BANKING : THE DEBT NET / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( A MUST READ )

Banking: The debt net

By Jennifer Hughes and Brooke Masters

Published: February 20 2011 22:38

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When Ireland’s High Court issued two rulings this month, the initial response was muted. The so-called direction orders were formalities that began the wind-up of Anglo Irish Bank and Irish Nationwide Building Society, the two failed banks at the centre of the country’s financial meltdown.

Then, a few days later, there was a response to the court action – one that goes to the heart of the crisis in the eurozone and the question of just who should bear the cost of the bust. Two of Anglo Irish’s bondholders, Cayman Islands-registered hedge funds run by Fir Tree Capital, filed a lawsuit in a New York district court claiming the Irish rulings were “egregious” and “brazenly violate[d]” its right to be repaid.

Fir Tree’s claim to victim status contrasts sharply with attitudes in Dublin, where calls to “burn” the bondholders of Irish banks are a central theme in the general election campaign – itself a result of the crisis that toppled the government – that reaches its conclusion this Friday. Voters facing swingeing cuts, tax rises and job losses are angry.

While such fury may be at its harshest in Ireland, it reflects a question being asked by many across the western world: why the investors who imprudently lent the money with which banks such as Anglo Irish made bad loans during the boom years now appear to be getting off scot-free, leaving taxpayers to foot the bill.

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To date, bondholders have been largely shielded from the fallout of the eurozone crisis. Bonds – a form of debt – rank higher than equity, meaning that when business turns sour bondholders have a stronger claim to getting their money back than shareholders. While “junior” bondholders are expected to take losses – in Ireland, these second-tier investors have received as little as 20 per cent of their money – a far larger group of senior bondholders have not, so far.

That is a state of affairs policymakers in Europe and the US are keen to change. In future, bond investors would lose part of their investment to, in regulatory parlance, “bail in” an ailing institution before taxpayers are called upon to bail it out.

The European Commission last month proposed a bail-in regime across the 27-member bloc. “We must put in place a system that is well prepared to deal with bank failures in an orderly manner – without taxpayers being called on again to pay the costs,” said Michel Barnier, the European Union’s internal market commissioner, at the time.

The US has already put in place bail-in-like powers as part of the Dodd-Frank financial reform act passed last year. The law includes a resolution scheme that gives regulators the ability to impose losses on bondholders while ensuring the critical parts of the bank can keep running. Employees will be paid, the lights will stay on and derivatives contracts will not have to be instantly unwound, one of the areas that caused market confusion when Lehman Brothers collapsed in September 2008.

Germany and the UK have developed their own versions of bail-in. This month Denmark deployed its powers for the first time on the tiny Amagerbanken, after loan losses unexpectedly wiped out its capital. Creditors stand to lose two-fifths of their investments.

Advocates of such measures see them as one way of sharing the pain and protecting taxpayers from footing the entire bill of future bank rescues. By quickly addressing the problems of sickly institutions, they would also help stabilise the financial system by removing uncertainty.

But bondholders and many bank executives warn that such moves could have negative consequences for the wider economy. Banks finance most of their customer lending through bonds. Raise the risks of bond investors losing money, and they will charge more in interest. If banks’ borrowing costs rise, that in turn will be priced into the costs of mortgages and other customer loans. Regulatory efforts to protect taxpayers could unintentionally expose them to a permanent rise in the cost of credit.

“[Bail-in] appears to be a self-serving cure to the financial community by the financial community, but in fact [it] contains the ingredients of causing greater harm to the broader economic world: the investment banks will shift the cost,” says Tom O’Riordan of Paul Hastings, a global law firm.

Furthermore, senior bank bonds are typically held not by hedge funds but by pension funds, insurers and other asset managers – the plodding pedestrians of the investment universe – attracted by the apparent safety and reliability of bank bonds. If that safety goes, there is a knock-on risk that the ultimate cost will be borne by those behind the insurers and pension funds: the general public.

Bail-in is a novel concept, which is one of the reasons it has caused such a stir. To start with, it is not an insolvency, a familiar process. When a bank or company goes bust, bondholders expect to lose money and take their place in the queue of creditors. What unnerves investors about bail-in is that it would take place in the no-man’s-land just before insolvency: a grey area where an institution is tottering but has not yet completely collapsed.

Banks in particular need a special regime because they crumble so quickly. Traditional insolvency systems are too slow because cash and customers flood out of the door as soon as trouble strikes.

“Insolvency is the third rail for banks. Touch that and everything starts to unravel,” says Wilson Ervin, senior adviser at Credit Suisse. “So you deliberately design bail-in to happen five minutes before that.”

As such, a bail-in is akin to an outpatient facility or an emergency room in a hospital – the patient is rushed in, patched up and sent out of the door again, albeit with life-altering injuries. Insolvency regimes, by contrast, have more in common with a long period of rehabilitation for a serious illness.

