Credit markets have deteriorated in 2010. The current bout of risk aversion stems from the comically low capitalisation of European banks.
Several large European banks sport a ratio of equity to assets below 3% – an insufficient cushion. That number does not inspire confidence among creditors. As a consequence, we believe the inter-bank market for short-term deposits has almost dried up.
It is no exaggeration to say large parts of the financial system remain ‘on life support’, with the ECB providing some €879bn of gross loans to eurozone banks.
Forget all the mumbo jumbo about stress tests, Basle-3, tier-1 hybrid securities and risk weighting – we need much more equity in the banks’ balance sheets. Only then will folk have confidence in the financial system.
Sell side analysts have variously suggested €80bn of new equity is needed in the European banking system. We think the real number is probably three times higher.
People forget that (i) a bank survives on trust, and (ii) at the beginning of the nineteenth century, shareholders’ funds represented 15%-20% of total assets.
During June, we used weakness in BP to build new exposure to their bonds.
We have taken this new position because Barack Obama needs ‘British Petroleum’ to stay solvent for at least five years. At the end of March, the company reported total assets of $241bn and book equity of $105bn.
Our worst case scenario sees $65bn of claims and spill costs, resulting in a $45bn writedown of US assets. Even after a $45bn write-off, BP would have $60bn of positive net worth and a liabilities/assets ratio of 70%. These are not great numbers for an oil firm, but probably survivable.
In this scenario, we believe BP would remain investment grade, with a BBB rating. With two year bonds yielding 6% per annum, the bad news is already in the price.
The biggest risk to our position is American litigation, which knows no bounds.
A handful of judges in Mississippi, Alabama and Louisiana could bring this company down. That is clearly not our view, but an extreme case the market has occasionally visited over the past month.
Some traders have played this name from the short side and certain television channels have happily championed the most bearish scenarios. But, in our view, BP will survive and eventually the shorts will be squeezed.
Peter Harvey is fund manager at Cazenove
