matt_russell_100

A new source of supply in the ABS market

One of the features of the ABS market this year has been the lower levels of primary issuance. That, coupled with increased comfort in the asset class and higher risk/yield appetite has caused spreads to tighten.

Slide1

We have had a few new deals, but 10 months in and new issuance volume is only about half the amount seen in 2012, and just a third of 2011 issuance.

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What we’ve seen of late, despite the subdued new issuance, is an increase in the number of these securities available in the market. In the not-so-distant past, banks would structure a securitised deal, place some with the market and keep some to pledge to their central bank as collateral for cheap cash.

Now spreads have tightened, and the market feels healthier, some of these issuers are taking the opportunity to wean themselves off the emergency central bank liquidity and are offering the previously retained securities to the public market.

Another dynamic in ABS at the moment is that ratings agency Standard and Poor’s is considering changing its rating methodology for structured securities in the periphery. S&P is considering tightening the six notch universal ratings cap – countries rated AA or above will not be affected, but bonds issued from countries with a rating below AA could be downgraded as they won’t be allowed to be rated as many notches above their sovereign as they were before.

The implication is that securities that get downgraded will become less attractive for banks to pledge as collateral because of the haircuts central banks apply to more risky (lower rated) securities. Our thinking is that southern European issuers will be hit hardest by this change. So unless the ECB loosens its collateral criteria (which it can and has done previously), one would expect to see more of those previously retained deals coming to the market as well.

So whilst we haven’t seen too much in the way of new issuance, it looks like we could be about to see an increasing number of opportunities in the secondary market.

 

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Tier 1 capital: too much faith in a Q&A, or why didn’t you call me?

It turns out that market participants may have put too much faith in the European Banking Authority (EBA). The EBA’s answer to a submitted question indicated that non-called bank Tier 1 instruments – or at least those similar to one described by the questioner – cannot simply be reclassified as Tier 2 capital after the first call date. The EBA’s answer to this specific question – which some wrongly characterised as an “EBA ruling” – fuelled speculation that all callable Tier 1 would henceforth be called at the first call date because of a loss of capital credit. Deutsche Bank’s 5.33% Tier 1, callable on September 19, 2013, leapt in price.

Jeff_Too much faith in the EBA

The market began to speculate that Deutsche Bank – which has declined to call capital instruments before – would have a change of heart and redeem this bond at the first call date. We don’t want to comment specifically on Deutsche Bank’s decisions here, but this non-call demonstrates why we don’t believe that investors can or should base valuations on their own predictions about whether or when banks will redeem their callable capital instruments. And the point to bear in mind here is that capital credit is just one factor for banks to consider when asking their regulator for permission to redeem an instrument. The importance of capital credit – and of elements within the tiers of bank capital – will vary widely from bank to bank. Finally, regulators need to approve the redemption in any event.

So is this the beginning of a trend of banks not calling their hybrids? We wouldn’t make such a sweeping declaration. First, even with the EU Banking Union project underway, many decisions are still made at the national level with respect to capital. CRD IV, the new Capital Requirements Directive that implements Basel III within the EU, is still being passed by legislatures of the member states. It’s possible that some home country regulators are allowing banks to continue to count their hybrid Tier 1 securities as Tier 1 capital through the end of 2013 irrespective of a call being missed. That may mean redemptions in 2014. Or it may not: these bonds might still be useful for banks as a buffer to protect their senior funding under new rules that banks will have to have a minimum amount of liabilities available for write-down or conversion to equity in case of a resolution.

Ana_Gil_100

Small business, big deal – a look into peripheral SMEs

It should come as no surprise to any investor that European banks are still too large. Despite having reduced their balance sheets by around €2.4tn since 2011, they continue to have the world’s largest asset base, with an aggregate balance sheet size circa 3.3x the Eurozone’s GDP. Further balance sheet contraction can be expected in the coming years as the European banks strive to recapitalise their balance sheets to conform to stricter Basel-III norms.

Whilst the ECB’s LTRO (long-term refinancing operation) liquidity injections and OMT (Outright Monetary Transactions) programme have arguably suppressed interest rates and helped debt capital markets, they have also anaesthetised bank lending to corporates, particularly in peripheral economies where the transmission mechanism of current accommodative policy continues to be broken.

