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Heinz: Beans, Buffett and the return of animal spirits

Posted on 22 March 2013 by Stefan Isaacs

After years of inactivity, the combination of strong corporate balance sheets and cheap funding has sparked demand for takeover deals. The largest and highest profile deal this year has been the acquisition of H.J.Heinz by 3G Capital and Berkshire Hathaway. It is exactly the type of business that Berkshire Hathaway’s Chairman and CEO Warren Buffett typically goes for: profitable growth; a very recognisable brand; and years of emerging market growth forecast in the future.

Berkshire Hathaway and 3G Capital are buying Heinz for $72.50 per share, a 19 percent premium to the company’s previous record high stock price at the time the deal was announced in mid-February. Including debt assumption, the transaction was valued at $28 billion. Berkshire and 3G will each put up $4.4bn in equity for the deal along with $12.2bn in debt financing. Berkshire is also buying $8bn of preferred equity that pays 9%.

Let’s not beat around the bush. It’s a great company. The business has seen thirty one consecutive quarters of organic growth, stable EBITDA margins, owns a number of globally recognised brands and should be well positioned for future emerging market led growth. Despite this, some are questioning whether Buffett is overpaying for Heinz. So is the price of the deal justified?

The answer, at least in part, lies with cost of debt. The pro-forma capital structure (per the offering memorandum) looks like this:

PF Capital Structure	Sources ($m)	Net Debt/PF EBITDA
Cash	-1,250
1^stLien	10,500	3.87 x
2^ndLien	2,100	4.75 x
Rollover Notes	868	5.11 x
Total debt	12,218	5.11 x

Preferred Equity	8,000	8.46 x
Common Equity	8,240

Total	28,458

Current price talk on the first lien debt sits at $ Libor + 2.75% (floored at 1%) with the second lien at 4.5%. If this is finalised, the company will see an approximate blended interest cost of 3.9% on its new debt securities. Prior to the transaction, Heinz was rated as a solid investment grade business attracting a Baa2/BBB+ rating. Assuming the deal goes through, its new second lien notes are expected to be rated B1/BB-, some five notches lower than Heinz’s current rating, reflecting the much higher financial leverage and structural subordination.

It’s worth noting that through last year Heinz’s 6.25% 2030 bonds traded in a range of 4–5%, despite the much higher rating and lower financial leverage at the time; albeit some term premium is warranted given the longer dated nature of the debt. The bonds have since sold off in recognition of the greater risk – as things stand they will remain in place.

Now let’s compare the price action of the proposed debt financing to the preferred equity to be owned by Berkshire Hathaway. Whilst the paper is structurally subordinate to all other debt, it still sits ahead of some $8,240bn of common equity and attracts a cash coupon (which can be deferred) of 9% vs the 3.9% weighted average above. It’s also worth bearing in mind that the transaction has been structured to encourage the preferred equity to be retired, at least in part, ahead of both the first and second lien debt, potentially leaving bondholders with significantly less subordination than at day one. I’d argue that this is by far the most attractive (quasi) debt to invest in within the structure, though that is hardly surprising given that unlike Buffett, few of us can write a cheque of this magnitude.

As animal spirits return and the leveraged finance community falls over itself to lend to well known companies, the likely winners in the space will be the private equity community. Whilst we are nowhere near the levels of the great private equity binge of 2004-07, the value of takeovers in 2013 is already running well ahead of 2012. After years of corporate deleveraging, we may now be entering into a period of increased M&A activity. Company managers may find that if they aren’t willing to start leveraging up given the environment of extremely low borrowing costs, then investors like Buffett will do it for them.

The Heinz deal has been another recent shot across the bows of the bond market. Rising leverage has a longer term implication for credit markets, in that it is bad for credit quality. Bigger and bigger companies are clearly in play and this is something we will be keeping a very close eye on.

If China’s economy rebalances and growth slows, as it surely must, then who’s screwed?

Posted on 1 March 2013 by Mike Riddell

OK so that wasn’t the exact title of the IMF’s paper from the end of last year – it was Investment-Led Growth in China: Global Spillovers – but you get the gist.

