Weekly Credit Update

Headlines from the credit market this week
Sideways is the best description of this week’s credit spreads movement, with iTraxx Europe on level with last week at 78bp while Crossover has widened by a single basis point to 429bp. Even though the secondary market has shown little sign of movement, there has been a continued flow of primary issuance which makes investors conserve their cash for further primary supply. We continue to fear that further issuance will weigh even more on secondary spreads. In the Nordic space ISS Holding tapped its existing notes due 2016 by EUR127.5m. Furthermore, DONG Energy plans to issue a 30 year Sterling issue today.

Germany and France agree on Greece support package
This week it seems that Germany and France have reached an agreement on how to cope with Greece’s debt problem, which involves a bilateral lending agreement between EU member countries and Greece and IMF support. This would be the first intervention by IMF in a eurozone country. The agreement is to be viewed as a last resort should the market financing for Greece be interrupted or insufficient. According to the news flow, EU member countries must unanimously agree on the aid package before supporting Greece but it was already backed by all 16 members of the eurozone late yesterday evening. All else equal a stabilisation of the Greek trouble should be supportive for credit spreads.

Danish Bank Package III in place
Earlier this week the parties behind bank package I and II agreed upon a solution for winding up banks post bank package I, as of 1 October 2010.

The basic items in the proposal are:

Most importantly, instead of the current unlimited senior unsecured guarantee, the new deposit guarantee is DKK750,000 (EUR100,000), which is twice as much as the precrisis deposit guarantee. This is actually old news.

Furthermore, a distressed bank can choose to voluntarily be taken over by Financial Stability (bail-out fund), which would continue to handle the liquidation of failed lenders. The purpose is to secure stabilisation of the banking sector should other banks than the current eight under management by Financial Stability get into trouble. Alternatively the bank could go into bankruptcy or seek a solution with one or more banks. In practice though a bankruptcy will be handled in the same way as a voluntarily takeover.

A new winding-up unit will be established as part of the Guarantee fund for depositors and investors. The new winding-up unit will be funded by member banks of the Guarantee fund for depositors (i.e. the banking sector carries the costs for the controlled liquidation and potentially losses of distressed banks, not the state). In cooperation with this new winding-up unit, Financial Stability will secure a controlled winding up of defaulting banks.

If a bank is taken over through Financial Stability, the entity is valued by the assets as of the date of the handing over, but without taking into consideration any intangible assets (goodwill, customer relations, etc.) and by withdrawing expected costs from the winding up of the bank. Four members from the sector will be in charge of the valuation of the assets – i.e. we expect a very conservative preliminary valuation. The assessed value will be transferred to the defaulting bank. Subsequently, all assets and part of the senior debt will be transferred to a new bank, which will continue as a subsidiary of Financial Stability until liquidation.

If taken over by Financial Stability the distressed bank will be recapitalised to comply with normal solvency and liquidity rules under the Danish FSA. The winding-up unit (i.e. the banking sector) will deliver and guarantee the required capital and liquidity injection. If the bail-out fund ends up with a loss, due to the wind up of a bank, the sector will have to cover this loss and is as such entitled to set up a guarantee of DKK3.2bn as a start up, as we have seen with the guarantee payment for bank package I. If this capital is utilised the sector will be charged a fee of up to 2 basis points of deposits per bank a year in order to re-establish the fund.

This means that in a case of a bank taken over by Financial Stability the loss is covered by (in order of appearance): Shareholders, holders of subordinated capital, the Guarantee fund for depositors (up to DKK750,000) and finally senior holders and depositors above DKK750,000. Further losses hereafter will be covered by the sector.

The set-up once again highlights the fact that senior liabilities, including deposits above DKK750,000, are at risk in the banks and this will cause flight to quality, or maybe more precise flight to size, which will mean that minor banks (and banks regarded as weak) will likely have difficulties attracting large deposit customers going forward.

It is thus important that especially the smaller banks are reviewing their deposits very thoroughly and take up senior debt via a state guarantee to counterbalance this possible outflow. Bank package II contains the possibility of issuing senior debt with state guarantee until end June 2010 (this could be extended to end-December 2010).

Furthermore, this proposal makes it more difficult for the banks to attract senior debt in the future, as, although their rights have not changed, the implicit assumption that senior debt would always be bailed out by the government is not valid anymore.

The new set-up seems somewhat complicated, but in short: What Bank package III really
does is to:

• Secure a smooth or controlled winding up of a distressed bank; and

• Secure a deposit guarantee of EUR100,000 (DKK750,000).

The big question is whether this new set-up will have an impact on rating agencies’ implicit government support models. Currently Denmark is regarded as a high support system country. This could result in a series of downgrades especially from Moody’s.