Small and medium businesses are crucial to the European economy. However, SMEs are facing severe financing problems of late, particularly those in peripheral Europe. Not only has credit availability dried up for these companies in the last five years, but those lucky enough to get access to credit are doing so at a significantly higher cost. As shown in the chart below, southern European companies are paying a 2-3% interest premium over their continental peers.

SME blog_31Jul

Looking at countries like Spain or Italy, the situation becomes particularly acute. To understand the scale of the problem we should look at the importance of small and medium sized firms in these countries. Italian or Spanish SMEs are responsible for 75-80% of job creation, compared to 50% in the US and 59% in the UK. Furthermore, SMEs and micro companies in these countries represent 99% of total national businesses and generate around 60% of GDP. However, their lack of access to capital markets makes them reliant on banks for borrowing.

ECB interest rates are currently as low as they have ever been. Yet, Spain is one of the European countries with the most punitive corporate financing costs. This is a problem that has often been described as the “diabolical loop” between the Sovereign and corporate sector.

We have previously discussed how the Spanish government is dangerously indebted and accumulates a high fiscal deficit. Such a situation naturally has important consequences for Spanish banks – investors know that if loan delinquencies start to rise, banks have a slim chance of being bailed out by their sovereign. A risk premium is therefore warranted, which is also passed on to the corporate sector in the form of higher financing costs.

The Spanish economy is undergoing a painful recession and the state of its corporate sector is a clear reflection of this. SMEs are deteriorating rapidly, as credit taps are running dry, companies have stopped hiring and have been forced into restructuring their businesses in order to remain competitive vs their continental European peers. As delinquency rates rise, banks’ risk premiums continue to soar and the economic situation deteriorates further. Reduced corporate activity diminishes fiscal revenues for the sovereign, worsening the country’s fiscal deficit and we are then back to square one. The diabolical loop starts again.

Whilst the UK launched the FLS scheme last year aimed at stimulating lending to the real economy, Spain could be running short on time to deal with a problem of potentially larger consequences. Spanish SMEs are the true back-bone of the economy; they are primarily responsible for the country’s wealth and economic growth. Therefore, reinstating credit access while allowing banks to re-size and heal is critical for economic stabilisation. Until this happens, it will be difficult for Spain and other peripheral countries to exit recession.

anthony_doyle_100

First home owner grants – a gift to new home buyers, or existing?

We aren’t the first to have a look at George Osborne’s “Help to Buy” scheme. It has been met by warnings far and wide. Sir Mervyn King stated that “there is no place in the long run for a scheme of this kind”, whilst Albert Edwards from Societe Generale was a little more blunt when he wrote that it was “a moronic policy”. Even the IMF and the OBR are getting in on the act, warning that the scheme may have more of an impact on the demand side of the house price equation, rather than fix the real issue which is a lack of supply.

What alternatives does Osborne have? Seeing as rising house prices do almost nothing to help the UK’s biggest problem, the Government should target the bigger problem, which is the UK’s dearth of investment.  Construction is a very low productivity investment. The UK needs investment in infrastructure, education, plants and equipment.  Without this the UK has very weak long run growth potential.

Now don’t get us wrong. We can see what George Osborne is trying to do. By announcing the “Help to Buy” scheme in the latest budget, the Chancellor is doing his best to stimulate economic growth through construction which will hopefully encourage consumption through the multiplier effect in an economy that has been anaemic since the financial crisis. The Government coffers will start to look better too due to higher stamp duty and income tax receipts. Who knows, it might also help in the polls. And it will work. We know this because Australia and Canada – two of the most expensive countries for housing in the world – have been running schemes like this for years.

The UK’s Help to Buy scheme will take two forms. The first part will offer buyers that qualify an interest-free loan (up to £120,000) from the Government. The second part will see the Government act as guarantor for a proportion of the borrower’s debt. In Australia, the “First Home Owner Grant” has been in existence in some form or another since 2000 and is a one-off grant to first home owners. It is not means tested and differs from state to state (in Sydney, the most expensive city in Australia, first home owners are currently entitled to $15,000 under the scheme). And in Canada, those looking at getting on the property ladder are entitled to a $5,000 tax credit and under the “Home Buyers Plan” can also withdraw up to $25,000 tax free out of their retirement savings to buy or build a home.