First a little preamble. Many people who were China bears last year have become less bearish or even outright bullish, no doubt on the back of an improvement in Chinese economic data and a corresponding rally in China’s equity markets. But I don’t think the better data (if you believe the data) should inspire confidence, and you could actually argue the opposite; the growth rebound in China is likely due to yet more government-encouraged unproductive and unprofitable lending. The quality of China’s growth has become increasingly poor, and the rate of growth is utterly unsustainable. The bigger the bubble, the bigger the eventual bust.

Morgan Stanley’s Ruchir Sharma wrote a piece in the Wall Street Journal this week about how China’s total and private debt has exploded to over 200% of GDP, and how the Bank of International Settlements has previously found that ‘if private debt as a share of GDP accelerates to a level 6% higher than its trend over the previous decade, the acceleration is an early warning of serious financial distress. In China, private debt as a share of GDP is now 12% above its previous trend, and above the peak levels seen before credit crises hit Japan in 1989, Korea in 1997, the US in 2007 and Spain in 2008′. There’s reference to this article among others in a good summary of China’s near unprecedented credit binge at FT Alphaville here.

The IMF has long been warning of the threat posed to global financial stability by the great Chinese credit bubble, and their study on global spillovers referenced above makes interesting reading. They estimate that for each percentage point deceleration in China’s investment growth, 0.5-0.9% is subtracted from GDP growth in regional supply chain economies such as Taiwan, Korea and Malaysia. Commodity producers such as Chile and Saudi Arabia are also likely to suffer substantial growth declines while countries such as Canada and Brazil would experience ‘somewhat significant output loss and slowdown’. There would be ‘a substantial impact on capital goods manufacturing economies such as Germany and Japan’, and one year after the shock, commodity prices, especially metal prices, could fall by 0.8-2.2% from the baseline levels for every 1% drop in China’s investment rate.

So what kind of correction in China’s investment growth rate is likely? China’s growth in fixed investment from 2002-2011 was 13.5% per year, a rate that greatly exceeded China’s GDP growth rate and meant that fixed investment is now running at about 50% of China’s GDP. No major countries have sustained such a high investment rate as a percentage of GDP – since 1960, the only countries to have managed a ratio of more than 50% for at least two consecutive years are Republic of Congo 1960-61, Botswana 1971-73, Gabon 1974-77, Mongolia 1981-87, Kiribati 1982-83 and 1985-90, St Kitts & Nevis 1988-90, Lesotho 1989-97, Equatorial Guinea 1994-98 and 2000-01, Bhutan 2001-04, Azerbaijan 2003-04, Chad 2002-03, and Turkmenistan 2009-10.

Judging by other countries at China’s stage of development, a more reasonable investment/GDP ratio is maybe 30-35%. Achieving this ratio will require a sharp drop in China’s investment growth rate to perhaps mid single digits, and if China’s slowdown proves to be hard rather than soft, then the investment rate will likely fall even further (taking two other post bubble economies in the region,Japanese investment growth has been negligible since the early 1990s, while Korean investment growth has averaged low single digits since the mid 1990s). According to the IMF’s model then, a drop in Chinese investment growth from 13.5% to 4.5% implies a 4%-7.2% hit to the GDP of countries such as Taiwan, Korea and Malaysia. Some commodity prices would fall almost 20%. Ouch. And if you want to get extra gloomy, you can also consider that such a large economic shock would also be accompanied by a reversal of the huge decade-long EM equity and bond inflows to the region, which is something else that the IMF has repeatedly warned about (eg see page 70 and Fig 2.51 of this report). It’s quite easy to see how a Chinese rebalancing and slowdown can develop into an Asian/EM financial crisis.

Finally it’s worth reproducing a chart I used in a note from last year demonstrating what happened to Japan’s GDP growth rate as it rebalanced away from an investment-led model and towards more of a consumption based model in the 1970s-80s (countries such as Thailand and Korea followed a very similar path 20 years later). When investment as a percentage of GDP falls, then the GDP growth rate falls too. Everyone accepts that China must reduce investment and increase consumption, but few people acknowledge that this means that China’s GDP growth rate will slow considerably.

