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'America First' Creates Uncertainty Over U.S. Role on Global Financial Standards

S&P Global Ratings

Credit Trends: Demystifying China's Domestic Debt Market

Banks In Emerging Markets 2019 - The Mid East, North Africa, & Turkey

S&P Global Ratings

U.S. Finance Companies Will Benefit From A Resilient Economy In 2019

S&P Global Ratings

Asia-Pacific Credit Outlook 2019 Cold Wind Blowing

'America First' Creates Uncertainty Over U.S. Role on Global Financial Standards

The world is waiting to see how the "America first" agenda promulgated by President Donald Trump's administration affects the role the U.S. plays in advancing international financial industry standards.

Under Trump, the U.S. has made some swift decisions to exit international institutions. The State Department recently announced the withdrawal from UNESCO, the United Nations' educational, scientific and cultural organization. Trump pulled the U.S. out of negotiations for the Trans-Pacific Partnership, an international trade agreement, and the president also moved to withdraw the U.S. from the Paris climate accord.

But the administration's stance on international financial standards has been more nuanced, according to some participants at the Sibos conference in Toronto. The uncertainty over whether President Trump will loosen financial regulation has slowed progress on the Basel Committee on Banking Supervision's revisions to the way banks calculate risk, changes that have been dubbed "Basel IV."

However, since President Trump has taken office, the U.S. has helped with the shaping of some international standards, said Shaun Olson, a senior derivatives adviser for the Ontario Securities Commission. He said years-old mandates, including those around over-the-counter derivatives, are moving forward.

"It's been business as usual," he said.

But the future is more uncertain. Olson said it has become more difficult to understand which new regulations and requirements policymakers will pursue. It is also unclear if the U.S. will actually put international standards that are being developed into place because some key regulatory positions have remained vacant since the Trump administration has taken over.

"Implementation ... could be delayed if there are vacancies," Olson said.

Olson was not the only one to say the U.S. continues to advance international standards. Karla McKenna, director of market practice and standards for Citigroup Inc.'s markets and securities services, noted that the Consumer Financial Protection Bureau and the Treasury Department's Office of Financial Research have moved ahead with adopting legal entity identifiers, data similar to a barcode that can identify parties in financial transactions.

McKenna said she expects the U.S. to keep playing a role in areas that can promote global stability. "Where it makes sense to keep America's markets and the other markets safe, I'm still seeing some forward progress," McKenna said.

But the Trump administration's main goal is to generate growth in the U.S., not promote global stability, said Aaron Klein, a Brookings Institution fellow and policy director.

Klein, who worked in the Treasury Department during the Obama administration and on the U.S. Senate Committee on Banking, Housing and Urban Affairs when it was chaired by Democratic senators Paul Sarbanes and Christopher Dodd, said the U.S. previously viewed global stability and global growth as beneficial to the country in the long run.

"That core tenet is not shared by the current inhabitants in the White House," he said. "Instead, the core idea is: 'This is a global competition.'"

Klein said he believes it is only a matter of time before the U.S. starts withdrawing as a leader, and even possibly as a participant in some global forums on international financial industry standards. He expects the first moves will come subtly with the U.S. ending the promotion of new ideas and raising skepticism on the advancement of others.

However, the Trump administration could find that staying involved in global forums is the best way to support the "America first" agenda, said Jeff Bandman, who held leadership positions with the CFTC before founding consulting and advisory practice Bandman Advisors.

"There is an effort to kind of use these international forums to advocate areas where there's concerns that American interest or the ecosystem is being harmed," he said.

Bandman said an example of this came in the Treasury's recent capital markets report, which called for changing the capital treatment of centrally cleared derivatives under Basel III's supplementary leverage ratio. Bandman also noted that the CFTC has maintained its leading role in the policy standing group for the Committee on Payments and Market Infrastructures and the International Organization of Securities Commissions.

From Bandman's perspective, it seems that the U.S. is taking the stance that financial markets are interconnected, and that it is important to have an international consensus on technical issues. Still, Bandman believes leaders of regulatory bodies will have to explain to the White House why being involved in global forums is consistent with the administration's agenda.

"You do need to have a good answer on why staying engaged and advocating vigorously is in America's interest," Bandman said.


Credit Trends: Demystifying China's Domestic Debt Market


- China's domestic corporate debt market, with debt outstanding of $6.6 trillion, is the third-largest domestic corporate (financial and nonfinancial) debt market, trailing the nearly $9 trillion U.S. market and Europe's $7.4 trillion (considering intra-European debt issuance as domestic funding).

- The market is split between the larger interbank market and smaller exchange markets (Shanghai and Shenzhen). Local government financing vehicles account for a sizable portion of the interbank market debt outstanding (over 60% by new issue count in 2014).

- As in many other countries, a number of market participants, like insurance companies and asset managers, engage in a buy-and-hold strategy for long-term debt in China, and banks typically match shorter-duration debt with their short-term liabilities, favoring liquidity over higher yields, as do money market funds.

- Looking ahead, China must carefully balance its need for economic growth with its need to manage the significant growth of its debt burden.

Feb. 19 2019 — For the past decade, China has experienced rapid growth in newly issued corporate debt (financial and nonfinancial), at an average rate of nearly 50% year over year. Issuance slowed in 2017 but resumed growth in 2018, with $2.6 trillion of new debt issued as of the end of the third quarter. The majority of this debt was financial debt issuance ($1.9 trillion), while nonfinancial debt issuance totaled $658 billion--the second-highest total in two decades. These figures exclude debt issued with maturities shorter than 31 days.

What is the size of China's domestic debt market? How has it evolved?

Of China's nearly $13 trillion in outstanding domestic debt (that is publicly traded), the financial sector holds the largest piece, at $4.9 trillion, followed by nonfinancial corporations and local governments at $2.7 trillion each. The majority of debt is held in the form of interbank loans and bonds in China's government-backed interbank market, which consists of a wide variety of financial institutions. Through China's Bond Connect, a new mutual market access program that will allow investors from mainland China and overseas to trade in each other's bond markets, the government's long-term aim is to open participation in this interbank market to foreign investors to help meet foreign demand for these securities while simultaneously managing its own risk.


Growth over the past several years in the corporate debt market has stemmed primarily from the financial segment, including policy bank debt, commercial bank debt, insurance debt, etc. Local and national government debt issuance, on the other hand, shrunk in 2018 to $557 billion and $346 billion, respectively (see chart 2).


Despite its size, the Chinese domestic debt market was still opaque to foreign investors just a few years ago. Amid continuous economic growth and more integration in the global markets, more and more investors are trying to understand China's domestic market and are eager to potentially capitalize on its high growth and investment return prospects. Additionally, investors may see the benefit of diversification by investing in the Chinese bond market, given the large and increasing importance of China to the global economy and, especially now, its comparatively higher economic growth prospects relative to other large economies.

To meet demand from these investors as well as sustainably manage its own capital market structure, China is in the process of deploying two major strategies: 1) opening credit markets to foreign investors and 2) bringing integrity and efficiency to the Chinese domestic debt market through standardization. Additional reforms aimed at supporting China's need for economic growth without excessive credit growth include policies to control public investment growth, constrain borrowing for state-owned enterprises (SOEs), and curb rapid growth in household debt.

Who are the issuers? Who are the buyers?

