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Ukraine: Bonds and Banks as Barometer

It’s not that I disbelieve economic statistics that governments publish. It’s that the bureaucrats collating the numbers don’t have anything to lose when they make an error. And these same bureaucrats actually answer to people in governments that sometimes have a vested interest in making things look better or worse that the reality. OK, my default setting is to think they are full of crap until proven otherwise.

This is especially so in Ukraine. We’ve seen a picture of state finances that looked rosy and an economic that exhibited an unprecedented collapse. Given that an old cold-war lizard named Putin invaded the country, I cannot fault them for errors in collection and reporting. Even trying to collect national data is a heroic effort involving getting shelled and exposed to whatever zombie virus that has infected the Russian military camped inside their border.

It is clear that the economy is not ready for recovery yet but things have bottomed. It will likely take a year or so of working through defaults, reprofiling and resizing businesses, and stabilizing the macro environment but this is how these tragic things work.

So I look to market data for level 1 assets—instruments with as much liquidity as possible—to give me a fairer clue what is going on. The market means that buyers and sellers have skin in the game, they are taking a view with enough conviction to have some skin in the game and feel pain when they are wrong in that view. The liquidity means that these buyers and sellers get an update on their view on a frequent basis. While not particularly liquid by just about any other standard, Ukrainian government bonds provide the benchmark.

I do not look at yield to maturity here because the country is absolutely in technical default. The only thing to look at in such a situation is the bond price, because people don’t expect a coupon payment. People buy bonds in these default situations because they have a view on the recovery value in default. If bond prices fall below an expected level of recovery, then it makes sense to buy them and pick up the difference between the bond purchase price and the declared recovery value.

There is a spot of contemporary history the price of these bonds tell for 2015, shown below. What you see in February is a deeply inverted curve that implies expectations of the future will not be better than the present time. Human energy moves with a low rhythm. In March and April the whole curve sold off by 15-20 basis points at each maturity as the pessimism concretized into imminent default amid the military invasion. The view of the future bottomed out April 1, and prices have since recovered a bit. The prices still indicate that a default is in the works, it’s just that it may be expressed as a reprofiling of bond terms friendly to creditors.

The other thing I look at is corporate balance sheets. In emerging markets, bank balance sheets are key. This data is always a little behind the times and the assets are illiquid and difficult to value, but financing is where the rubber hits the road. It just so happens that Oschadbank and Ukreximbank (the number 2 and number 3 largest banks by assets in Ukraine) presented balance sheet data this month.

It is a grim picture indeed.

Net income losses in 2014 were 3x worse than all recorded income for Oschadbank. Ukreximbnak losses were about 10x recorded income. The asset book fell off a cliff for both banks and Ukreximbank equity was nearly wiped out. Oschadbank fared poorly as well.

As expected, the liability side shows less reduction, largely reflected in a big depositor run.

Operational metrics show that the implosion of loans issued is nothing short of astonishing.

And then you see how much of a dog Ukreximbank is: NPL ratios for Ukreximbank exceed 40% in 2014 and loan loss reserves cracked 30%. And this isn’t a 2014 phenomenon. This bank has always had a crappy loan book. In contrast, Oschadbank NPLs didn’t crack 10% (10% is horrendous) until 2014. I can only assume that Ukreximbank is deeply politicized and is mandated to keep state owned enterprises on life-support no matter what. Regardless, that is a steep level of reserves. I’d be surprised if they weren’t released in coming quarters and result in a big pop in the bottom line by Q4. That is, if the lizard stays in the Kremlin and out of Ukraine.

Regarding capital adequacy, I look at a very simple measure readily available from any balance sheet: the equity to assets ratio. This tells me more about the ability of a bank to absorb the fabled “Black Swans” that come along every five to ten years or so. Basel I capital adequacy is more subtle and prone to gimmicks, but broadly consistent with equity to assets.

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