Chinese housing market, not so magic – will the dragon run out of puff?

Posted on 18 January 2013 by Magnus Paterson

‘The ruin of a nation begins in the homes of its people.” – Ashanti proverb

In the last ten years, around the world, we’ve seen a series of housing led credit booms inflict heavy recessions on economies. We seem to be seeing the same thing happening today in parts of China.

Deutsche Bank’s excellent economist Torsten Slok has produced the following graph; which clearly shows how unaffordable house prices are becoming, relative to incomes, in some major Chinese cities.

While property prices in the rest of the world continue to adjust towards more fundamental valuations, China’s credit boom is allowing the opposite to happen.

Current property prices in major Chinese cities are unsustainable. Either they adjust (a bursting of the bubble) or real wages have to catch up (massive inflationary pressure).

The currently inflated dragon is unlikely to survive in its current form.

Another year over – 2012 returns in fixed income markets

Posted on 28 December 2012 by Anthony Doyle

It’s been another massive year for the global economy. Europe saw LTROs, Greece got a haircut, sovereign downgrades and record high unemployment rates. The peripheral European nations attempted to implement austerity measures with limited success. The US re-elected President Obama and the focus quickly shifted to the upcoming fiscal cliff. In the UK, an Olympics induced bounce in growth was the sole bright spark for an economy which appears to be stuck in quick sand and may well lose its prized AAA rating in 2013.

The IMF, being unusually succinct, probably summed up the state of the global economy the best by entitling their latest World Economic Outlook “Coping with High Debt and Sluggish Growth”. The advanced economies account for around two-thirds of global GDP and if they are sluggish then global growth will be sluggish too.

With all this uncertainty and risk in 2012, how have fixed income markets performed? Surely government bonds will be the safe haven of choice?

In absolute and local currency terms, it’s been another great year for the markets with everything generating a positive return except UK linkers. It’s been a fall in grace for UK linkers, which were actually one of the best returning asset classes of 2011. The UK linker market was buffeted in 2012 by weak growth expectations and uncertainty surrounding proposed changes to the RPI calculation.

But looking elsewhere, investors had the opportunity to secure some excellent returns in 2012 by taking some risk. The best performing asset class of our sample was European subordinated financial debt which registered a return of 29.5%. European high yield wasn’t far behind with a return of 27.1%, followed by Sterling banks which returned 23.0%.

ECB President Mario Draghi and the ECB’s measures to support the Eurozone also had a positive effect of debt investors in peripheral Eurozone debt, with an index made up of bonds from Greece, Ireland, Italy, Portugal and Spain government bonds up 18.7%. Not a bad return for investors considering the question marks hanging over the ability of these nations to service their respective debt obligations in an environment of political uncertainty and recessionary levels of growth.

Other highlights include global high yield (up 18.7%), European peripheral financials (up 17.0%) and US high yield (up 15.6%). At the less risky end of the spectrum, European investment grade corporates returned 12.8% and US investment grade corporates returned 10.2%. Emerging market debt also did well, with EM sovereigns debt posting a fantastic return of 21.4%.

As outlined earlier, it appears that the global economy faces some substantial fundamental headwinds. So how was it that the riskiest asset classes in fixed income have performed the best? Three little words – “whatever it takes”. Mario Draghi’s speech in late July supercharged returns for the riskiest asset classes and stimulated the “dash for trash”. “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough”.

Well Mr Draghi, the markets have certainly believed you. For example, an index of government debt issued by Greece, Ireland, Italy, Spain and Portugal had up until the speech date generated a return of around 5%. The index ended up generating a 17% return, with investors comforted by Mr Draghi’s comments.

It seems to us that the Ostrich effect (the avoidance of apparently risky financial situations by pretending they do not exist) had a significant impact on markets in 2012. And in a world of ultra-low interest rates and negative real returns in cash, investors must take on risk. It is precisely what central banks are encouraging us to do. But uncertainty breeds volatility and in order to generate higher returns investors must face this volatility head on. It will be a feature of the market in 2013.