Issuers in the interbank market (with tenors greater than 31 days) are typically industrial and commercial banks, as well as nonfinancial corporations seeking bank funding in the form of loans and bonds, though the former are the considerably larger funding source. In the exchange market, nonfinancials dominate the debt outstanding in both the Shanghai and Shenzhen exchanges.

The buyers in the interbank and exchange markets are typically banks, asset managers, mutual funds, and insurance companies, though their strategies differ greatly depending on their roles. We will detail these differences later.

The majority of debt outstanding in China's domestic debt market is financial debt, which accounts for $4.9 trillion, compared with $2.7 trillion in nonfinancial debt, $2.7 trillion in local government debt, and $2.2 trillion in national government debt (see chart 4). In contrast, the largest share of debt in the U.S. is Treasury securities, which account for $14.8 trillion, or 36%, whereas corporate debt (financial and nonfinancial) accounts for just under $10 trillion (23%), as shown in chart 5. Securitizations are also a considerable part of the debt outstanding in the U.S., with $9.5 trillion in outstanding mortgage securitizations and $1.6 trillion in asset-backed securitizations.

Chart 6 illustrates how a local Chinese investor would view the domestic debt market, using the categorical terminology used in China.


The majority of Chinese debt is held in the interbank market (see chart 7). The alternative, the exchange markets (including both the Shanghai and Shenzhen stock exchanges), have government debt, both local and national, as their largest holdings, though the exchange markets are smaller in debt volume than the interbank market. Over three-quarters of the country's deposits and commercial loans are controlled by the big five state-owned commercial banks.

Local government financing vehicles (LGFVs) are a special type of debt in China. These are economic entities, established by Chinese governments and their departments and agencies through fiscal appropriation or injection of assets to finance government-invested projects, primarily infrastructure projects, or construction and real estate development projects. According to the State Council, all LGFV borrowings since 2015 are corporate debt, and no level of government is a backstop for these. The Ministry of Finance's annual quota for the issuance of local government bonds falls far short of the infrastructure investments needed to support local GDP growth and improve social welfare. As a result, many local governments have continued to mandate that LGFVs finance a significant level of infrastructure or social projects. This trend has been further fueled by easy credit from banks and "shadow banks" and by the availability of alternative financing (such as financial leases) from mid-2015 to late 2017.

At the end of 2017, China's outstanding government debt on balance sheets amounted to RMB29.95 trillion (or US$4.41 trillion), of which local authorities have raised RMB16.5 trillion (or US$2.43 trillion) through bond issuances since 2015. S&P Global Ratings estimates that the ratio of government debt to GDP was well above 60% in 2017, including hidden debts (like LGFVs). However, the default risk of LGFVs is increasing. China has opened the possibility of insolvent LGFVs filing for bankruptcy, but managing the aftermath of defaults is a formidable task for top leadership (see "China's Hidden Subnational Debts Suggest More LGFV Defaults Are Likely," Oct. 15, 2018).

Note that the figures in chart 7 include debt issues that are issued in both interbank and exchange markets; when this happens, the issues are included only in the primary market of issuance to avoid double-counting.


How liquid is China's domestic debt market?

Liquidity, as measured by traditional government and corporate debt turnover ratios (debt volume traded divided by debt volume outstanding), has declined from the highs of roughly five years ago to 0.34 and 0.09, respectively (see chart 8). The rapid growth of debt volumes has contributed to the fall in these ratios.

Banks participating in the interbank market bring liquidity to an otherwise illiquid debt market through the purchase of government debt securities and lending to other institutions (the coupons and spreads cover operating costs). Commercial banks typically match the durations of the liabilities they have on their own books (both in developed markets as well as in China), and liabilities are relatively short-term; thus, commercial banks tend to favor shorter-duration bonds for higher liquidity.

Mutual funds and insurance companies, however, typically follow a buy-and-hold strategy, resulting in lower active trading for less liquid debt. Foreign participation in the Chinese interbank bond market, while nearly nonexistent at present, will likely increase with Bond Connect.


While small in debt volume as compared with financial and nonfinancial corporate debt, the securitization market in China is growing rapidly. S&P Global Ratings expects that more established market infrastructure, stable asset performance, and a continued need for consumption and mortgage funding will enable the overall market to grow. We believe some economic reforms, like administrative and regulatory streamlining from the 2018 National People's Congress and Chinese People's Political Consultative Conference sessions, might encourage investment and support more sustainable long-term economic and credit growth in China.


By comparison, China also had the second-largest securitization issuance volume in the world in 2018, at $260 billion--over double the volume issued in Europe (see chart 10). The largest issuance volume came from the U.S., with $530 billion.


What is the maturity profile? Which industries are most vulnerable?

As of Sept. 28, 2018, a sizable volume of approximately $3 trillion was due to mature by 2019 in the domestic Chinese corporate debt market, reflecting the historical bias toward short-term debt, and another $3.2 trillion is poised to mature by 2023 (see table 1). The majority of the $6.2 trillion in corporate debt maturing by 2023 is financial debt, at $3.7 trillion. Another $3 trillion in government debt (both national and local) is set to mature by 2023. Over these five years, we expect that debt costs will likely rise--though monetary policy has recently eased funding costs--and government reforms and investment in the infrastructure of the domestic capital markets will likely help business sustainability, promoting debt issuance in the process.


Of the Chinese domestic nonfinancial corporate debt maturing by 2023, industrials hold roughly half, at $1 trillion, followed by real estate at $282 billion (see chart 11). Following utilities with $197 billion, materials and energy tie for fourth place at $186 billion. Lower demand for real estate and lower profitability will likely increase the perception of risk for these firms and subsequently push refinancing costs to potentially unsustainable levels to compensate investors for the risk they are taking on. Some issuers in this sector may face increasing default risk as well. The energy sector is also an area of concern, given comparatively low oil prices.


How do the Chinese financial system and credit market differ?

The activities of China's financial system are supervised by the People's Bank of China (PBOC), China Banking and Insurance Regulatory Commission (CBIRC), and China Securities Regulatory Commission. Additionally, the National Development and Reform Commission (NDRC), a macroeconomic management agency under the State Council, also oversees markets. For example, it plays a role in determining the criteria companies must meet before issuing onshore bonds. The PBOC, which is the central bank, has a mandate to maintain financial stability with monetary policy, while the CBIRC is primarily responsible for supervising the establishment and ongoing business activities of banking and insurance institutions and taking enforcement actions against regulatory violations.

There are three policy banks: China Development Bank, Agricultural Development Bank of China, and Export & Import Bank of China. China's big five state-owned commercial banks are Industrialand Commercial Bank of China, Bank of China, Agricultural Bank of China, China Construction Bank, and Bank of Communications. Besides state-owned commercial banks, there are also city commercial banks and other commercial banks (see diagram).

The four largest banks in the world are Chinese banks. According to data published by S&P Global Market Intelligence as of April 6, 2018, 18 of the top 100 banks are headquartered in China, and they collectively reported $23.761 trillion in assets. The U.S. had the next-highest number, with 11 banks and $12.196 trillion in assets, followed by Japan with eight banks and $10.534 trillion in assets. The seven largest banks in the world by asset value are Industrial and Commercial Bank of China Ltd., China Construction Bank Corp., Agricultural Bank of China Ltd., Bank of China Ltd., Mitsubishi UFJ Financial Group Inc., JPMorgan Chase & Co., and HSBC Holdings PLC (see table 2).


