€370bn of unsecured bank bonds mature before bail-in provisions kick in

Eurozone banks have 5.5 years to convert their €370bn of unsecured debt into secured bonds. They certainly won't be able to roll most of that debt because the bail-in provisions are expected to kick in on 1-Jan-2018 when unsecured bonds will essentially carry "equity risk".

Source: Barclays Capital (click to enlarge)

As Barclays points out in a bail-in "equity would absorb losses first, followed by subordinated bondholders, then senior bondholders". Withing the next 5 years many banks who still have some unencumbered assets would move to covered bonds to refinance these notes.

Interestingly, deposit guarantee programs (but not the guaranteed depositors) would be pari passu with senior unsecured creditors. That's why Germany (who has more than one deposit insurance program) is concerned about moving to a pan-Eurozone deposit guarantee program. If periphery banks fail, Germany would once again be on the hook.

MarketWatch: - Germany's Federal Association of Public Banks said Monday it is opposed to a banking union as proposed by the European Commission and fears it might lead to a looting of the German banks' deposit insurance funds.

"It seems to me absurd that our deposit protection schemes, which were built over many years, should be used for insuring savings deposits in euro-zone crisis countries," said association President Christian Brand. Such a collectivization of risks would significantly go beyond the idea of European solidarity, he added.

But unless a pan-Eurozone deposit insurance program is put in place, many periphery banks would lose their deposit base. Without deposits or the ability to issue unsecured debt, many banks will become permanently dependent on the ECB for funding.

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Bail-in provisions will exacerbate run on banks, drive German asset inflation

This Sober Look post discusses the reality of unsecured EU bank bonds that are expected to have zero recovery due to the so-called "bail-in" provisions. Should a bank were to become "insolvent", these provisions will allow the regulators to force orderly defaults, subordinating these bonds behind any government bailout funds. But because most bank assets that would have value in a liquidation are already pledged (particularly in the periphery) to the ECB under the LTRO programs, there will be nothing to recover under these unsecured claims. Unsecured bank bonds have basically become equity with no up-side. The provisions will essentially put an end to most EU banks' ability to issue anything but covered bonds.

FT: - Sweeping reforms to shift the burden of rescuing failing banks from taxpayers to bondholders are to be unveiled by the European Commission, despite fears it will further rattle nervous bank investors.

When a bank is deemed to be failing, regulators will win extensive powers to write down non-guaranteed deposits and senior unsecured bondholders, according to draft proposals obtained by the Financial Times.

While the broad thrust of EU bank resolution reforms are well known, its publication has been delayed for more than a year over fears the so-called “bail-in” tools would make it even harder and more expensive for banks to raise money.

What's more, large depositors such as corporations, trusts, pensions, asset managers, insurance firms, etc. will have to view their cash at banks as unsecured lending to these institutions.

Within the euro area these bail-in provisions will simply drive bank clients to move balances to German banks and into German government paper, further exacerbating TARGET2 imbalances and run on periphery banks. This flight of capital is even starting to drive German asset price inflation.

Pimco: Evidence so far points to accelerating asset price inflation in Germany rather than consumer price inflation. Capital flight and their “safe haven” status have inflated the prices of German government bonds. Concerned about the stability of the euro, Germany’s savers are shifting their money into real estate. German residential house prices and rents rose by 4.7% last year, the fastest increase since 1993’s reunification boom. So far, Germans are not leveraging to buy houses. Growth in German mortgages is paltry at just 1.2% per annum according to the ECB as of December 2011, but in our view all ingredients for a debt-financed house price boom are there. Distrust in the euro is rising, German households’ debt level is low, as are interest rates and unemployment. The ECB’s monetary policy is too loose for Germany’s domestic conditions, just as it was too loose for Spain and Ireland in the early years of monetary union when Germany’s economy was weak.

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Unsecured EU bank paper is expected to have zero recovery

The spread between senior and subordinated credits of EU financial firms is now off the peak reached in the second half of last year, but remains elevated.  This spread can be seen in the CDS markets by comparing the senior and sub EU financials iBOXX CDS indices (chart below).

Sub to senior EU financials iBOXX CDS spread

This spread indicates that senior unsecured bank bonds are substantially lower credit risk than the bank subordinated paper. Such differentiation makes sense in the context of corporate debt markets, but Barclays Capital argues that it's utter nonsense when it comes to the EU banking sector.

Barclays Research believes that recovery in the case of a default is close to zero for any unsecured EU bank paper, whether it is senior or subordinated. Therefore the market shouldn't differentiate materially between the two. Here is why:

1. The rapid rise in secured borrowing in the Eurozone and increased issuance of covered bonds will end up encumbering the bulk of banking institutions' assets, leaving little recovery value for unsecured creditors.

Barclays:  In Europe, secured borrowings continue to increase, with funding from the European Central Bank soaring, most notably through the recent 3y LTRO, and outstanding covered bonds continuing to climb. We estimate that approximately €4.5tn of high-quality assets at European banks are now encumbered to support covered bonds and central bank borrowings, reducing their availability for unsecured creditors in liquidation.

2. The new regulation in Europe will permit bank regulators to effect a "bail-in". The regulators will be able to inject capital below the secured debt, heavily subordinating any unsecured paper.

Barclays:  Orderly liquidation frameworks, which have been adopted in countries such as the U.S., U.K., Germany, Spain, and Denmark and are to be proposed across Europe, give regulators the ability to haircut bondholders while preserving other creditors, effectively subordinating unsecured bonds.

The diagram below illustrates how unsecured lenders who are ordinarily pari passu with the bank's depositors and general creditors become subordinated in a bail-in.

Bail-in illustration (Barclays Capital)

This means that in an event of a bank failure there is little recovery value for all of bank unsecured paper and there will be little difference between senior and subordinated unsecured bank bonds. Therefore the market is mispricing the relative credit risk between the two types of bonds. According to Barclays there should be little spread between the two.

Barclays: Under most legal frameworks, senior debt and non-deferrable subordinated debt (lower tier 2) effectively have the same probability of default. In these situations the difference in spread should be explained by a lower recovery assumption in liquidation for subordinated bonds compared with senior bonds. If senior bond recovery assumptions approach 0%, then there is no justification for senior bonds to trade tighter than subordinated bonds.

As market participants come to terms with these issues, the market for unsecured bank paper diminishes dramatically and spreads between unsecured senior and subordinated paper should tighten. On the other hand secured bond,s which the market views as having imbedded protection against a bail-in, are fast becoming the primary source of longer term bank financing.

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