About the only thing we can say for certain is that it is unlikely that fixed income will continue to generate excellent returns across the spectrum from government bonds to high yield. For example, double-digit returns in European investment grade are not normal and has occurred only three times in the last seventeen years. On the other hand, the asset class has posted a negative return in only two of those seventeen years, with the largest loss being -3.3% in 2008. In US high yield, the consensus amongst analysts is that high yield markets will generate a return of around 4-6%, the result of coupon clipping. Analysing returns for the asset class shows that a coupon-clipping year has occurred only once in the past twenty-five years.

We posted our bond market outlook last week. It looks like the US may experience a housing induced growth spurt, Europe will eventually get round to dealing with its issues and the UK has a long way to go to secure economic growth. We like non-financial corporates, are worried about EM debt valuations and remain confident that there are still attractive investment opportunities in several areas of the fixed income universe. For an expansion of these views and more, please see here.

How much of the “improvement” in peripheral EZ sovereign creditworthiness is actually due to the CDS short selling ban?

Posted on 25 October 2012 by Jim Leaviss

Since the middle of this year, credit spreads on peripheral sovereigns have narrowed considerably. Having been as wide as 600 bps, Spanish 5 year CDS is now around 300 bps, Italy is down from 500 bps to 250 bps. Ireland now trades at just 200 bps. Now at least part of this performance can be put down to Draghi’s speech in July in which he said “within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough”. And after the “whatever it takes” speech, Draghi eventually followed this up in September with the announcement of the Outright Monetary Transactions (OMT) programme in which the ECB would buy short dated government bonds of Eurozone members where bond spreads reflected too high a breakup premium (but with some conditionality attached in return). So is the improvement in credit sentiment a reflection of conviction in the European authorities to “save” peripheral bond markets? Perhaps.

The other dynamic over the past few months might be just as powerful – a growing realisation amongst hedge funds and other asset managers that the EU Regulation on Short Selling and Sovereign Credit Default Swaps, finally published in April, might well force them to close out short positions in the troubled sovereigns. The Regulation states that uncovered (“naked”) sovereign CDS shorts on European Union (not just Eurozone) nations will not be permitted, and must be closed out by 1st November 2012. “Naked” broadly means not hedging an underlying government bond exposure – it covers bearish trades on government creditworthiness. The short can be closed out by either using an opposing CDS contract, or by buying underlying government bonds to the same value. Whilst there is an exemption for positions initiated in a period before the Regulation was published, any short positions put on since then have to be closed out, whether this is a single name CDS or even an index which includes an EU member (for example the iTraxx Sovx CEEMEA index, a CDS index consisting of 15 sovereigns from Central and Eastern Europe, Middle East and Africa, includes Poland, and so a naked short position in the index would be banned). The Regulation is global in its reach and so should forbid even, for example, a Singaporean bank dealing with a US insurance company out of an office in Chile.

So as November approaches, the market is one-way. Whilst there is likely to be some sort of market maker exemption for having short positions (nobody seems entirely sure), there is no longer any willing counterpart to take the short risk positions off the Eurozone bears’ books. So they are forced to cover these positions at increasingly penal levels, and in doing so exacerbate the squeeze.

You can see that the impact is wider than just the Eurozone nations – UK CDS has fallen to 30 bps, despite deteriorating growth and fiscal conditions (and the chance of a AAA downgrade in the next few months). You can see a similar impact in the US, and also a very strong correlation with European sovereign CDS and European banks, and even high yield (the Itraxx Xover index on the chart). In other words, might the general rally in bond risk assets in the past few months be at least partly linked to this short CDS ban? Might the Regulatory deadline date at the start of November trigger the end of this trend? And given the high interdependency between the sovereigns and the banking sector in Europe, will short positions in future go into banks if investors are not allowed to short European sovereigns anymore?

Competition: the 10 winners of the book are…

Posted on 13 July 2012 by Jim Leaviss

First the the answer. Denmark cut official interest rates on its certificates of deposit to MINUS 0.2%. We now have negative nominal interest rates on short dated government bills or bonds in several countries – including Switzerland, Finland, France, Denmark, and Germany.