Chinese companies raise funding by issuing debt in China's interbank or exchange markets in a variety of forms. SOEs typically issue debt with a tenor between three and 30 years and are generally traded on the interbank bond market. Due to lower demand, tenors greater than 10 years are rare. Non-SOE companies, on the other hand, typically issue short-term (less than one year) and supershort-term (less than 270 days) commercial paper notes, as well as short-term funding (up to one-year tenors), medium-term notes, and long-term bonds for debt typically three to 30 years in tenor. Note that medium-term notes in China can exceed the typical tenors of three to seven years seen in developed markets. Again, however, market demand for longer tenors is small, making them atypical.

Among long-term bonds (greater than one year in tenor), the majority of debt outstanding is in the financial segment ($3.4 trillion), while corporate bonds account for the second-highest debt outstanding ($1.4 trillion) (see chart 12). The real estate sector holds a sizable concentration (18%) of corporate bonds and may have higher risk than other segments, given signs that property sales are past their peak in China, especially at a time of rapidly rising funding costs for the sector (see "China Property Watch: Which Developers Will Be Dragged Down In A Sliding Sector?" Nov. 6, 2018). Nevertheless, just over half of debt in the corporate segment belongs to industrial companies, many of which are state-owned and have options to help mitigate refinancing risk.

Bank loans make up the major part of the Chinese debt market, while the bond market is relatively small but growing. Although some issuers have defaulted in the domestic bond market in the past few years, the default rate is only roughly 0.6%--low when considering the higher default rates in other markets--due to the market's large increase in debt volume. Increasing defaults are a normal part of the development of capital markets as investors become more selective to be adequately compensated for risk.


What's expected for Chinese domestic credit growth in 2019?

Although deleveraging remains a high priority for the Chinese government, policy measures, including modulating the pace and intensity of the deleveraging process, may be used to minimize disruption to economic growth objectives. S&P Global economists project softened growth for the Chinese economy, to 6.2% in 2019 and 6.0% in 2020, but this slower growth is still quite healthy. We anticipate a softening in the government's growth target and a pause--but not a reversal--in deleveraging efforts, but the focus of the Chinese government will likely be balancing deleveraging policies and the growth of China's economy. Overall, we expect capital spending to remain more disciplined, setting the stage for China to continue the major undertaking of reducing its debt burden (see "China Inc. Will Struggle To Stay On The Deleveraging Path," Oct. 14, 2018).


China faces tension from trading partners' complaints and aspects of the economic road map its leaders have set out since 2015. This tension has put homegrown innovation, rapid development of the new economy, and a transformation of SOEs at the heart of the reform process. The two key aspects of the road map are the "Made in China 2025" program, which aims to quickly ramp up market share for domestic suppliers in a variety of industries, and the priority to make SOEs "stronger, better, and bigger" in order to develop their capacity for innovation and "exercise a greater influence and control over the economy." Meanwhile, the private sector has grown its footprint substantially over the past 10-15 years and now accounts for a very large share of total employment (see chart 16) (see "U.S.-China Economic Friction: Technology More Than Trade," Oct. 17, 2018).


While the timeline is difficult to forecast, China's bond market reforms are consistent with its goal of a more open, market-based economy over the long term. Bringing integrity and efficiency to the Chinese debt market through structural reforms should accelerate foreign participation and sustainable growth.

Banks In Emerging Markets 2019 - The Mid East, North Africa, & Turkey


- Difficult economic and political conditions will likely continue to test MENAT banks this year.

- While we anticipate loan growth to average 7%-8% in 2019, we don't think this level, if adjusted for inflation, is sufficient to finance the region's development needs.

- Weak asset quality will continue to weigh on our view of the credit quality of banks in the region, particularly those in Turkey.

- High dependence on foreign funding remains one of the most prominent risks. While some banks still rely on nonresident transfers, which we expect to continue growing, others are more dependent on volatile wholesale external funding.

Jan. 17 2019 — After a difficult 2018, banks in the Middle East, North Africa, and Turkey face more of the same this year due to tighter global liquidity conditions, a stronger U.S. dollar, and geopolitical as well as local instability. S&P Global Ratings believes the region's prospects for economic growth will be dampened, notably by Turkey's expected contraction (-0.5% real GDP growth in 2019). While a weaker Turkish lira has put intense pressures on those private-sector borrowers indebted in foreign currency debt, it has also benefited Turkey's export sector, including tourism, which posted very strong results last year. Nevertheless, much of the lira's depreciation has passed through into higher inflation. A 26% minimum wage hike scheduled for this year is likely to push prices up further, cutting into consumers' already weakened purchasing power. On a positive note, lower commodity prices could provide some breathing space, as most of these countries are commodities importers. We expect oil prices to stabilize around $55 in 2019-2020.

Chart 1  

We expect loan growth to stabilize around a nominal 7%-8% on average in 2019, ranging from 0% for Turkey to 17% for Egypt. However, we consider these figures, if adjusted for inflation, as insufficient to cope with the economic development needs in the Middle East, North Africa, and Turkey (MENAT). Several economies in the region, in particular Jordan and Lebanon, are facing an overall stagnation in lending activities. The Syrian conflict in particular, coupled with social domestic tensions, generally depressed tourism and trade activities, notably for Lebanon and Jordan, which are finding it difficult to process large inflows of refugees that dwarf those into Europe and the U.S. Upcoming elections in Turkey and Tunisia will be critical for the stability of their economies and banking sectors, as they may motivate governments to actively interfere in monetary and other policy settings. Some scenarios could set off another round of market volatility, including exchange rate volatility in Turkey. That could create further difficulties for corporate loan quality.

Chart 2  

Asset quality will continue to weigh on our view of the credit quality of banks in the region. This is particularly relevant for Turkey, where we estimate that problematic loans (Stage 2 and Stage 3 loans) could climb to about 20% of total loans. Tunisia is also another country where we continue to view asset quality negatively. While banks' reported nonperforming loans (NPLs) dropped slightly in the past two years, we think asset quality indicators could be worse if banks were to adopt International Financial Reporting Standards 9 (IFRS 9).

High dependence on foreign funding remains one of the most prominent risks for MENAT banks, in our view. While some still rely on nonresident transfers (Morocco, Lebanon, Jordan, and Egypt), which we expect to continue growing, others are more dependent on volatile wholesale external funding (Turkey). On Sept. 30, 2018, the total external debt of Turkish banks stood at $100.4 billion ($117.8 billion including nonbank financial institutions) including $40.5 billion coming to maturity in the next 12 months ($47.0 billion including nonbank financial institutions). These numbers exclude other short-term liabilities, including, among others, nonresident deposits (both in Turkish lira and foreign currencies), which stood at $60.6 billion on Sept. 30, 2018. The volatility of the Turkish lira and uncertainty related to policy direction, as well as the deterioration of the country's relationship with Western allies, weighed on investor sentiment toward Turkey and led to the default of some corporates and nonbank financial institutions. Market access has somewhat improved recently, with several banks refinancing their debt with high rollover rates, albeit at higher costs. It is important to note that banks still have some foreign currency-denominated assets (about $95 billion on Sept. 30, 2018). If rollover rates drop below a certain level or banks lose a significant amount of other short-term debt, the risks will be displaced to the balance sheet of the central bank because banks will have to use their foreign currency reserves deposited there.

