from variable G3 risk appetites. This is test many of them are likely to pass, thanks in large part to highly liquid net foreign asset positions vis-a-vis the late-1990s reversal in capital flows.
- US rebound. A more vibrant US household sector would produce a stronger global growth outturn. This would add steam to commodity prices, not least oil. While such a result would undoubtedly feed public anxieties over monetary and fiscal stimuli and the path of inflation (especially in the euro-area), such worries would almost certainly be overdone.
Outlook. The strength of recovery in the US economy remains the key swing factor in global forecasts for 2010. A ‘double dip’ would see US growth drop back in early 2010 as consumers fail to sustain momentum in the short run, potentially halving the forecast growth rates for consumption and GDP compared with OECD figures — and keeping the US current account deficit in decline. Alternatively, consumer confidence could produce a much stronger rebound in 2010, albeit below-par, leading to deterioration in the current account.
Increasing exposure to patent expiries and downward trends in pipeline quality continue to underpin Moody’s negative outlook for the industry, though the outlook for generics is more positive.
Excerpts from Moody’s latest Global Pharmaceuticals Firms Industry Outlook:
- Companies have taken measures to alleviate these pressures – mainly through acquisitions; M&A strategies are expected to remain a key feature of the industry, albeit to a lesser extent than in the past 12 months.
- Although the implications of US healthcare reform are still in flux, we currently do not believe reform measures will be extremely onerous for the industry.
- Vaccines for swine flu will provide a boost to 2009 earnings for some companies; however, future revenue and earnings from pandemic flu vacinnes are unpredicatble and are not part of our base forecats.
- Despite recent M&A activity, liquidity has remained strong for most pharmaceutical companies, which have benefited from eay access to capital markets.
- Our outlook for generics-focused companies is more positive; despite ongoing pricing pressure, generics companies will benefit from a significant number of new generics in the coming years.
At June 2009, Moody’s had already factored in the expiry of some of the largest-selling drugs in the industry, including Pfizer’s ( PFE) Lipitor (LTM to September 2009 sales of US$11.4 billion), BMS/sanofi-aventis’s Plavix (US$10.0 billion) and AstraZeneca’s Seroquel (US$4.8 billion).
The revenues to be lost by the industry are expected to only be partially offset by drugs currently in late-stage development or in the approval process.
In addition, Moody’s pipeline assessment has recently tended to move downward due to higher hurdles to develop blockbuster drugs, such as increasing competition in a number of therapeutic categories and the US Food and Drug Administration’s (FDA) more cautious approval stance. Moody’s pipeline assessment of a peer group of large pharmaceutical companies has eroded to 16% at June 2009 from 20% in 2006.”
More positively, Moody’s notes that several interesting drugs have been approved since its June 2009 Industry Outlook was published, both in the US and Europe. These include Onglyza (saxagliptin), a DPP-IV inhibitor for the treatment of Type II diabetes co-developed by Bristol-Myers Squibb (BMY) and AstraZeneca (AZY) (as of 30 September 2009, Moody’s peak sales estimate for Onglyza is US$2 billion) and Effient (prasugrel), a blood-thinning drug for the prevention of heart attack and stroke co-developed by Eli Lilly (LLY) and Daiichi Sankyo (US$2 billion peak sales estimate).
Fitch has a slightly more positive view than Standard & Poor’s of the prospects for US retailers and consumer products companies. We featured S&P’s outlook earlier this week, in which S&P said that industries that depend on discretionary consumer spending may not rebound anytime soon.
Fitch says it expects increased stability among retailers as cash flow improves and sees 2010 as a turning point for consumer products companies.
Key points from Increased Stability Expected in 2010 for U.S. Retail due to Improved Cash Flow & Liquidity
- Some Negative Rating Outlooks may migrate to Stable if sales trends stabilize, margins improve on better inventory positions and cash flow generation and liquidity remain adequate.
- Fitch expects that 2009 holiday same store sales could be mildly positive as weak same store sales in the prior year are anniversaried and retailers needed to clear excess inventories at deeply discounted prices.
- In 2010, overall retail sales are anticipated to be flat to up modestly from 2009 levels
- Fitch expects well-capitalized operators such as Kohl’s, (KSS) Macy’s, Inc. (M) and J.C. Penney (JCP) to increasingly consolidate share and post same store sales in the plus 1% to minus 2% range, given investment in stores even during the economic downturn, improved assortments via exclusive and private brands, and continued focus on providing compelling value.
- Fitch expects operating profit for Limited Brands Inc. (LTD) to improve in 2010 as its focus on operating efficiencies and conservative inventory management help offset negative same-store sales expectations.
- CVS Caremark (CVS) is well-positioned with leading market shares in all prescription distribution channels – retail and in-store clinics, mail, and specialty. Fitch expects the company to continue to drive share gains given its industry leading retail same store sales growth but recent contract losses on the PBM side will temper sales and earnings growth in 2010.
Excerpts from 2010 Should be a Turning Point for U.S. Consumer Products Sector
Fitch Ratings expects U.S. consumer products companies to see modestly rising demand as global economies revive.
However, revenue growth rates will be well below historical levels and price increases are not expected to be as important as they were during 2009.
Fitch says large acquisitions did not play a meaningful part in top-line growth for the sector in 2009 nor are they projected to do so in 2010 except for The Stanley Works (SWK) merger agreement with Black & Decker (BDK). Niche purchases for growth, to support ongoing businesses or to enhance operations may happen. However, divestment of non-core assets and brands could also occur in the Household and Personal Care space given retailer focus on shelf-space rationalization.
“Ratings are not anticipated to change meaningfully for the Household Products, Personal Care and Toy sectors” said Grace Barnett,” Director at Fitch. “For the Appliances, Home and Hardware, and Tools sector there is still reason to be cautious but these companies may have reached a turning point and positive revisions to the currently negative outlooks could occur,” said Tom Razukas, Managing Director at Fitch.
Research Recap has highlighted the relative strength of South Korea’s economy and its manufacturers during the economic downtown, so we thought it would be helpful to take a deeper look at the country. The Economist Intelligence Unit is now estimating the country’s real GDP growth in 2009 at 0.6%, compared with an expected contraction of 1% previously estimated. By special arrangement with the EIU we are pleased to offer complimentary access to the EIU’s latest Country Report South Korea.
- The green shoots of South Korea!s economic recovery, which began to emerge in the second quarter of 2009, have continued to remain in evidence, with real
GDP maintaining its growth rate in the third quarter of the year, domestic factories running at higher capacity and the country!s merchandise export
sector continuing to stabilise.
- There is a growing consensus among economists that South Korea is coming out of the global economic downturn faster than
many of its industrial peers.
- Nonetheless, the Ministry of Strategy and Finance (MOSF) is sticking to its cautious stance on an exit strategy regarding the emergency policy measures that were initiated as the domestic economy began to deteriorate in the second half of 2008.
The green shoots of South Korea!s economic recovery, which began to emerge in the second quarter of 2009, have continued to remain in evidence, including domestic factories running at higher capacity.
- The financial-sector regulator, the Financial Supervisory Service, is using pre-emptive measures to try to prevent companies from going bankrupt and
asset price bubbles from emerging.
- In year-on-year terms, real GDP edged up by 0.6% in the third quarter of 2009 after three consecutive quarters of contraction.
- The weakness of the won in international foreign-exchange markets has been a boon for the local economy, which is dependent on merchandise exports.
The EIU’s 25-page Country Report South Korea has been made available free of charge to ResearchRecap users for 30 days by special arrangement with the Economist Intelligence Unit, an Alacra content partner. After 30 days, the report will revert to its regular AlacraStore price of $270.
Analysts are mostly skeptical about the likelihood of Hershey (HSY) and Ferrero mounting a successful joint bid for Cadbury (CBRY) to thwart Kraft’s (KFT) pending bid for the company. However, the threat of a rival bid may be enough to coax a slightly sweeter offer from Kraft.
Both Bloomberg and Reuters offer good summaries of analyst opinion and FT Alphaville weighs in with a JP Morgan analysis arguing that it is difficult to see how the financing would work for Hershey without it either almost doubling its existing equity (and convincing shareholders to buy it), or losing its investment grade credit rating.
The big question mark is how much equity can HSY raise from existing shareholders through a rights issue (we doubt Ferrero or Cadbury shareholders would take HSY non voting shares) without the Trust subscribing to the rights and HSY still keeping its dual class share structure. – JP Morgan
The FT’s Lex notes that, “to the distress of Cadbury shareholders hoping for a more full-fat alternative to Kraft’s cheeseparing bid, the likelihood of a Ferrero or Hershey offer – separately or jointly – remains slim.”
In Lex’s view Hershey would be better of partnering with Nestle (NESN).
However, Nestle may be more interested in Mead Johnson Nutrition (MJN) following its spinoff from Bristol-Myers Squibb (BMY). The maker of Enfamil baby formula would appeal to Nestle because of its strength in Latin America and Asia, says Claudia Lenz, an analyst at Bank Vontobel AG.
Previous ResearchRecap posts on this topic are here.
For the latest analyst comments see Alacra Street Pulse.