We had 167 correct answers, and out of the hat came the following 10 winners who each get of a copy of “Debt: The First 5,000 Years” by David Graeber. And yes, we are aware that David Graeber isn’t the greatest fan of capitalism and markets – but even bond fund managers sometimes need to take a break from reading “Atlas Shrugged” and Milton Friedman.

Richard Cavey (The Chester Partnership Ltd), Mark Wharrier (Newsmith), Robert Harper (Brewin Dolphin), Paul Wilson, Stephen Buckle (Kingsfleet Wealth Ltd), David Thornton (Premier Asset Management), Andrew Wilson (Brooks Macdonald), Gary Laing (Deutsche Bank Private Wealth Management), Tom Winstanley, Edward Fane (Thesis Asset Managment plc)

We’ll be in touch with the winners for your contact details and your books will be with you shortly. Congratulations and thanks for all the entries

Competition: win David Graeber’s “Debt: the First 5000 Years”

Posted on 6 July 2012 by Jim Leaviss

I’ve not read David Graeber’s “Debt: the First 5000 Years” yet – an anthropological investigation into the origins of money and debt – but have had it highly recommended to me and the reviews on Amazon suggest it’s a staggering original work. So I’ve bought a job lot for the team, and 10 extras for you to win in today’s competition.

Question: Denmark yesterday cut official interest rates on its certificates of deposit. To what level?

Please see here for terms and conditions, and submit your answer here by 5pm on Thursday 12th July 2012. The first 10 correct answers out of the hat will win a copy of the book.

Bail-ins: Damned if we do; damned if we don’t

Posted on 23 May 2012 by Ben Lord

We have written on numerous occasions about the hitherto inseparable links between sovereigns and banks, and we have also written about the benefits of writing down bonds to create capital (see The New Era for Bank Bonds: Send In The Clowns? and Equitisation of bank capital bonds) . In 2007 the global markets woke up to the fact that the US subprime market was blowing up, and in 2008 realised that due to financial engineering and securitisation, both of which were preposterously known at the time as ‘risk dissemination and minimisation’, banks the world over had major solvency issues as vast quantities of investments plummeted in value. This, in turn, led to a liquidity crisis as the investment markets shunned investment in banks and the interbank market froze over.

The crisis we are in today is the same crisis we were in 5 years ago. Sovereigns had to step in to guarantee their banking systems, so as to enable debt to be rolled over and confidence to return. In the short term the most important thing was to provide liquidity, which we saw through government guaranteed debt issuance and secured funding directly with central banks in the UK, US and more recently Europe. Next, sovereigns had to buy huge volumes of illiquid assets from their banks (US), or provide direct capital injections to support their solvency (US and UK), as the perception dawned that the liquidity crisis was caused by a solvency crisis.

All this time, the inevitable link between sovereigns and banks was becoming more and more deeply intertwined. And whilst it may feel that the Great Recession has metamorphosed from a banking crisis to a sovereign one, it hasn’t really: sovereigns took on increased liabilities to protect their banking systems and now find themselves in the ‘limelight’. It’s the same crisis, with a different focus.

Many European banks, though, remain substantially undercapitalised. Hence, the system is still overwhelmingly dependent on central banks to provide them with liquidity at an affordable cost. All the time the sovereigns providing liquidity are becoming more and more tied to the health or otherwise of their banks and the assets they are taking from them as collateral.

Has the time come for this cycle to end? Might the severance of this link bring the beginning of the end of the sovereign crisis? Many European banks are still on 24 hour life support, saddled by enormous levels of liabilities that are cutting off new lending and suffocating new investment through the multi-year crisis in confidence in lending to and investing in banks.

So how will this occur? Well my sense is that there’s abundant liquidity at the moment after all the LTROs, inter-central bank funding lines, secured lending facilities and covered bond new issuance. The problem is far more one of solvency and capital adequacy in Europe, where the very worst of the banking crisis continues today. For sovereigns to provide their national banks with the recapitalisations they need, via wholesale nationalisations, would only see a worsening of the sovereign debt crisis, as the funds would have to come from somewhere. So this approach doesn’t really work. And is it really desirable from the perspective of the taxpayer?