But while this emergency treatment may save the patient, it will not come cheap. “Bondholders’ biggest fear is not getting repaid. With bail-in, that has to be a big risk and it will cost the banks,” says one investor. “Bail-in should only ever be the very, very last resort but our fear is that regulators will do anything to prevent a failure and [impose losses] way too early.”

According to a client survey by JPMorgan, a quarter of senior bondholders said they would not buy bonds that could be bailed-in. Analysts also calculated that responses to the survey implied bail-in would lead to banks paying on average an extra 0.87 of a percentage point for borrowing – a significant surcharge.
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The timing of the debate is unfortunate. Markets have not fully recovered from the crisis; investor confidence remains fragile. While the biggest banks are able to sell bonds, smaller institutions and those from weaker economies such as Spain and Portugal are still struggling to tap the market at prices that make economic sense.

Many of these weaker banks are still largely reliant on the European Central Bank for funding. In January the ECB privately warned the European Commission about the dangers of its bail-in announcement – even if it felt the long-term principle was sound – spooking the still jittery markets.
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When Brussels unveiled its plans in early January, bond markets choked. For a few days they virtually froze as investors digested the implications. While nerves have since steadied, one outcome is already clear: investors are increasingly seeking specially protected bonds that would not be subject to bail-in. These include ultra-safe covered bonds backed by bank assets such as mortgages (see box below). This year, banks are selling record amounts of them.

“Investors face uncertainty,” says Fabio Lisanti, co-head of European debt capital markets at UBS. He says that “the pain is creeping up the capital structure”, taking in instruments that were previously considered untouchable.

“It’s hard for bondholders to make clear investment decisions in this environment,” he concludes. Nervous investors tend to demand a further premium to cover the risks of the unknown.

Rating agencies have already warned that the presence of bail-in is likely to lead to downgrades – another factor likely to push up borrowing costs. Moody’s Investors Service last week downgraded the junior debt of five Danish banks and 23 German ones, and has warned that it is reconsidering its assessments of all banks’ junior debt in the light of bail-in regimes.

There is also the question of whether bail-in would, in fact, help stabilise the broader system. Those inside the legal and insolvency worlds warn against thinking it could be a panacea whereby a weekend trip to the emergency room produces a once-again sprightly bank come Monday morning.

Tony Lomas, head of PwC’s insolvency practice, should know. The man heading the ongoing efforts to unwind Lehman’s sprawling European operations sees bail-in and other, related, powers that the EU is seeking as more akin to managing a terminal case by limiting the pain.

“Bailing in a class of creditors is only a fraction of the answer, in terms of what you need to achieve market stability,” he says. He lists other requirements, including a new legal framework to avoid triggering technical defaults on a bank’s dealings with its counterparties, substantial fresh liquidity and major operational changes to resolve quickly the problems that caused the institution to falter.

“Bail-in might allow you to freeze the institution, giving you some critical time to sell off or transfer the systemically important and viable pieces, but it’s highly unlikely to create an environment where you can preserve a bank in anything like its original form,” adds Mr Lomas.

The US experience bears him out when it comes to larger institutions. While the Federal Deposit Insurance Corporation, a bank regulator, has lots of experience of successfully shutting down small institutions, it has had far more trouble with bigger, more complex ones.
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In Europe, lawyers have cautioned that altering existing insolvency regimes to reflect the new powers is no simple task since it touches on fundamental areas of law such as property rights.

This is one of the arguments that Fir Tree has made in its complaint about the treatment of bondholders in Anglo Irish. It is a familiar position. Bondholders have none of the potential upside offered to shareholders, for whom theoretically the sky is the limit.

The best outcome that bond investors can expect is to receive their money and interest on time. This is why they have always guarded the legal covenants and conditions they felt guaranteed that they would be paid back in full.

That now looks set to change. While challenges such as Fir Tree’s are likely to continue, bondholders face an increasingly united regulatory front on both sides of the Atlantic.

“It is going to be the very rare case that the unsecured creditors are going to be paid in full,” says one senior US regulator. “We are not going to make additional payments to long-term bondholders.”

Who’s in the queue

- Depositors Bank savers protected partially by government guarantee in the event of insolvency

- Senior secured (or covered) debt Backed by a ringfenced pool of bank assets (say, mortgages) and an undertaking to make good on rotten loans – even in bankruptcy

- Senior debt takes priority over junior debt and equity. Cheaper than both as it has strictest repayment terms

- Subordinated (or junior) debt ranks below other debt. Terms may allow issuer to delay repayment, or skip or defer interest payments

- Equity Shares in the ownership of the company; first to take losses, therefore most expensive to issue

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Copyright The Financial Times Limited 2011.