Chart 5  

We expect return on assets to decline slightly for MENAT banks in 2019, to an average of about 1.2%. Some banks have benefited from higher government bonds yields (particularly in Egypt, Lebanon, Tunisia, and Turkey). Others have continued to benefit from low cost-to-income ratios in a global comparison, given the low cost of labor in some systems. We expect both trends will continue in 2019. However, we believe cost of risk will increase slightly in some systems in 2019, such as Turkey and Tunisia. In Turkey, we think the backlog of problematic assets will contribute to higher cost of risk, while in Tunisia the decline in real estate prices will push some banks to beef up their provisions against exposures of real estate developers.

Chart 8 

The development and sophistication of regulatory frameworks for banks remain disparate across the region. Tunisia and Egypt lag behind the rest of the region that has moved toward a stricter regulatory environment under Basel III, sometimes with specific adjustments (Morocco for example). Three out of six countries started implementing IFRS 9. Only Morocco is pursuing the implementation of a recovery and resolution regime. We assess the banking authorities in Tunisia as the weakest among MENAT countries. Although several reforms have been implemented in the past five years, banks continue to report under Basel I and local accounting standards, for example.

Egypt: High exposure to the sovereign and low financial inclusion mean significant untapped potential

In 2018, S&P Global Ratings upgraded the sovereign rating on Egypt to 'B' from 'B-' and revised upward the Banking Industry Country Risk Assessment (BICRA) to group 9 from 10 (on a scale of 1-10 with 1 being the lowest risk), on the basis of low loan leverage, strong liquidity in the domestic banking sector, and supportive Central Bank of Egypt policies through injections of Tier 2 capital. This led to higher ratings for three rated domestic banks. We expect Egypt to experience strong economic growth averaging over 5% from 2019 to 2021, with a smaller current account deficit relative to 2015-2017 and rising investment. Egypt's external position is improving on the back of rising domestic gas production, which curbs imports, and a rebound in tourism. While external financing needs remain high owing to higher levels of short-term external debt, we expect them to decline gradually over the next three years. However, we expect fiscal challenges to remain considerable but on a downward trajectory. High interest rates and higher currency depreciation or oil prices than we expect could derail government efforts to reduce gross government debt from around 90% of GDP currently.

We expect loan growth in 2019 to stabilize at around 15%-18%, compared with around 50% in 2017, primarily because of the devaluation of the Egyptian pound and government-directed lending. We also think that NPL ratios will stabilize around 5% (or about 8%-9% including restructured loans or asset swaps). Nevertheless, given the inflationary pressures and their negative impact on borrowers' debt-servicing capacity, we expect credit losses to increase to 150 basis points (bps) in the next 12-24 months, from 135 bps in 2017. We anticipate the NPL coverage ratio to remain around 100% over the next 12-18 months.

The loan-to-deposit ratio remains low in Egypt (about 40% as of October 2018). Financial inclusion is low: the stock of banks' credit to the domestic private sector stood at less than 30% of GDP at end-June 2018. Excess funds are channeled to domestic government debt, creating a direct link between government's creditworthiness and banks'.

Jordan: The banking system remains vulnerable to regional geopolitical risks

We expect Jordan's GDP growth will reach 2.8% by 2020, up from 2% in 2018 but much lower than the 6.5% rate from 2000 to 2009. Political developments in Syria and Iraq have led to a high financial burden related to the significant influx of refugees and to the closing of former trade routes. This has weighed on economic dynamism and translated into high unemployment and sluggish growth. Over the past couple of years, the reopening of the Syrian-Jordanian and Iraqi-Jordanian borders has led to a slight revival of trade activities. Therefore, we expect a slight rebound over the next four years, permitted by a rise in exports and investment projects, notably in the energy and construction sectors.

The current macroeconomic and geopolitical situation has taken its toll on the banking system as well. With the exception of the sizable cross-border operations of Arab Bank PLC, Jordan's largest bank, the domestic banking system focuses on pure domestic commercial banking operations, both conventional and Islamic. The low-growth environment, higher interest rates, and rebalancing of lending to the private sector from the public sector will result in deteriorating credit conditions for Jordanian banks. Therefore, we expect increased NPLs, though stable profitability thanks to higher margins. However, considering the Jordanian banking sector's track record and regulatory framework, we do not expect a large increase in the cost of risk over the next two years, but rather a slight pickup to about 100-120 bps.

On a positive note, we believe banks' profitability will be sufficient to absorb the rising costs of risk. This is based on an ample customer deposit base, enabling a stable and less costly funding source. We also expect steady moderate lending growth rates encouraged by the recent pro-growth policy led by the central bank.

Finally, we continue to see the banking sectors' significant exposure to sovereign debt (around 20% of total assets) as additional credit risks.

Lebanon: Geopolitical uncertainties and exposure to sovereign debt are the main risks

In November 2018, we revised downward our BICRA on Lebanon to group 10 from group 9, on the basis of significant market distortions created by the Banque du Liban's (BDL) stimulus packages and swaps operations. Although this weakened the stand-alone credit profile of two of the Lebanese banks we rate, all issuer credit ratings remained unchanged at the level of our 'B-' sovereign rating. We project the Lebanese economy to grow by about 2.5% over 2018-2021, increasing from 1.4% in 2017, but lagging behind the levels seen in 2007-2010 (9.2%). However, we believe that large fiscal deficits and increasing public debt will continue to characterize the Lebanese economy in the next two years. Net government debt represents 124% of GDP, which we expect to increase further to 156% by 2021. Given rising global interest rates and external financing costs as well as uncertainty about policymakers' ability to address macroeconomic reforms, we continue to see the government debt as burdensome for the banking sector both directly and indirectly via placements with the central bank offered as part of its "financial engineering" deals. Lebanese banks have high direct exposure to sovereign credit risk. That said, we do not expect a deterioration in domestic economic conditions, excluding unexpected major political instability.

The central bank started reducing its involvement in the economy in 2018. The reduction in BDL's economic stimulus package and subsidies will lower growth in the short term, mostly affecting the real estate and construction sectors. We believe the current operating environment, coupled with an increase in interest rates, will lead to a contraction of lending portfolios and higher deterioration of asset quality, from NPL ratios of 5.7% as of year-end 2017. Nevertheless, we expect the banking sector's profitability to remain higher and more stable than for other sectors in the Lebanese economy. This is mostly based on BDL's support by offering various instruments with effective returns in excess of those on the sovereign debt, but also due to Lebanese banks' significant geographical footprint. The Lebanese banking sector's return on equity has been about 11%-12% over the past few years, a level we expect to stay stable for the next couple of years.

System funding has so far been supported by a highly solid deposit base, with a pronounced nonresident component as well as a high foreign currency-denominated share (69.5% on October 2018). Deposit inflows have proven to be resilient in the past, as most are coming from the Lebanese diaspora.

Political risk remains one of the highest concerns for Lebanon. We forecast that political deadlock will continue to obstruct policymaking. Lebanon held parliamentary elections earlier in 2018 after almost a decade of political turmoil, but the process of forming a government was still on hold as of mid-January 2019, delaying the implementation of structural reforms and preventing the country from tapping pledged donor funds. We expect sectarian divisions and rising tensions among neighboring countries to further weaken the political landscape and weigh on economic growth.