The problem is, these schemes have generally caused housing affordability to worsen in Australia and Canada. The chart below (courtesy of Torsten Slok at Deutsche Bank) highlights just how overvalued house prices are in parts of Australia and Canada. The fact that Wollongong ranks higher than New York on a house price to house income ratio seems like madness to me.

Wollongong

Another interesting result of Torsten’s affordability chart is the prevalence of New Zealand cities like Auckland and Christchurch. And you guessed right, New Zealand also has a form of the Help to Buy scheme, called the Welcome Home Loan. And if you are a New Zealander with some pension savings, you could be allowed access to your retirement savings to get on the housing ladder.

Home buyer schemes push up prices primarily through the accumulation of mortgage debt. Arguably financial companies have done the correct thing in tightening lending standards and reducing loan-to-value ratios. With the UK government now guaranteeing up to 20% of a new mortgage, those “riskier” types of borrowers that previously wouldn’t have qualified for a mortgage now have the ability to enter into the housing market. Demand increases, supply may not respond to the same extent and prices rise. Additionally existing home owners may sell their home and acquire more debt in order to buy a more expensive home. Who knows, mortgage equity withdrawal levels might come back in a big way too. But sooner or later, the house of cards will come crashing down – as we are all very familiar with.

The charts below highlight the relationship between rising levels of mortgage debt and house prices in Australia, Canada and the UK. Australia is a very interesting example as the First Home Owners Grant has been increased and decreased over time with house prices suitably responding.

Australia relationship debt

Canada relationship debt
UK relationship debt

The UK’s Help to Buy scheme is most likely going to encourage a further accumulation of mortgage debt, leading to higher house prices, causing housing affordability to worsen from current levels for those who don’t have access to the scheme. Arguably, this scheme will also make income inequality much worse, so those who aren’t in a financial position to buy a property will fall even further behind.  It will also worsen the wealth age gap, i.e. it’s the older, existing homeowners who are most likely to benefit, to the detriment of younger people who don’t have a home and need somewhere to live.

We have already seen evidence of house prices increasing in the UK, with yesterday’s RICS house price balance at levels not seen since January 2010. This data is consistent with the stronger house price data we have seen recently from mortgage lenders Halifax and Nationwide indicating that we are back at pre-crisis highs. One has to wonder whether a scheme encouraging financial companies to lend and consumers to borrow is the brightest thing to do in an economy with £1.26 trillion (or 80% of GDP) mortgage debt outstanding. Especially as it is designed to make an already expensive asset even more expensive, which could lead to financial instability if the economy wobbles and ultimately cost the taxpayer big time.

With house prices set to rise further in the short term, the question has to be asked – is this a help to buy or help to sell scheme?

mike_riddell_100

Pese a las apariencias, los países periféricos de Europa continúan padeciendo una crisis de deuda

This article appeared in English on 26 April.

A comienzos de esta semana, las rentabilidades de la deuda española a 5 y 10 años cayeron hasta los niveles más bajos desde el cuarto trimestre de 2010. No cabe duda de que esta recuperación fue estimulada por los comentarios de Mario Draghi relativos a que el BCE haría « todo lo necesario para salvar el euro» y posteriormente alentada por la mejora de los datos económicos de la zona euro registrada durante el segundo semestre de 2012 la cual, probablemente, se debió en parte a las palabras de Draghi. No obstante, la recuperación de los países periféricos ha continuado durante este año a pesar del importante deterioro que han sufrido los datos económicos en los últimos meses. Actualmente, los fundamentales económicos y las valoraciones avanzan rápidamente en direcciones opuestas.

Lo anterior queda reflejado en el siguiente gráfico: el eje izquierdo representa el diferencial de rentabilidad entre la deuda italiana y alemana a 10 años, y el derecho representa el índice Citi Eurozone Economic Surprise (de forma que si la línea verde asciende implica que los datos económicos son más débiles de lo previsto).

