Wednesday, November 9, 2011

Possible Downgrade of Nomura's Credit

Moody's announced that they may downgrade the long term credit rating of Nomura Holdings one notch to one notch above junk level.  This really could be lights out for Nomura (as an independent entity, at least).

I don't know if this means Nomura will end up bankrupt, but this is really bad news if the downgrade actually happens (a single downgrade won't bankrupt the company, but the jitteriness of markets will make it difficult).  As I said in my previous post (How Do You Solve a Problem Like Nomura),  one big issue with them is their big move into global markets and my concern was their history of losses and failure in previous attempts at globalization. 

Apparently, Moody's is very worried about this too.  On a balance sheet and capital ratio basis, Nomura seems pretty sturdy, with capital ratios close to 20%.  But I think the constant losses overseas and their big expansion, doubling down (or more) into an area that has been a source of big losses for them over the years is very scary.

Now, this credit downgrade wouldn't matter so much if Nomura was more a domestic business.  Japanese institutions are not so sensitive to the ratings of Moody's or S&P, nor are individual investor clients at their retail branches.

But since they are expanding rapidly globally in the wholesale markets, credit ratings are much, much more critical as clients are sophisticated institutional investors and they do tend to be highly sensitive to credit ratings.  This is even truer today after Lehman, Bear Stearns (and the problems of unwinding trades, getting prime brokerage account assets transferred) and of course the recent MF Global makes things much worse.

Here is a look at the long term credit ratings of the major global investment banks:

                                         Moody's               S&P           Fitch
Deutsche Bank                  Aa3                       A+             AA-
UBS                                  Aa3                       A+             A
Goldman Sachs                 A1                        A               A+
Morgan Stanley                A2                         A               A
J.P. Morgan                      Aa3                       A+             AA-
Merrill Lynch                   Baa1                     A                A+
Nomura                           Baa2                     BBB+

This is obviously problematic for many reasons.  Of course, the first issue is funding cost.  For investment banks, funding is everything.  If you don't have good funding in such a highly competitive, low margin business, you are not going to do too well.

Second of all, for derivatives, repos and other businesses that involve a counterparty, Nomura is not going to be an attractive counterparty.  Counterparties will demand more collateral or less favorable terms. 

Also, even clients that don't get into a counterparty situation with Nomura (such as repos or swaps and other derivatives) may not want to have too much assets in their accounts held there, whether it be in regular accounts, or especially in prime brokerage type accounts. 

This wouldn't have been as much of an issue a few years ago, but especially after the Lehman prime brokerage fiasco and the current MF Global mystery (of missing $600 million in customer funds), I think clients are much more sensitive to these things.

Nomura is going global to compete with the other global investment banks head-on.  But look at the above credit ratings.  Why would someone deal with Nomura when they can get Aa3 counterparties?  What can Nomura offer that the other banks can't that would make it attractive to deal with a lesser credit?  Investment banking is a highly competitive business where only the top players earn profits over time, and I would think this credit rating gap is a huge disadvantage in that situation.

In the end, things may turn out OK, but Nomura sure picked a tough time to go all out expanding globally.  The downgrade may not occur, but even if it doesn't, there doesn't seem to be much margin for error.  Any more surprises to the downside can really be the end of this company.

Having said that, bankruptcy probably won't happen; it will probably be merged with someone given how Japanese regulators have dealt with weak banks over the years. 

As I said in my other post, I really think the best solution is for Nomura to become the Japanese arm of a major global institution.  The domestic operation is a great business that could add a lot of value to a global major.

But of course, that will never happen.

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