Morocco: Stable banking industry, but pressure on asset quality persists

We expect real GDP to decelerate to about 3.2% in 2019 before accelerating to around 4.1% over 2020-2021. The expanding automotive and tourism sectors, coupled with increased demand for phosphates and derivatives, will stimulate the long-term performance and somewhat reduce the reliance on cyclical sectors, notably agriculture. However, we consider that high unemployment levels, low revenues, and high-income disparity across the country will continue to fuel social tensions. As such, we view positively the government's willingness to make the development of the economy more inclusive.

The Moroccan banking sector remains constrained by its high exposure to commercial real estate risks. This is reflected by overleveraged developers who face decreasing real estate transactions. We forecast overall NPLs to remain high over the next two years (around 7%), with steel, tourism, commercial real estate, and construction bearing the highest credit losses. Moreover, we do not exclude that the ongoing effort by the Central Bank of Morocco (BAM) to harmonize its loan classification and the increase in the general provisions requirement could lead to a decline in asset quality indicators for Moroccan banks.

Profitability is set to remain high in the next two years, despite the increasing provisioning required by IFRS 9 (adopted in 2018), owing to low costs of labor and to a large share of noninterest-bearing deposits (67% of the deposit base as of mid-2018). We forecast that credit growth will be steady at 4% over 2019-2020, based on the recovery of corporate growth and still-dynamic household lending. Though margins will suffer from low interest rates and tough competition in Morocco's banking sector, we anticipate that African subsidiaries will continue to contribute positively to the financial performance of larger Moroccan banks.

We expect customer deposits inflows, especially from Moroccans expatriates, to continue to fully fund credit growth, given banks' limited access to external funding. We expect the latter to remain marginal, notably due to the high costs of fundraising for Morocco in the international capital markets. We believe banks will continue to use domestic capital markets to match increasing funding needs and reinforce their capital base.

In early 2018, BAM widened the fluctuation bands between the dirham and the currency basket to +/-2.5% (versus +/-0.3%). We expect the transition to be long and gradual (15 years) and have limited impact on banks as most financial institutions have marginal exposure to foreign currency-denominated assets.

Tunisia: Subdued economic conditions and overreliance on central bank liquidity remain the main challenges for Tunisian banks

Over 2018, the Tunisian economy showed some slight signs of economic pickup on the back of better agricultural output and a strong rebound in tourism. However, this has not been sufficient to counterbalance the country's high current account deficit, unemployment ratios, and government debt. In our base case scenario, we forecast current economic conditions to persist over the next 12-18 months, with GDP growth averaging 2.8% annually and a gradually narrowing in fiscal and current account deficits that will remain significant. This is based on more aggressive reform implementation, which we expect to continue under the existing government. That said, with the upcoming 2019 election, political uncertainty is increasing. The risk is exacerbated by the chronical dependence of the country on donor financing and the link between the availability of this funding and reform implementation speed.

As for asset quality, Tunisian banks have one of the highest NPL ratios in the region, which we expect to climb to 18% over 2019-2021, incorporating restructured and other tourism sector loans not classified as nonperforming and anticipating increasing financial stress for borrowers as interest rates move higher.

Private-sector leverage remains high. We forecast it will remain at about 85% of GDP in 2019 due to hawkish loan growth over the next three years. Even though Tunisian banks don't use complex products and exhibit a somewhat moderate risk appetite, net margins will remain constrained by price competition.

Although Tunisian banks are mainly funded by customer deposits, the mismatch between their assets and liabilities persists, as the pace of deposit growth is not sufficient to fund the system's lending portfolio. We do not expect to see a reversal of the trend--at least in the short term, mainly because of a growing shadow economy. As such, we expect banks to continue relying on central bank refinancing. We also believe the new rule for the loan-to-deposits ratio as well as haircuts on eligible assets, coupled with expected moderate loan growth, will help to gradually reduce the volume of refinancing.

Turkey: Asset quality and profitability will remain under stress in 2019

Last year was extremely challenging for the Turkish banking system. In August 2018, we lowered our foreign currency sovereign rating on Turkey to 'B+' from 'BB-', on the back of steep depreciation in the Turkish lira, which hurt fiscal balances and financial asset quality. At the same time, we revised lower the BICRA on the country to group 9 from group 7, on our view of increased credit risk in the economy as well as weakening institutional framework and industry stability. As a result, we downgraded the long-term ratings on six Turkish banks.

Political concerns and geopolitical turmoil over the past two years have tested the Turkish economy, leading to a significant decline in the lira over August 2018. Inflation in Turkey rose above 25% in October 2018, and we expect the figure to only gradually decline to 9% over 2020. The central bank fought inflation by raising the rate on the late liquidity window by 11 percentage points to 24% during 2018. However, we believe the volatility of the Turkish lira may undermine the central bank's efforts to anchor inflation, particularly if domestic or geopolitical instability flares up in coming months. This is especially true given the concerns about the recent degradation of institutional checks and balances, including the independence of the central bank: President Erdogan's centralization of power around the central bank brings into question the overall independence of the banking sector and the country's rule of law. The government's response to the recent financial market volatility has been modest, potentially undermined by upcoming elections in March 2019, which limited the rise in interest rates in recent months.

Over the next two years, we expect a reduction in Turkish banking system business volume, and higher credit and funding costs, in line with a contraction of the economy of -0.5% in 2019, before a return to modest growth of 3% by 2020. Banks have proven to be resilient so far, but this resilience hinges greatly on external funding and investors' confidence. We forecast loan growth of 0% in 2019, and we expect that the higher funding and credit costs--due to interest rate spikes, partly compensated by inflation-linked bonds--will weigh on bank profitability over the next 18-24 months. The asset quality deterioration will also hurt banks' profitability, as lenders will need to increase provisions. In addition to the impact of economic contraction and private-sector deleveraging on asset quality, currency depreciation limits borrowers' repayment and debt-servicing capacity given the high share of foreign currency corporate loans (about 40% as of June 2018). Hence, we expect to see reported NPLs to double over 2019 and 2020 to about 6% of total loans. Overall, we estimate that problematic loans (Stage 2 and Stage 3 loans) could climb to about 20% of total loans. We consider the energy, commercial real estate, and construction sectors will continue to represent credit risks for the banking sector.

The capitalization of Turkish banks is also weakening due to lira depreciation (since capital is largely lira-denominated while risk-weighted assets have a large foreign exchange portion) and mark-to-market losses on government securities. Regulatory forbearance initiatives aim to alleviate such pressures. In August 2018, the regulator introduced measures that eliminated mark-to-market losses from lira depreciation and higher rates on capital. Banks are trying to issue hybrid instruments, but there is constrained investor appetite.

U.S. Finance Companies Will Benefit From A Resilient Economy In 2019


- We believe economic growth and low unemployment in the U.S. in 2019 will support the credit quality of most of the finance companies we rate.

- We believe rising interest rates represent a threat to most finance companies, though some may temporarily benefit from expanding interest margins and when rising interest rates affect credit quality remains unknown.

- We have stable outlooks on 77% of the nonbank finance companies we rate, positive outlooks on 9%, and negative outlooks on 14%.

Jan. 16 2019 — S&P Global Ratings expects continued economic growth and low unemployment in the U.S. in 2019 to support the credit quality, funding, and earnings prospects of most of the finance companies we rate. However, rising interest rates and volatile financial markets could threaten those benign conditions, particularly if the U.S. economic expansion is in its latter stages.