Recuperacion de la deuda soberana de los paises perifericos pese al empeoramiento de los datos

Sigo manteniendo mis dudas respecto a la solvencia de España donde, por insolvencia, me refiero a la situación en la que la ratio de deuda pública sobre el PIB aumenta de forma indefinida. Sí, el BCE puede inyectar liquidez en España para posponer el pago de la deuda y sí, podría decirse que hay muchos otros países desarrollados que se encuentran enla misma situación—la ratio de deuda pública sobre el PIB de Japón se acerca rápidamente al 300%, lo que hace que la deuda pública española parezca relativamente raquítica. Pero como ya hemos visto en el caso de Grecia, la deuda soberana de la zona euro puede ser y será reestructurada si se considera que un país es insolvente y, como ya comentamos anteriormente en una entrada de 2010, parece que  España se dirige hacia tal situación.

Centrándonos en la dinámica de la deuda española a largo plazo, es preciso recordar que la ratio de la deuda pública sobre el PIB de un país cambia en funciónde las siguientes tres variables:

  1. La diferencia entre los costes de financiación de la deuda y el crecimiento nominal como porcentaje del PIB. Si el coste de financiación es mayor que el PIB nominal, aumentará la ratio de deuda pública sobre el PIB.
  2. El cambio en el balance primario de un país como porcentaje del PIB (donde balance primario es el balance presupuestario antes del pago de intereses). Un mayor déficit presupuestario equivale a un aumento de la ratio de deuda pública sobre el PIB.
  3. Variaciones en el ajuste deuda-déficit. Normalmente este ajuste es relativamente pequeño, pero si un gobierno recapitaliza un banco, la ratio de deuda pública sobre el PIB aumenta (más información).

La ratio de la deuda pública sobre el PIB de España se ha disparado como consecuencia de estas tres variables. Analizando a su vez cada una de estas variables, en el siguiente gráfico representa el crecimiento del PIB nominal de España comparado con su coste de financiación nominal a 6 años (en sentido estricto, el dato incluido en la fórmula debería ser el promedio de los costes en concepto de interesesque, en el caso de España, en la actualidad es próximo al 4% —en este caso he utilizado la rentabilidad de la deuda española con vencimiento a 6 años en su lugar). Un coste de financiación del 4% estaba bien entre 2001 y 2007, cuando España aun podía generar un crecimiento del PIB nominal de entre el 7 y el 9%, pero dada la situación actual no es una cifra tan positiva.

Incluso con un menor coste de financiacion, sin crecimiento Espana sigue mostrandose insolvente

Dado que los costes de financiación de España son superiores a su tasa de crecimiento nominal, necesita acumular un superávit primario para poder estabilizar su ratio de deuda pública sobre el PIB (tal como se ha indicado en el punto 2). Pero en la actualidad España presenta un enorme déficit presupuestario (del 10,2% de media desde 2009) y por tanto tiene un enorme déficit primario. En el siguiente gráfico mostramos cómo el FMI ha aumentado de forma constante sus previsiones para el déficit presupuestario español desde 2011.

Los deficits presupuestarios han superado sustancialmente las expectativas

En parte el FMI ha previsto déficits cada vez mayores debido a que sus previsiones de crecimiento han sido excesivamente optimistas. En el siguiente gráfico se muestra como en el 2011 el FMI pensaba que España estaría actualmente creciendo a un ritmo estable del 2%, mientras que la realidad es que se encuentra todavía inmersa en una crisis (recientemente se ha confirmado una tasa de desempleo del 27.2% para el primer trimestre del ano, una cifra récord). La mayoría de las estimaciones de crecimiento a largo plazo elaboradas son simples promedios históricos a la larga, pero dados los elevados niveles de endeudamiento tanto público como privado de España, así como el deterioro de su demografía, la tasa de crecimiento potencial a largo plazo puede ser de tan solo el +1% anual.

El crecimiento de Espana se ha quedado sustancialmente por debajo de las expectativas

¿Y qué sucede con el tercer punto relativo a la ratio deuda/PIB: los ajustes deuda-déficit? Nuestro analista de banca española, Ed Felstead, considera que no es impensable que incluso algunos de los bancos que ya han sido recapitalizados por el estado necesiten serlo nuevamente, a pesar de haber transferido sus activos y préstamos inmobiliarios más tóxicos ala Sareb, el «banco malo» español. Las ratios de préstamos morosos de los bancos ya «saneados» siguen siendo elevadas y la generación de ingresos se mantiene baja debido a la reducción de los márgenes de beneficio. Si se produjera un mayor deterioro de préstamos no-inmobiliarios, los bancos tendrán que hacer mayores provisiones, lo cual generará pérdidas, sin que haya forma de sustituir el capital perdido. Es probable que dicho deterioro se produzca dada la frágil situación de la economía española, junto con el hecho de que las ventas de activos por parte de la Sareb ejercerán presión sobre los precios de los mismos, y la posibilidad de que se introduzca una nueva legislación en materia de ejecuciones hipotecarias y las deudas en mora más favorable para los prestatarios.

