Time for bank bond write-downs
After years of insulating risk-takers from the consequences of their decisions, maybe it’s finally time to try something else.
Europe’s current crisis, and specifically the death spiral some of its banks and peripheral sovereigns are locked into, may provide just such an opportunity. It may now be time to cross that red line and force some bank bondholders, even senior bondholders, to take losses.
Throughout the now five-year-old global financial crisis, writing down bank debt when banks are insolvent is a step that policy-makers have been almost universally unwilling to take.
Fearing a rolling line of bank failures if the weak were allowed to go down, policy-makers have generally followed the following three-point script:
First, make abundant liquidity available to banks, ensuring that they don’t fall over in a panic. The European Central Bank’s unlimited LTRO is the logical extension of this.
Second, create conditions where banks can profit, hoping they rebuild their own capital. JP Morgan’s recent speculative losses are a good example of how this doesn’t always work, while the US mortgage market, where lower interest rates from quantitative easing don’t always make it through to borrowers, is a good example of how when it does work the gains are unequally distributed between Wall Street and Main Street.
Third, inject capital or buy illiquid assets from banks, some of which you may need to take on to national balance sheets. Europe is in this phase now, as shown in Spain where Bankia has been nationalised and now requires a capital injection of at least €9bn. It is worth noting that in the only place where this script was not followed, Iceland, growth has now returned and the banking system is on a reasonably sound footing.
There are a number of serious problems with the extend, pretend and then underwrite approach.
First, the incentives are all wrong. Bondholders are taught that the analysis they need to do is not so much on the soundness of the bank they lend to, but on the politics, strength and will of the state which houses it.
Second, the results are actually pretty poor. Growth has not reignited in the US or in any of the places where banks and their lenders have been protected, arguably because the system is still labouring under too much debt and doing so with hobbled banks, some of whom have prioritised speculation over capital intermediation.
Third, and this is where Europe comes in, taking on the debts of an ailing bank system can easily ultimately take down the sovereign which stands guarantor.
The pain in Spain
While Europe has lots of problems outside its banking system and many institutions which need reform, it is where it is in no small part because the potential liabilities of many peripheral country banking systems threaten to be too much for their sovereigns to bear.
The more liquidity and aid banks are given, the worse the balance sheet of the country looks. The greatest threat out of Greece may not be its exit, but what this does to Spain’s banking system, which is to say, what it does to Spain.
Ben Lord, fund manager at M&G Investments in London, argues that it is time for this cycle of dependency to end. Bail-ins, where senior and subordinated bondholders make a contribution, in some cases of 100%, may be in order in some cases where the bank is weak and the sovereign weakening. This is a rapid way to create capital and deleverage the system.
It won’t, of course, be necessary in every country, or even in every bank in the weaker countries.
“If this doesn’t work, then nationalisation is the last resort, and the taxpayer must step in one last time,” Lord wrote in a note to clients.
“But this situation of creeping nationalisation where taxpayers provide 24-hour life support in European banks through emergency policy response after emergency policy response, at the expense of much higher tax and lower quality of life across all citizens for a very long time feels wrong, at least before the risk-takers have suffered.”
While this proposal has logic and justice on its side, it probably is unlikely to be put into place. If a strong and extremely stable state like the US had difficulty grasping the politically toxic nettle of imposing losses on bondholders, it will be that much harder in Spain or Portugal, which are struggling not just with recession but with uncertainty about their role in the eurozone and about the eurozone itself.
If Europe chooses bailouts over bail-ins, growth will be suppressed and the fruits of growth will be unfairly distributed; in other words, more of the same.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. To contact him by email: email@example.com)