S&P Global economists expect U.S. GDP growth to slow to 2.3% in 2019 from 2.9% in 2018, the unemployment rate to drop to 3.5%, and the Federal Reserve to raise its target range for the Fed funds rate by 50 basis points (as a result of two rate hikes). We expect those economic conditions to support the credit quality of most types of consumer and commercial loans and therefore earnings. That said, stiff competition in certain lending areas, like residential mortgages in recent years could ultimately result in a significant rise in loan losses if the economy does not perform as well as we expect.

Although the number of expected interest rate hikes in 2019 has been lowered to two from three by our economists, we believe rising interest rates represent a threat to most finance companies. For instance, higher rates continue to limit residential mortgage originations and could lead to increased capitalization rates (cap rates) on commercial real estate properties. Also, the recent rise in rates and the concurrent market volatility could slow economic growth and weaken funding availability for finance companies.

Entering 2019, we have stable outlooks on 49 (77%) of the nonbank finance companies we rate. (We classify finance companies as either nonbank finance companies [NBFI] or financial service finance companies [FSFC]. The former have more significant balance-sheet risk while the latter depend more on cash flows). We have positive outlooks on six (9%) companies and negative outlooks on 9 (14%) companies. Four of the companies on negative outlook are residential mortgage companies struggling with lower origination volume, a heightened competitive environment pressuring profit margins, and elevated expense bases. Two of those companies, DiTech Holding Corp. and Stearns Holdings LLC, said they are considering distressed debt exchanges.

Rating trends on rated subprime consumer lenders are probably the most idiosyncratic. There are four companies with a positive outlook because of improving leverage and debt ladders, and three with negative outlooks because of bespoke regulatory issues. In the last three months, we have also taken two subprime consumer lenders to default/selective default, Community Choice Financial (now CCF Holdings LLC) and Sterling Mid-Holdings Ltd.

Vehicle Finance: Delinquencies Stabilizing As Underwriting Standards Improve In Subprime

Auto loans have been the fastest-growing consumer segment since the end of 2010, increasing at a 7.8% annual rate over that period. Total consumer auto loan debt increased by $554 billion, compared with growth of $1.8 trillion across all consumer debt, according to the Federal Reserve Bank of New York's Quarterly Report on Household Debt and Credit from November 2018. Growth in originations peaked in 2015, at a time when we believe competition was particularly intense, leading to relaxed underwriting standards. Over the past three years, however, lenders have pulled back on subprime originations as credit conditions worsened despite lower unemployment. Growth since 2016 has slowed and been led by higher FICO loans.

Chart 3

We see the greatest risks in leases and nonprime, particularly deep subprime. We believe previous loosening of credit standards, lower residual values, and rising interest rates are posing challenges for vehicle finance companies, though used car values have held up better than expected. Longer loan terms, however, widen the gap between the outstanding loan amount and the vehicle value, thereby increasing loss severities.

Overall, our current ratings anticipate that earnings will soften as losses for auto lenders persist, but not enough to erode lenders' capital positions. Positively, we believe that underwriting standards have now tightened for most of the companies we cover, particularly for subprime loans, as lenders adjusted their risk appetites in the face of increasing delinquencies and defaults, and recoveries that were then expected to decrease going forward. Through a recession, we would be vigilant of a company's ability to retain access to bank funding for warehouse lines as credit quality deteriorates, as well as its ability to continue to issue debt in the asset-backed securities (ABS) market.

Auto loan delinquencies of more than 90 days increased 30 basis points in the third quarter of 2018 compared with the same period in 2017, per data released by the Federal Reserve Bank of New York. Similarly, over the past year, delinquency rates have also risen across all other consumer segments other than mortgage by an average of 41 basis points. With 4.27% of loans 90+ days delinquent, auto loans are at their highest delinquency rate since the first quarter of 2009, when economic conditions were much worse. We believe delinquencies were driven higher primarily due to loosening credit standards, particularly in 2015 and 2016 vintages. If economic conditions worsen meaningfully in 2019, the "risk layering" some auto lenders have employed in recent years (higher loan-to-value ratios, longer terms, and lower FICOs) could cause delinquencies and losses to spike higher than the peak during the last recession, which was led by subprime.

Chart 4

However, while delinquencies continue to rise, auto lenders have tightened their lending standards, which the FICO distribution of auto loans demonstrates. That trend could help offset some of the impact from the weaker underwriting in prior years. The median FICO of loans originated was 704, as of third-quarter 2018, up from 696 three years ago. The last time the median FICO for auto loan originations was above 705 was in the first quarter of 2011. Similarly, 25th percentile and 10th percentile FICO scores are also modestly higher from three years ago and stable from a year ago, according to the Federal Reserve Bank of New York, which demonstrates tightening lending standards over the past couple of years.

Chart 5

We believe the companies we rate vary in their ability to navigate deteriorating credit quality. Some saw higher credit provisioning from 2015 and 2016 vintages significantly erode profits or result in losses. Others have been able to navigate higher provisioning with a material, but less significant, impact on earnings. Importantly, all of the companies we rate were able to continue to tap the ABS market with no impact on the availability of bank provided warehouse funding. We downgraded Drivetime Automotive Group in August, in part due to proximity to covenants from increasing delinquency, though it did not see a decrease in warehouse funding. We expect 2017 and 2018 vintages to be of better quality, helping to improve provisions across the sector.

Residential Mortgage: Survival Of The Fittest

We expect a tough residential mortgage origination market to continue into 2019, further pressuring earnings and leverage for the companies we rate. We currently have negative outlooks on five of the mortgage companies we rate. We do not expect the recent dip in the 30-year mortgage rate to provide any meaningful support to origination volume, especially because we are entering the seasonally weaker winter months.

Chart 6

Overall, the industry is still grappling with too much supply of companies willing to originate mortgages and not enough mortgage demand from consumers. This places downward pressure on gain-on-sale margins. The Mortgage Bankers Association (MBA) expects total origination volume to remain relatively flat in 2019 at $1.62 trillion (24% refinance/76% purchase) from a forecast of $1.64 trillion for 2018 (28% refinance). The 2019 forecast is based on the 30-year rate rising to 5.0% in 2019. This activity is down drastically from the $2 trillion of activity in 2016 when interest rates averaged 3.65% and refinance volume constituted 49% of total volume. S&P Global economists expect the 30-year rate to reach 5.1% in 2019 from the current 4.5%.

Chart 7

As interest rates rise, we expect to see diminishing valuation gains to mortgage servicing rights (MSRs). Generally speaking, MSRs increase in value as interest rates rise because homeowners are less likely to refinance their mortgage. However, as the 30-year mortgage rate gets further away from the average interest rate on the unpaid principal balance of mortgages serviced, the mark-to-market gain on the associated MSR diminishes; this is because if consumers are unlikely to save any money by refinancing at today's current interest rates, then they are just as unlikely to refinance at any rate higher than today.

Moreover, delinquencies on mortgage payments are at cyclical lows. If delinquency rates normalize to higher levels, MSR valuations will fall. Although we do not expect 90+ day delinquency rates to return to the last recession's peak of 8.9%, we also do not expect them to remain at their current 1.06% level. Higher delinquencies will lower MSR valuations because they can decrease the expected life of the loan, are more expensive to service, and incur increased carrying costs from advances that servicers have to provide to the mortgage investor. Rising delinquencies could also pose some capacity issues for an industry that is in consolidation.

Although industry consolidation is occurring, it is at a slower pace than we originally expected. We still expect larger servicers and originators to look for economies of scale, and smaller players look to sell or close while under pressure. Over the last three months, Mr. Cooper (formerly known as Nationstar) acquired mortgage company Pacific Union Financial and Seterus Inc., a servicing platform, from IBM Corp. DiTech Holding Corp. remains for sale and announced in December that it elected not to make a $9 million cash interest payments on its second-lien notes because it is in active discussions with certain of the company's creditors and other parties regarding the evaluation of strategic alternatives (due to a 30-day grace period we did not view it as default).

In addition to these midsize deals, stronger mortgage companies are likely to poach broker talent from their competitors while smaller firms shed jobs or close shop. The Bureau of Labor Statistics reported that mortgage banking firms cut 3,100 jobs in November, while mortgage brokerage companies cut 900.

At a policy level, the White House nominated Mark Calabria to head the Federal Housing Finance Authority (FHFA), the federal agency that is responsible with managing Fannie Mae and Freddie Mac while they are under conservatorship by the U.S. Treasury. Mr. Calabria was most recently the chief economist for Vice President Mike Pence and is said to favor a stronger role of private capital in the housing sector. We remain uncertain about the prospects for government-supported entity reform in 2019 and even beyond that.

Separately, the Federal Housing Administration (FHA), which provides mortgage insurance on loans made by FHA-approved lenders, has expressed concern that underwriting standards on mortgages have become riskier over the past two years. Inside Mortgage Finance reports that the share of mortgages made to homeowners with FICO scores below 700 and debt-to-income ratios above 43% rose to 45.6% at the end of 2018, up from 35% in the first quarter of 2017. We believe select originators are stretching their underwriting standards in an attempt to bolster origination volumes--a practice that could lead to higher mortgage delinquencies down the road. In anticipation of a tougher economic environment, Ginnie Mae's chief credit officer sent letters to the agency's largest servicers, including several of the companies we rate, requesting their contingent liquidity plans to address a scenario where delinquencies rise and the cost to service a mortgage increases.

Payday Lending: Softer CFPB Rules Seem Likely, But State Regulations Could Pose A Challenge

Rolling into 2019, we believe there are tailwinds for better-positioned payday companies because of lighter federal regulations and no pending debt maturities for the year. That said, we still believe that the narrow product suite and homogenous customer base lends itself to significant competition, which could pressure earnings.

In the latter half of 2018, the pendulum oscillated back in favor of payday companies. The Consumer Financial Protection Bureau (CFPB) said it will propose changes to the underwriting provisions of its payday lending rules (anticipated to be announced this month) and delay its effective compliance date (currently August 2019). Specifically, the CFPB is reconsidering the ability-to-repay underwriting provisions and not the remittance provisions. We expect the revised rules to benefit payday companies because they will reduce underwriting requirements and compliance costs, and allow companies greater flexibility to maintain their current origination volumes and profit margins.

At the CFPB, Kathy Kraninger was appointed as the new director. Departing director Mick Mulvaney, in turn, became the acting White House Chief of Staff for President Donald Trump following the resignation of General John Kelly. We expect Ms. Kraninger to continue down the path of a softer stance for the CFPB that is more business friendly. This is in stark contrast to the CFPB under the Obama Administration when director Richard Cordray actively created new consumer protection policies and levied monetary penalties against businesses.

Even with the positive momentum of lighter federal regulations, we remain cautious as new state laws are being created to curb high-cost short-term lending, such as:

  • In October 2018, the Ohio legislature implemented House Bill 123, which is applicable to loans made after April 26, 2019, and limits permissible fees and charges on short-term loans and eliminates the Credit Services Organization (CSO) model. Absent an alternative product, we expect companies such as ACE Cash Express and Curo Group Holdings Inc. to exit the Ohio market.
  • In November 2018, Colorado voters passed Proposition 111, a ballot measure that will cap the annual interest rate on payday loans at 36% and eliminate all other finance charges and fees, effective February 2019.
  • In Georgia, short-term payday is currently banned and a lack of reform to the pawnbroker statute could hurt lenders. Without a change in law, the lenders would need to obtain Georgia licensed industrial loan licenses to continue operating. This would have the greatest impact on TMX Finance.

We still favorably view companies transitioning to more installment lending from short-term lending and streamlining their business operations by reducing retail footprints. Those companies would be in a better position to adapt to regulatory changes.

In 2018, we revised our outlook to positive from stable on Curo Group Holdings Inc., CNG Holdings Inc., and ACE Cash Express Inc. and to stable from negative on Enova International Inc., driven by steady operating performance and reduced financial leverage expectations. Nevertheless, given the ongoing product transition, we still expect companies to have increased compliance costs, higher charge-offs, margin compression, and an increase in loan loss provisions, which explain why our ratings remain concentrated in the low 'B' and 'CCC' categories.

In 2018, we also saw capital markets relatively open to payday companies as Curo Group Holdings Inc., TMX Finance LLC, and Enova International Inc. refinanced their debt stacks. We also experienced market gyrations affecting weaker performing payday companies' ability to refinance debt. These companies either missed an interest payment or restructured their capital structure through exchanges, which we view as tantamount to default, resulting in downgrades to 'CC' or 'SD' (selective default). In December 2018, we saw CCF Holdings LLC (f/k/a Community Choice Financial) and Sterling Mid-Holdings Ltd. issue new payment-in-kind (PIK) notes to satisfy their debt obligations. Looking forward, there is about $315 million of debt maturing in 2020 collectively for the payday companies we rate, which is significantly down from $1.3 billion last year due to these recent debt exchanges.

Commercial Real Estate: How Close Are We To An Inflection Point For Credit?

For the commercial real estate (CRE) finance companies we rate, losses continue to be relatively minimal as the underlying economy supports CRE fundamentals. However, provisions have started to tick higher among some of the companies we rate as vacancies rose across U.S. metro areas. Barring a significant decline in credit quality, we expect higher interest rates to boost margins in the short term on the back of floating-rate transitional loans held on balance sheets. Over the longer term, rising rates could increase funding costs for borrowers and lead to increasing delinquencies and charge-offs. We also believe rising rates could cause cap rates to rise, which could decrease real estate values.

During the past couple of years, companies such as Ladder Capital Finance Holdings LLLP and Starwood Property Trust Inc. have expanded their use of unsecured funding because of surging demand in the capital markets. We have seen CRE finance companies also increase their use of collateralized loan obligations (CLOs) over the past couple of years to fund further origination growth. The CLO nonrecourse structure allows for more diverse funding and greater leverage compared to advance rates for repurchase facilities while complying with risk-retention rules. If the CLO market remains open to CRE finance companies, it could fuel further origination growth and higher leverage through 2019.

We remain vigilant about the potential impact of strong competition on the quality of loan portfolios, especially given that many companies we rate have not gone through a downturn and many of them still use a significant amount of repurchase facilities that could impose margin calls if credit deteriorates. We will also remain vigilant about how companies can further origination growth in a more competitive environment and if this leads to diversification into new areas.

Vacancies for multifamily real estate appear to have troughed in 2016, with multifamily vacancies at 4.8% as of third-quarter 2018, up from 4.2% as of fourth-quarter 2016, according to Bloomberg data provided by REIS Inc. Retail vacancies have remained relative steady at 10% since 2015, though they remain substantially higher than precrisis levels as demand for retail space has fallen because of growing online sales. Office vacancies also have not recovered to prerecession levels and are now at 16.6% as of third-quarter 2018, up from their precrisis trough of 12.6%.

Chart 8

We remain watchful of property prices, which have more than doubled since the last trough and are currently led by multifamily. Multifamily cap rates continue to head lower and were at 5.6% as of the end of the third quarter of 2018, compared with 6.0% in the year-ago period. Retail cap rates are higher at 8.1% as of third-quarter 2018, compared to 7.6% in the year-ago period. Office cap rates have been relatively stable at close to 7% over the past couple of years.

Chart 9

Commercial Real Estate Services: Solid Footing Supports Momentum

We expect another healthy year from the CRE services companies we rate, following what was already a very strong 2018. Last year, we upgraded CBRE Services Inc., Jones Lang LaSalle (JLL), Cushman & Wakefield, and multifamily originator Walker & Dunlop. We also assigned a new rating to Newmark Group Inc. in October. That said, all of the CRE services firms we rate have stable outlooks because our favorable view of the sector and individual issuers are largely reflected in our current rating assessments despite growing positive sentiment around the shared workspace industry.

Thematically, we see many common trends in the issuers we rate:

  • Leverage is declining due to strong operating results. Many companies we rate have targets to keep their net debt to EBITDA comfortably below 2.0x, a level we view favorably since some revenue streams are more sensitive to economic cycles.
  • Across the board, CRE services companies are reporting strong performance in their leasing segments, typically the largest revenue segment for all CRE services companies, as the industry has plenty of white space to grow into. Rising employment also supports leasing. JLL reported that global office leasing markets volumes were at the highest levels since 2007, with year-to-date totals 8% higher than in 2017.
  • Capital market-making remains strong as the industry benefits from strong investor demand and liquidity. Multifamily housing and the U.S. lead the pack for investment activity.
  • Companies are also reporting healthy profit margin expansion from a combination of higher operating leverage and cost savings.
  • Lastly, strategic recruiting and infill acquisitions remain a preferred way for issuers to reinvest their capital.

Notwithstanding these tailwinds, we enter 2019 with rising rates and increased capital market volatility--two factors that investors fear could derail the momentum. Companies, however, are confident that momentum will remains on their side.

Although we believe CRE issuers enter 2019 on strong footing, S&P Global economists expect economic growth to decelerate over the next two years. Though higher interest rates have not led to higher cap rates so far, we do expect cap rates to rise eventually, which will dampen capital markets activity. We also expect CRE services companies to continue to pursue acquisitions, which creates the possibility of incremental leverage and execution risk. Nevertheless, we expect CRE services to be better-positioned compared with the 2008 recession, as they have transitioned to more contractual fee revenue sources relative to more volatile capital market revenues.

Student Lending: Private Loan Originators Would Benefit From Any Regulation That Tries To Slow Federal Loan Growth

As of the third quarter of 2018, there was over $1.4 trillion of student loans outstanding, according to the Federal Reserve Bank of New York. Student debt now contributes 11% of all consumer debt and is the largest segment of consumer debt after mortgages, which totals 68% of consumer debt, or $9 trillion outstanding. As of the first quarter of 2003, by comparison, student debt totaled $241 billion outstanding, or just 3% of total consumer debt.

If student balances continue to grow, student loan servicers would probably see limited benefit based on historical data, in our view. Servicers like Nelnet and Navient receive recurring allocations of new student loans to service from the Department of Education based on certain performance indicators such as delinquencies and consumer surveys.

In theory, as student debt accumulates, the amount of servicing Nelnet and Navient have to do should also grow, and revenues should follow. However, despite the growth in student lending that has occurred, Nelnet and Navient have not seen comparable growth in servicing revenues in recent years, excluding acquisitions. While there have been other factors limiting growth of servicing revenue, such as run-off on Nelnet and Navient's Federal Family Education Loan Program portfolios and a more fractured servicing market, it is still difficult to conclude that a growing federal student loan market will necessarily result in an equal rise in servicing revenues for all servicing companies. This is especially true since the federal government is likely to migrate to a single servicing platform that could affect costs across the servicing business as servicers have to abandon their own servicing platform that was essentially a fixed cost and pay to use the government-approved platform that will likely have a cost per loan.

Chart 10

Were the federal government to pull back on student lending, the addressable market for private student loans would grow significantly--and could as much as double or triple given their relative size ($105 billion of federal loan originations compared with $10 billion for private loans in the 2016-2017 academic year). Sallie Mae, which has over 50% market share in the student loan space, would likely be a meaningful beneficiary.

A growing private student loan space would also make entering the market easier. On the other hand, if the federal government were to increase limits or take any other action that would increase originations, the serviceable market for private student loans could shrink by 50% or more due to the same relativity. This would likely result in downgrades. We view this as less likely because this would contribute to the growth in student debt that has already been identified as a problem by most stakeholders. Lastly, were the federal government to make private student debt easier for consumers to discharge--whether in bankruptcy or some other means--credit quality for private originators would likely suffer.

Chart 11

Finance Company Ratings Already Incorporate Our Expectations For Next Year

S&P Global Ratings expects the credit quality, funding, and earnings prospects of most of the finance companies we rate to hold firm in 2019, on the back of continued economic growth and low unemployment. However, rising interest rates and volatile financial markets could affect finance companies we rate negatively, principally by decreasing credit quality and increasing credit costs, possibly leading to downgrades. Upgrades are less likely, given where we are in the economic cycle and the unlikelihood of improving credit quality in most of our sectors.

Asia-Pacific Credit Outlook 2019 Cold Wind Blowing


Overall: We expect credit conditions in Asia-Pacific to tighten further in 2019. With U.S. interest rates rising and sentiment weaker, financing conditions are likely to constrict as macroeconomic indicators soften.

What's changed: Market optimism is fading. Given that the U.S. economy is likely to slow down through 2019, investors are turning conservative, leading to credit tightening, capital flow volatility, and pressure on some emerging market currencies.

Rsks and imbalances: Corporate refinancing risk, U.S.-China strategic confrontation (most visibly over trade), asset repricing risk, and China’s debt leverage are the top risks for the region going into 2019. In particular, the first two risks are high and worsening.

Financing conditions: Headwinds in 2019 include climbing borrowing costs (as the Fed continues its rate hikes), refinancing of U.S. dollar-denominated debt, capital market volatility, and declining investor sentiment.

Macroeconomic conditions: The pace of the regional slowdown is the key uncertainty. Current data and economic policies are still supportive of a gradual and benign slowdown. We forecast China’s GDP growth to ease to 6.3% in 2019 from 6.5% in 2018.

Sector themes: Corporates will find refinancing more challenging in 2019. While banks will also be challenged by higher interest rates; most bank outlooks will remain stable. For sovereigns, protectionist policies between China and the U.S. could intensify, weighing on regional growth.

Dec. 03 2018 — Indonesian President Joko Widodo’s "winter is coming" quote aptly characterizes the trend in Asia-Pacific credit conditions going into 2019. At the International Monetary Fund's meeting in Bali, October 2018, President Widodo highlighted that the continuing U.S.-China trade dispute and technology disruption on many industries are among the many issues plaguing the world. Likewise, S&P Global Ratings considers these two issues to be among the top-five credit risks in Asia-Pacific. In addition, the Asia-Pacific faces the risk of commodity, currency, equity, and property price volatility. Corporate refinancing risk and China’s high leverage round up our top-five credit risks. In summary, the outlook for 2019 is more pessimistic than it was a year ago.

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