Por ello, si no se consigue reanudar el crecimiento en España, los gastos de financiación seguirán superando la tasa de crecimiento, continuarán existiendo grandes déficits presupuestarios y posiblemente veamos la necesidad de realizar nuevas recapitalizaciones bancarias. El FMI ya no prevé una estabilización de los niveles de endeudamiento españoles, al contrario,cree que continuarán aumentando en un futuro próximo, y esto es con unas expectativas de crecimiento del PIB que pueden considerarse todavía algo optimistas. La deuda de los países de la Europa periferica, sobre todo la española, parece todavía vulnerable a sufrir a una venta masiva.

Menor crecimiento y mayor deficit rapido deterioro de la ratio de deuda

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mike_riddell_100

Peripheral Europe is still facing a debt crisis, despite appearances

Earlier this week, 5 and 10 year Spanish yields fell to the lowest levels since Q4 2010. The rally was no doubt kick started by Mario Draghi’s “do whatever it takes to preserve the euro” comment, and was given further fuel by the improvement in Eurozone economic data over the latter half of 2012, which was probably due in part to Draghi. However, the peripheral rally has continued this year in the face of a significant deterioration in economic data in recent months. Economic fundamentals and valuations are currently moving rapidly in opposite directions.

The chart below illustrates this – on the left axis is the Italian 10 year yield spread over Germany, and on the right axis is Citi’s Eurozone Economic Surprise Index (so if the green line moves up, data is coming in weaker than expectation).

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I continue to doubt whether Spain in particular is solvent, where I’d define insolvency as being where a country’s public debt/GDP ratio increases indefinitely. Yes, the ECB can throw liquidity at Spain to keep the debts rolling over, and yes, many other developed countries are arguably in the same boat – Japan’s public debt/GDP ratio is quickly rising towards 300%, which makes Spain’s public debt burden look relatively puny. But as we’ve seen with Greece, sovereign Eurozone debt can and will be restructured when a country is deemed insolvent, and as previously argued in a comment in 2010, this is where Spain appears to be heading.

Focusing on Spanish long term debt dynamics, it’s worth recapping that the change in a country’s government debt/GDP ratio is a function of three variables, namely:

  1. The difference between debt interest costs and nominal growth as a % of GDP. If interest costs are greater than nominal GDP, then this leads to a higher public debt/GDP ratio
  2. The change in a country’s primary balance as a % of GDP (where a primary balance is the budget balance before interest payments). A larger budget deficit equals a higher public debt/GDP ratio
  3. Changes in the stock-flow adjustment. This adjustment usually relatively small, but if a government recapitalises a bank, the public debt/GDP ratio increases (see here for more information)

Spain’s public debt/GDP ratio has been soaring because of all three of the above variables. Taking each of these variables in turn, the chart below plots Spain’s nominal GDP growth against its 6 year nominal borrowing cost (strictly speaking it should be the average interest cost that goes into the formula, which for Spain is currently about 4% – I’ve taken the yield on Spain’s 6 year maturity as a proxy). A borrowing cost of 4% was fine from 2001 to 2007, as Spain was able to generate nominal GDP growth of between 7 and 9%. It’s not so fine now.

Slide2

Given that Spain’s borrowing costs are higher than its nominal growth rate, it needs to run a primary surplus if it is to stabilise its public debt/GDP ratio (as per point 2). But Spain is actually running a huge budget deficit (averaging 10.2% since 2009), and is therefore running a large primary deficit. The chart below shows how the IMF has steadily increased its forecast for Spain’s budget deficits since 2011.

Slide3

Part of the reason why the IMF has forecast larger and larger deficits is down to its growth forecasts being hopelessly optimistic. The chart below shows how in 2011, the IMF thought Spain would be growing at a tidy 2% by now, when instead Spain remains mired in a slump (yesterday it was announced that the unemployment rate hit a record 27.2% in Q1). Most forecasters’ long term growth estimates are simply countries’ long run historical averages, but given Spain’s high private and public debt levels, as well as deteriorating demographics, Spain’s long run potential growth rate may be as little as +1% per annum.

