In The Australian Financial Review I reveal that house prices have stabilised after modest falls over April and May and explain the key lesson for equities, hybrids, subordinated bonds, and senior bonds from the sudden and spectacular failure of Spain's fifth biggest bank, which is about the same size as Macquarie (click on that link to read the column for free via Twitter or AFR subs can read here). Excerpt below:
"First, no taxpayer funds were expended with Europe's Single Resolution Board cancelling all shares and Additional Tier 1 (AT1) capital hybrids, and converting all Tier 2 (T2) subordinated bonds into equity, which was sold to the acquiring bank, Santander, for merely €1. Markets have been exercised by the fact that the recovery rate on the T2 sub debt and the AT1 hybrids was the same (zero) when investors have historically assumed that T2 bonds should carry a much skinnier risk premium. In Australia the major banks' five-year T2 bonds pay a credit spread above the bank bill swap rate of just 1.68 per cent, which is less than half the 3.63 per cent spread investors require from the majors' five-year hybrids. Ipso facto, hybrids (sub debt) are relatively cheap (expensive). Deutsche Bank's analysts commented that this "precedent should have negative implications for T2 pricing in our view, as the pricing difference between T2 and AT1 should mainly reflect recovery expectations given default". They added that "rating agencies may reconsider differences between AT1s and T2, which reflects higher recovery expectations on the latter". A second insight was that senior bond holders avoided any bail-in despite European regulations allowing for this possibility, which resulted in the prices of these securities rallying. Deutsche Bank opined that "this suggests authorities may have decided to avoid potential complications related to the bail-in of senior unsecured creditors, which rank pari-passu with corporate deposits (and subordinated to retail deposits)", as they do here. "In our view the development is positive senior unsecured bonds, negative for T2 bonds and technically positive for AT1 hybrids, given potentially increased interest from existing T2 bondholders," Deutsche Bank said. Another takeaway was that the "non-viability" clauses in the T2 bonds and AT1 hybrids, which allow the regulator to write them off, were triggered when Banco Popular's risk-weighted total capital ratio was 11.9 per cent, or miles above the 5.125 per cent capital ratio level that is normally perceived to be the threshold at which write-off/equity conversion occurs. Last year this column argued that these default risks could indeed materialise at capital ratios that were much higher than the standard 5.125 per cent level. In Banco Popular's case, the capital structure worked exactly as it should: equity bore the first losses, followed by hybrids and then subordinated bonds. It just so happened that the gap between assets and liabilities was wide enough to warrant all securities being wiped out concurrently. Whether this happens in other bank busts depends on the magnitude of the capital shortfall (or the size of the ex ante buffer). There have certainly been other cases where higher-ranking securities, including hybrids and T2 bonds, have been spared with only equity incurring losses. This supports the emphasis savvy investors place on non-risk-weighted equity (or leverage) ratios. Whenever a bank and/or regulator assumes away the value of an asset using the artificial risk-weighting method, there is always the possibility that this write-down proves wrong. When large numbers of loans start going sour, sophisticated investors focus on the true dollar value of a bank's buffer that protects liabilities from assets. With this in mind, APRA's boss Wayne Byres recently highlighted that "overall leverage has not materially declined" since the GFC. "The proportion of equity that is funding banking system assets has improved only modestly, from a touch under 6 per cent a decade ago to just on 6.5 per cent at the end of 2016," Byres rightly warned. APRA's performance during the next crisis will likely be determined by the extent to which it has the conviction to compel an improvement in these non-risk-weighted metrics. Financial markets expect it to adopt a tough line, which is why major bank equities have been faring poorly of late while their senior bonds have been rallying (credit spreads have been shrinking). All else being equal, lower leverage is a credit (equity) positive (negative)."
Christopher Joye is Co-Chief Investment Officer of Coolabah Capital Investments, which is a leading active credit manager that runs over $2.2 billion in short-term fixed-income strategies. He is also a Contributing Editor with The AFR.