A quiet revolution took place on Wednesday, an earthquake that failed to register on the markets’ otherwise highly sensitive seismographs.
The silent revolution took place in the market for deeply subordinated bank debt after yesterday’s rescue of the equally deeply distressed Banco Popular by the mighty house of Santander. This was the first time that the eurozone’s bank rescue regime was fully implemented and therefore also the first time that the rules governing the treatment of Additional Tier 1 capital notes, also known as contingent convertibles or CoCos ,were put through their paces. Tier 2 notes, supposedly less deeply subordinated than those of Tier 1 status, were also brought into the settlement and the result was a total wipe out of the AT1 bonds and a mandatory conversion of the Tier 2 notes into common equity, which is worthless as the entire bank was then bought by Santander for €1. Senior note holders, on the other hand, remain untouched.
As a result, Popular’s subordinated debt dropped from its market price of around 50 cents in the euro to zero while senior debt rallied sharply. More to the point, the rest of the AT1 markets tood up in exemplary fashion, despite the considerable fear that if one bond were ever to be bailed in, investors would flee the entire asset class in blind panic. In fact many issues rallied on relief that the edifice had survived the quake with none of the much-feared contagion cracks appearing. Let’s face it, from the moment the first CoCo bond appeared on the horizon, arguments have raged as to how they should be valued and priced.
AS EXPECTED
Yesterday’s events proved the bond to be just as binary as the banking authorities had envisaged and the embedded risk to express itself just as it said on the tin but it will make the pricing of bonds issued by banks in ambivalent circumstances very difficult. It will also make the market for all forms of subordinated debt very hard to access for troubled institutions, giving added credence to the old wisdom that a banker is a person who will lend you an umbrella when the sun is shining, only to ask for it back when it begins to rain.
We know how much the bail-out of the banks cost in 2008 but imagine what would have happened if every major bank that was bailed out had been obliged to nix all of its outstanding its subordinated debt before being thrown a life jacket. Chapeau to the authorities; the bailing-in exercise for Popular has worked a treat and exactly as the blueprint would have had it. What we don’t know though is what would happen if a broader, systemic crisis were to reoccur. Oh, sorry, how silly of me; there will now never be another banking crisis will there? Our financial system can never again find itself over-borrowed in the face of a cyclical economic downturn, can it?
That said and without worrying about what might or might not happen one day, the single resolution board and its mechanisms have worked a treat and that is something we should applaud. Next up undoubtedly will be some of the Italian regional banks, many of which have never been in the AT1 market. Given, however, that in terms of recovery there will be no difference between Tier 1 and Tier 2 debt - zero in both cases - there might be some repricing to be done and there is also the prospect of higher volatility in times of balance sheet stress that investors will want to see more generously rewarded. The chances of this happening in a grown-up fashion are slim in a era of investors reaching for yield at all costs but there is surely room for a Black-Scholes-like model for measuring and pricing volatility in subordinated bank debt. Nobel Prize, anyone?
CRUDE
Despite the Middle East disintegrating into further turmoil, crude prices haven’t shot higher but fell out of bed again. In heavy trading on Wednesday WTI plummeted from US$48.19 per barrel to close at US$45.72. Conflict all across the region and oil prices collapsing? The rise in US oil inventories might be cited as the reason for the sharp fall but Qatar’s isolation and the Tehran attacks should really be pushing the price higher. It might not have felt like it but yesterday Brent made its low for the year to-date and WTI closed within 20 cents of its own May 4 low.
A 5% fall in oil because of rising US inventories while the geography is catching fire? Nah! There must be more to it and any ideas will be welcome.
Finally, election day here in the UK and James Comey’s testimony in Washington later. Plenty to keep us occupied today, even if the election results won’t be with us until long after the markets have closed, but nothing to be trading on. Hands best kept in pockets.