We all know there’s no such thing as a free lunch so it should come as no surprise that a new IMF working paper finds that the long-term costs of economic stimulus measures outweigh the short-term benefits.
The paper, which is not official IMF policy, uses the IMF’s Global Integrated Monetary and Fiscal Model to compute short- run multipliers of fiscal stimulus measures and long-run crowding-out effects of higher debt.
First the good news:
- Multipliers of two-year stimulus range from 0.2 to 2.2 depending on the fiscal instrument, the extent of monetary accommodation and the presence of a financial accelerator mechanism.
- We find that the multipliers of a two-year fiscal stimulus package range from 1.3 for government investment to 0.2 for general transfers, with targeted transfers closer to the upper end of that range and tax cuts closer to the lower end.
- In the presence of monetary accommodation and a financial accelerator mechanism multipliers are up to twice as large, as accommodation lowers real interest rates, which in turn has a positive effect on corporate balance sheets and therefore on the external finance premium.”
Now the bad:
- As for crowding-out, a permanent 0.5 percentage points increase in the U.S. deficit to GDP ratio leads to a 10 percentage points increase in the U.S. debt to GDP ratio in the long run.
- Servicing this higher debt raises the U.S. tax burden and world real interest rates in the long run, thereby eventually reducing U.S. output by between 0.3 and 0.6 percent, with the size of the output loss again depending on the distortionary effects of the fiscal instrument.
- The real interest rate effect (but not the tax burden effect) affects the rest of the world equally and accounts for output losses of around 0.2 percent.
These output losses are larger than the corresponding short-run stimulus effects for the same instruments. But much more importantly, they are also permanent.”
“The foregoing suggests that a carefully chosen package of fiscal and supporting monetary stimulus measures can provide a significant contribution to supporting domestic and global economies during a period of acute stress. But such measures should also be embedded in a conservative medium-term fiscal framework which ensures that deficits and debt do not drift upwards permanently when the economy recovers. In the absence of such a framework the long-run costs would far exceed the short-run benefits.”
Fiscal Stimulus to the Rescue? Short-Run Benefits and Potential Long- Run Costs of Fiscal Deficits
Charles Freedman, Michael Kumhof, Douglas Laxton, Dirk Muir, Susanna Mursula
Yesterday ResearchRecap featured HBS professor Bill Sahlman’s provocative if problematic proposal for a new “monitor of management excesses” to address the systemic corporate governance flaws that contributed mightily to the near collapse of the financial system.
Now, in a similar vein, Booz and Company partner Richard Rawlinson offers thoughtful suggestions on how corporate leadership can and should change to address the same issues.
Writing in strategy + business Rawlinson expects a move away from the “CEO as hero” model toward a more diversified team approach with greater focus on corporate responsibility and risk governance.
The quickest impact on business leadership in business will probably be felt at the board of directors level. Driven by fear of the risks that have been exposed, board leaders will start by changing their own behaviors. Directors want more visibility into corporate practices and risks, and more data to directly verify more dimensions of corporate performance.
There could be a renaissance of institutions with a tradition grounded in cooperatives or member-owned organizations, of which there are many in Europe (including some, like Rabobank Group in the Netherlands, that have weathered the storm in financial services reasonably well).
…. leadership team members will have to learn to recognize the power of the unknowable. We have found out the hard way that conceptual financial models, which seemed for a time to provide a new means of rapid growth, can actually obscure the underlying realities of the economic system. We now have some catching up to do as we recognize the failure of these models to comprehend and control the complexity and interdependence of our world.
Leaders in financial services might do better if they understood that we human beings are all limited, that our best course is to accept that we are intrinsically prone to get things wrong, that we need to keep our wits about us, and that to succeed in the arcane world of finance, we need most of all to stay grounded in day-to-day reality.
In composing teams, boards will tend to favor a diversity of characteristics, and they should guard against the drift toward homogenization. Further, power and control will be separated more actively and structurally. There may be a segregated, internal governance structure in some organizations — beyond the CEO’s control, but reaching down into the company — whose role will be to audit and hold to account those with primary decision-making authority.
Central corporate leadership at the financial-services firm Barclays PLC is entirely devoted to governance, leaving day-to-day and even month-to-month management to the divisions. The center has a strong risk control function, but also governance roles across many other areas of the business. And despite Barclays’ extensive involvement in the debt market and other troubled markets, it has avoided many of the problems facing other banks.
Of course, there is a risk that such governance models will simply re-create the old bureaucratic staff structures that hobbled companies in the 1960s and 1970s. What we will need is tightly limited roles and processes, a separate voice and perspective, and a smaller number of resources and processes.