Slide4

What about the third point about the debt/GDP ratio, namely stock flow adjustments? Our Spanish banks analyst Ed Felstead believes it isn’t inconceivable that even some of the banks that have been recapitalised by the state will need additional recapitalisations, despite the transfer of their most toxic real estate developer loans and assets to Sareb, Spain’s ‘bad bank’. Non Performing Loan (NPL) ratios at the now ‘clean’ banks remain high and revenue generation remains low on falling margins. Any further deterioration in asset quality on non-real estate developer loans will result in the banks having to take more provisions, which will lead to losses, with no way to replace the lost capital. This deterioration is likely given the state of the Spanish economy mentioned above, along with Sareb asset sales putting pressure on asset prices, and potential new borrower-friendly legislation on foreclosures and arrears.

So in the absence of a miraculous return to growth, Spain’s borrowing costs will continue to exceed its growth rate, large budget deficits will remain a feature, and it’s easy to see how further bank recapitalisations will be necessary. The IMF is no longer forecasting that Spanish debt levels will level off but will continue rising for the foreseeable future, and that’s even with what appears to be over-optimistic mean reverting GDP growth assumptions. Peripheral Eurozone bonds, and Spain’s in particular, look vulnerable to a sell off.

Slide5

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ben_lord_100

I predict a CypRIOT: Three major implications for the European and UK banking systems

Stefan blogged earlier this week about the landmark sovereign bailout occurring in Cyprus, and about some of the interesting issues this raises. Sure enough, the parliament did not approve the package in the form talked about at the weekend. The reason? The taxes were felt too painful for the poor and too lenient for the more wealthy. This harks back to a blog I wrote about a couple of years ago, and goes to reiterate the issues we discussed then. However, for now I wanted to highlight some of the issues that this raises more specifically for the European banking system at large.

Firstly, depositors were presumed to be guaranteed by governments up to at least  €100,000 in Europe. Last weekend, that notion was dealt a brutal blow by the Cypriot situation. However, it feels to us as though the main reason for the parliamentary delays is that deposit guarantees could and should remain in place – or at least to a greater extent than was implied in the original bailout package. This package stated that those people with deposits of less than €100,000 would pay a 6.75% tax, whilst those with more than this amount would be taxed 9.9%. The politicians that have delayed the approval of the rescue package want to see greater amounts of the burden borne by the wealthier (those with more than €100,000, and perhaps an even higher rate borne by those with greater amounts than, say, €500,000 in deposits), and so lesser amounts of the burden borne by those with small amounts of deposits.

My guess is that this is the key issue here. If the tax rates are not changed, then I would expect to see some significant moves in Spanish, Italian and other peripheral deposit flows and movements. As a risk, this must not be underestimated by the Troika. Why not maintain the deposit guarantee and generate the amount raised by the taxes, through taxing more on those with more than €100,000, more still on those with more than €250,000, and more still on those with more than €500,000?

Secondly, subordinated debt bail-in is a key part of the package, and without it one senses the Troika will not part with the bailout funds needed. We have expected weaker banks in weaker regions to have to use this as a necessary tool to break the sovereign-bank link for some time now. It is now official, and being used. I would expect more of these to come.

Thirdly and finally, sovereign bailouts of banking systems where the sovereign is already in an over-levered position will no longer be tolerated. It is time to break the sovereign-bank feedback loop (as we previously wrote about here). This has to be through bail-in and burden-sharing. However, the most unpalatable part of the proposed package to us (and I guess to many riotous Cypriots) is this: up until 2007 it was believed that senior bank bondholders ranked pari passu with depositors in the event of a bank failure. And now in 2013 we learn quite vividly that in actual fact in Cyprus depositors are likely to be subordinated to a bunch of wholesale and institutional (ie banks and insurance companies) investors?

The capital stack has been turned on its head in this regard. No one used to buy senior unsecured bank debt because they thought that depositors would take losses before them. Rather, it was because the markets believed 100% in the government guarantee of depositors. The pari passu relationship of depositors and bondholders supported high valuations on senior bank bonds. Thus to be pari passu with depositors, senior bank bonds need to take the same losses as depositors are. In my opinion, this part of the proposed deal is the most disgraceful.

