Monday, October 10, 2011

As Dexia shows, without disclosure, bank bond investors will always be protected like depositors

A Richard Barley Heard on the Street column in the Wall Street Journal observed that Dexia's bond investors are being protected from losses.

Regular readers know that without disclosure of each bank's current asset and liability-level data, bank bondholders will be protected just like depositors.

Without this level of disclosure, bank bondholders and other creditors do not have the data they need to assess the risk of the bank.  Therefore, if policymakers and financial regulators want the banks to have access to the capital markets, they have to protect the debt.

The question is how to transition from where we are today (only the financial regulators have access to this data and bondholders are protected from losses) to a point in time in the future (when all market participants will have access to this data and bondholders can incur losses).

The transition requires two activities:

  • banks must be required to disclose all of their current asset and liability-level data through a data warehouse with 5 years.  This information will be provided for free to market participants;
  • governments will guarantee all debt issued prior to the availability of a bank's current asset and liability-level data in the data warehouse.  Banks have an incentive to disclose their data as quickly as possible because the market will assume a delay in disclosure reflects the fact that a bank has something to hide and will reduce its access to and drive up its cost of funds regardless of any government guarantee.
Removing the implied guarantee from bank bondholders is another reason that European policymakers need to require current asset and liability-level disclosure in their "solution" to recapitalizing the Eurozone banks.
So much for bail-in. Financial policy makers have spent the last three years discussing the need to ensure that bank bondholders bear losses in future bailouts. Yet Dexia has just been rescued for a second time in a deal that will include a €90 billion ($120.4 billion) funding guarantee over 10 years from the governments of France, Belgium and Luxembourg—effectively allowing bondholders once again to walk away. 
True, Dexia has some specific features that could make greater burden-sharing risky. For a start, there is a limited amount of debt available: Of its €186 billion of long-term capital-markets funding, €99 billion is in covered bonds, Fitch notes. These rank as senior secured debt, backed by pools of assets as well as the bank....
This need to bailout Dexia's covered bond holders confirms the FDIC's worse fears about covered bonds and highlights the potential for abuses of these securities.

Think what would have happened if all of Countrywide's subprime mortgage backed securities had instead been issued as covered bonds.  The short term profits would have gone to management and the shareholders.  The long term cost of all these underperforming assets would have been picked up by the US taxpayers - as oppose to investors in structured finance securities.

By bailing out the covered bond holders, France and Belgium are taking on the risk of the performance of the underlying collateral.
The European Commission may yet require some burden-sharing from subordinated bondholders. But that may only go as far as deferred coupon payments, an outcome already priced in. 
But there are good reasons why policy makers wouldn't want to inflict losses on senior unsecured bondholders .... policy makers will have been conscious of the significant contagion risks at a time when the European bank-funding market is frozen and the sector faces €1.7 trillion of refinancing over the next three years. 
Denmark, the only European state to force losses on unsecured creditors in bank restructuring, has had to back down after the country's banks found themselves shut out of funding markets: This weekend's rescue of Max Bank treated unsecured bondholders equally with depositors.

No comments: