Friday, February 3, 2012

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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