The solution? We need new capital, in substantial scale, and fast. The time may have come to sever a significant part of the link between a sovereign and its banks. Unsecured bank bonds in peripheral Europe where the sovereigns are struggling under high borrowing costs, and so where the cost of providing guarantees and funds to their banks are painful, should now be written down in certain cases. Both subordinated debt and senior unsecured bonds would see defaults, in some cases even to zero. This would generate huge amounts of capital (which writing down only subordinated debt would not achieve on its own), and does not involve the troubled sovereign having to borrow more from the markets or seeing debt / GDP levels spiralling. Yes this is painful for investors and to risk-taking savers who are exposed to bank bonds in their pensions and so who suffer losses there. But the write downs are taken. Capital is generated. Deleveraging of the system occurs quickly and substantially (at last!). And the severance of this part of the sovereign-bank link (deposit guarantees must remain in place) means that the banks might just stop dragging the sovereigns down with them.

Policymakers and politicians must be aware (and I’m assuming they are already) of the benefits of this first step towards cleansing the system. If this doesn’t work, then nationalisation is the last resort, and the taxpayer must step in one last time. But this situation of creeping nationalisation where taxpayers provide 24 hour life support in European banks through emergency policy response after emergency policy response, at the expense of much higher tax and lower quality of life across all citizens for a very long time feels wrong, at least before the risk-takers have suffered. Could now be the time for bank bondholders to see defaults, where they are needed? There are countries where these dramatic measures aren’t needed, as well as individual banks where they won’t be needed within troubled systems. The process will be painful for bearers of risk (investors and savers), but it might, more importantly, provide the capital the system so needs to start restoring confidence in the banks, and the sovereigns would benefit from cutting the tie with the non-deposit banking system. So policymakers have to work out whether society overall would be better off with this new approach than the current one. They may very well conclude that the present situation of taxpayers being subordinate to bank bond holders, rather than vice versa, is a morally repugnant system.

Some of us are damned if we change tack and take this approach. All of us are damned if we don’t.

The “safety race”: the systemic implications of the bank asset grab

Posted on 26 April 2012 by Jeff Spencer

Anyone monitoring the risks in the global financial system knows that those of us who lend to banks are increasingly asking for some kind of security in order to do so. Issuance volumes for covered bonds have increased and more countries have recently passed covered bond laws or are in the process of debating legislation. Andrew Haldane, Executive Director for Financial Stability at the Bank of England, raised greater asset encumbrance at banks as a serious concern in a recent speech.

The speech outlines three “arms races” that banks have been or are now engaged in. One of these is a “safety race” in which investors all want to be first in the queue in case of liquidation. It is true that this “race” to the front of the queue has intensified in the past several years, but many forms of bank lending or trading have only been done on a collateralised basis for some time in the form of repo or derivatives trading with collateral posting requirements. The race for safety has only intensified as many banks have been forced to substitute collateralised central bank funding for other sources of funding that have been more difficult or too expensive to access. In the speech, the topic of pledging assets to receive central bank funds – in many countries the biggest reason for higher and higher encumbrance – is referred to. Repo, derivatives and covered bonds are not mentioned by name, but are implicitly involved in the “safety race”.

Certainly the thesis that investors are less and less willing to provide unsecured financing to the banking system is not new or controversial. That said, if you ran a poll as to the reasons investors have on balance pulled back, we strongly suspect the average investor would cite bail-in proposals and resolution regimes as being at least as important as encumbrance, since under the pre-Lehman assumption of state support the question of asset encumbrance and recovery rates didn’t really come up: the expectation (made explicit in ratings pre-crisis) was that the liquidation of systemically important banks was almost purely hypothetical.