So, I find myself wondering how on earth a deposit tax found its way into the package. The answer to me seems to be quite simple: contagion, or the avoidance thereof. We all know that in Europe and the UK in the future (as in the US already), senior bank bonds will be bail-in-able or writedownable if a bank fails or gets into difficulty. We were originally told that the date for senior bank bond bail-in in Europe would be 2018, although there has recently been much talk about bringing this forward to the beginning of 2015. It has long struck me that this should be the favoured route out of the bank-sovereign interconnectedness problem in Europe: continue to promote and enable senior issuance in Europe by banks, and then implement a higher level piece of legislation that at some date in the future makes all debt in the Eurozone and UK writedownable.

No matter how small Cyprus is relative to the rest of the Eurozone, if the Troika had forced senior bank bondholders to accept losses before 2018 – or is it 2015? – senior bank debt spreads would have suffered significantly across Europe. Given that this is the most attractive funding market for banks at the moment, as it is still cheap to issue from a bank’s perspective, and as sovereigns do not want to have to (or cannot, in the Cyprus case) step in to take on more liabilities on behalf of their banks, the Troika has ripped up the rule book and done the insane.

I think parliamentarians in Cyprus should force a rethink on the sovereign-bank feedback loop, as well as forcing a more palatable (ie Robin Hood) sharing of the burden between smaller and larger depositors. After all, can anyone truly imagine the French, German or any core European government accepting losses for their depositors whilst a bunch of international senior bank bondholders get made whole? Our view is that depositors should be protected (at least to the guaranteed amount) over and above all wholesale creditors, whether senior or subordinated. This is the first step to break the sovereign-bank loop. The second step, only to be used in cases where there is not enough senior and subordinated debt to prevent the sovereign, and so tax-payers, from having to bail out the failed institutions, is to look at forcing losses on depositors, but with preserving the preceding guaranteed amounts of deposits. The final, most radical, and rarest, step is to have to renege on that deposit guarantee amount, so as to avoid tax-payer bailouts and increased probability of sovereign default.

Depositors across Europe are already watching Cyprus carefully. My guess is that many are starting to check the amounts they keep with any one institution or in any region. Subordinated bondholders are already aware of the risks if those banks get into difficulty, but senior bondholders in my opinion are not. These investors must ask whether the Cyprus package is likely to be copied in future cases. And they must also start to wonder if they still have until 2018 before senior bonds can be bailed in, or if it is significantly sooner.

richard_woolnough_100

RBS – The Goodwin Lottery?

Vince Cable has suggested that the government’s shareholding in Royal Bank of Scotland should be parcelled off to UK citizens. The UK government’s ordinary shareholding in RBS Group (A shares) today stands at 65.29%, which goes up to  81.15% including B shares (shares with priority over dividends).

Assuming the UK government would distribute A shares only, this would give us roughly 63 shares each that would be worth £222 based on yesterday’s closing share price of £3.54. This very simplistic way to dispose of the government’s ordinary stake could well be described as fair, though it would leave lots of individual holders and create administration and system chaos. Is there a better way? How can you reduce this administrative nightmare, make the give away more popular, or improve RBS’s future prospects?

How about simply having a lottery, as opposed to the shares being split? We could have a lottery based on the electoral roll for example. However, winners would get substantially more shares each, say 300,000, which at £3.54 a share would be worth just over a million pounds each. We could in effect create more than 13,000 new millionaires. It could maybe even be marketed as the Goodwin Lottery!

A second alternative would be to actually embrace free choice and the market economy via selling tickets for the lottery. This could not only create the same amount of millionaires, but would raise extra revenue for the government. The use of the existing Camelot lottery network would make that relatively efficient.

A third alternative would be to basically “de-mutualise” it. This would involve an open offer for sale of the government’s share holding to individuals, with all proceeds raised contributing to new equity for a new invigorated bank. This would act as a deeply discounted rights issue with the government stake being 100% diluted, and their huge loss being the new investors’ gains.

The ideal solution for the UK economy is to have a thriving competitive banking sector, at a minimum cost to the taxpayer. If the politicians decide the best way to do this is to simply give the shares away then hopefully they may improve their plan to get some of the potential benefits outlined above.

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Going Dutch – SNS nationalisation

We have been talking about the emergence of, and the effects of, the financial crisis in our blogs for a number of years now. However, more than 5 years into the crisis even we can be surprised. On Friday the Dutch government nationalised SNS, as capital injections from the private sector failed to appear. This action was undertaken to maintain the stability of the Dutch financial system.

This legal manoeuvre involved a confiscation of all SNS equity and group and bank level subordinated debt by the authorities, and an injection of cash into the bank. The holders of the aforementioned equities and bonds quite simply no longer have these securities. To paraphrase Monty Python, they are ex securities. Investors have lost all legal rights. Instead, they have been offered potential compensation based on the value that the Dutch government ascribes to the securities. However, their judgement of what that amount may be is highly likely to be zero.

We have examined many times the potential weakness embedded currently in financial issuers and how the tiering of debt is becoming more significant for investors. Before the financial crisis, senior and subordinated debt from the same bank were seen as equal under all circumstances except an event of default, in which case the senior bonds would see better recovery values. The fact that for systemic reasons the authorities wouldn’t want the bank to stop operating meant that subordinated debt benefitted from the halo effect of the perceived need to sustain the bank for the benefit of the financial system. However, since 2008, countries all over Europe have been putting in place legislation, in the form of so called “resolution regimes”, to allow them to deal with failing banks, without necessarily having to keep the whole bank going. This use of these recently introduced new laws in the Netherlands allowed the authorities to separate the claims of subordinated bond holders from those of other, more senior, bond holders. This is something we have not encountered before in this form (for example, while the UK government did nationalise the preference shares as well as the equity of Northern Rock, it didn’t actually nationalise the subordinated debt, whereas in Denmark a different approach was followed, leaving bondholders on the wrong side of a good bank/bad bank split). This Dutch approach allows for the quick and efficient bailing in (writing off) of subordinated debt and allows the bank to continue operating, thereby protecting the financial system.

‘Going Dutch’ is an expression used when you agree to share a restaurant bill. However, going Dutch SNS style means subordinated bond holders pick up the tab, as they have been eliminated, losing all the capital value of their investment. They have explicitly provided 1 billion euros of capital to help the ongoing health of the Dutch financial system.

Early intervention of this sort to protect the financial system is obviously bad news for subordinated bond holders, with their status becoming more equity and less bond like. It will be interesting to see what the market and the rating agencies think of this new approach in the ongoing battle to support the financial system. Is it a one off, or something we are going to come to see as common practice?

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Contingent capital notes – bank equity’s best friend?

As investors, the majority of our time is spent pricing risk with an increasing amount of that spent trying to value optionality. We’ve always had to price the optionality inherent in owning certain bonds. For instance what’s the likelihood of a call option sold to a bond issuer being exercised? What’s the likelihood of an early refinancing, or perhaps a change of control? These and other options are both risks and opportunities that credit investors will regularly have to consider and reconsider.

Some of the more recent options that credit investors have been forced to consider are those embedded within contingent capital notes or CoCos. These aren’t entirely new securities with Lloyds having exchanged bonds for CoCos back in 2009. Simplistically these ‘first generation’ CoCos are designed to behave like a traditional bond until a pre-defined trigger is breached. When triggered, first generation CoCo holders are forcibly converted into equity at pre-determined pricing, aiding the bank with its recapitalisation efforts. These instruments have found favour with the regulator not least because traditional subordinate capital instruments proved themselves almost entirely ineffective in providing loss absorbing capital.

However, since the issuance in 2009 the market has moved on somewhat and a new breed of CoCo has since emerged. Many of these newer instruments (see chart above) are designed to be written off entirely in the event of a trigger without the conversion into equity discussed above. This optionality has two obvious implications. Firstly, given that investors are written down to zero without equity conversion, any prospect of participating in a future recovery becomes null and void. Secondly (with the caveat that the quantum of issuance remains small for now), the prospect of a bond essentially performing the role of a non dilutive emergency rights issue has to be positive for all other stakeholders in the bank, not least common shareholders. And don’t forget that the majority of these instruments will see their coupons paid before tax, further enhancing the relative value of said issuance.

Selling all this optionality does have its price, as do most things in life, but the current exuberance in credit markets may yet see CoCo investors fail to exact an adequate premium.

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