Haldane proposes in the speech that, along with sensible macroprudential measures to curb systemic leverage and risk-taking as well as the speed of trading, regulators look to limit the amount of asset encumbrance at banks. How that sits with a central bank’s liquidity provision against collateral makes for an interesting thought experiment, but the more serious implication is that the real limits on pledging collateral could (if they emerge as policy proposals) be found in the new attempts to bring the repo market out from the shadows, which will form the subject of discussions being carried out by the FSB, EU, IOSCO and other bodies over the course of 2Q and 3Q 2012. Another area limitations may emerge is in covered bond regulations, which are constantly evolving. (Note that the US and Canada, both with longstanding deposit insurance arrangements, already limit the amount of covered bonds that banks can issue, even though neither country has a legislative covered bond framework yet.)

It’s worth thinking about whether limits on asset encumbrance actually benefit senior unsecured bank bond investors. There is at least a case to make that more of the benefits would accrue to shareholders, since leverage without asset pledges should still, all else being equal, increase returns to them, whereas senior unsecured investors, even having potentially better recovery prospects, would have to resort to pushing harder for faster implementation of the Basel III leverage ratio in order to gain protection. Current covered bond issues, at the margin, may be relatively more attractive than they already are, if there were to be a possibility of regulatory limits on issuance.

Finally, what about creditor bail-ins? Discussion continues about how this will be implemented in the EU. If it turns out that new “senior” debt, that explicitly allows write-downs, has to be issued to meet a bail-in debt requirement, it’s hard to argue that any investor would buy it without significantly more information on asset encumbrance. Investors would have to stand a chance of attempting to work out a recovery rate on their debt if they were to commit to automatic write-down in the event of resolution. The paradox is that the more serious regulators have become about bail-in, the more counterparties and lenders have grabbed collateral. The only obvious pressure valve is pricing, which makes it logically very difficult to argue that unsecured bank debt will see a significant rally in the near future.

Asset encumbrance remains a topic to watch, certainly, and it presents more evidence that bank balance sheets remain in a state of flux, so talk of a recovery in the senior unsecured market remains premature.

Greece. Private sector involvement indeed.

Posted on 12 March 2012 by Richard Woolnough

The news of the Greek default hardly came as a massive surprise, having been years in the making (see Stefan’s blog from 2010) but we have certainly learned a few things, such as the privileged position of the ECB with regard to their holdings of Greek bonds (as I mentioned in a recent blog). Last week’s ECB press conference provided Draghi an opportunity to explain why the institution he heads should have super-senior status. He said the following in response to the question as to why the ECB should be treated differently:

“I can answer saying that the SMP was a monetary policy instrument. So the purchases of Greek bonds done under that program responded to public interest policy – general policy considerations. And as such, they deserve protection. This is one reason. The other reason is that I think the balance sheet of the ECB should be protected, because only through the integrity of the balance sheet of the ECB you can have the ECB independence in pursuing price stability in the whole of the euro area, and price stability is in the interest of all the members. So I think that’s one other reason why this exchange of bonds was quite right to do. But there is a third reason, I think, that people rarely think about this. I mean, we forget that this money is taxpayers’ money. And so the ECB has, in a sense, the duty to do everything to protect the taxpayers’ money that was entrusted with it. So this exchange of bonds was actually the right thing to do from this point of view as well.”

In summary, he stated 3 reasons:

As this was done in order to promote public interests via the purchase of these securities, no losses should be incurred.
The ECB needs to be protected, and can not suffer losses as this would damage its reputation and its balance sheet.
The ECB is acting on behalf of tax payers, and that tax payers should not take losses.

Well, a private sector holder of Greek debt was also:

Trying to promote the public interest by recycling capital from lender to borrower to finance government expenditure.
The private lender’s reputation and balance sheet matter to it as well.
The private sector is also generally a tax payer.

So,

The ECB can take policy actions without fearing loss.
The ECB can be complacent about making mistakes as someone else picks up the bill.
The ECB represents the state and the state should never suffer losses.

Given the ECB’s role as lender of last resort, explicitly to banks and implicitly to sovereign states, it is not surprising that corporate credit is becoming more desired and relatively better rated than many sovereigns and banks where the ECB has the potential to become involved.