It’s a changed, changed world.
The introduction of bail-ins and burdensharing means capital markets will never be the same.
Intuitively, making creditors share some of the pain of public bailouts make some sense, but it does take a chunk out of credit quality, which means there are fewer buyers, and the debt is often more expensive to issue. With that in mind, here are some Monday thoughts from UBS bank analyst Alastair Ryan:
Western governments have more debt than those of more historically-default-prone economies (Chart 1). It is, in retrospect, the pre-2007 period in the western world that was the abnormal one. As IMF data shows, defaults and banking crises are far from unusual. By making default more likely, bail-ins in the Eurozone make it a world more like the other one, which defaulted 65 times since the mid-1970s – and which has an average debt/GDP of only 45%. With more debt than a ‘bail-in’ structure would typically support, the Eurozone is asking a question to which the answer for many of its members may be a difficult one.
…
Feedback loop (1): More convexity is less stability
The feedback loops resulting from these shifts in credit quality are powerful. First, if the transition for banks to the new world is difficult and the cost of failure elevated, the risks of failure must be more worrisome for debt providers. This introduces greater convexity into bank funding markets, making failure a more proximate risk; and so on.
Feedback loop (2): Sovereign bond holdings rising
Banks are traditionally significant holders of domestic government debt. This may be for carry-trade income and is encouraged by its almost-universal zero risk weighting. Most essentially, though, it is required by regulators for liquidity purposes. As regulatory demands have risen sharply, banks’ holdings of government bonds have escalated. Chart 4 shows the UK situation for illustrative purposes.
Needless to say, a banking system would in any event be severely stressed by a sovereign default. One that has been encouraged to build its ownership in the sovereign rapidly will be particularly vulnerable to bad outcomes.
Feedback loop (3:) No CDS means lower gross
The proposals to force holders of Greek sovereign debt to take losses without this triggering CDS is likely to be compounding the problem: holders (especially banks) that had hedged gross positions with CDS now find an increased risk that their hedges are worthless. This will inevitably reduce their appetite for gross positions in the first place.
Feedback loop (4): Those that bought ‘convergence’ gone
Banks’ term debt issuance compared with maturities so far this year tells a number of stories. First, as the ECB recently commented: “Funding vulnerabilities continue to be an Achilles’ heel for many euro area banks.”
The UK banks continue to issue well in excess of maturities, in spite of shrinking their balance sheets. The same is true in the Netherlands. These two markets are making the most rapid progress in making balance sheets ‘safer’ – although even this isn’t necessarily a good thing, as discussed in In a lonely place, 7 July 2011. The French banks are terming out their notoriously short-dated wholesale books. This will likely drag significantly on their earnings, but addresses one of the key concerns over what are otherwise well-positioned banks in a stable economy. Spanish issuance is now running behind maturities YTD, having been well ahead earlier on in 2011 … Perhaps most striking, though, is the huge gap in German financing. The system has issued €60 billion less YTD than has matured, a rollover rate of a little over 40%. It is hard to regard this as reflecting anything other than the run-off of much of the system.
You might want some extra detail here. Landesbanks and other German pseudo-bank institutions (think Depfa-esque things) were historically major buyers of so-called ‘spread’ at a time when non-German eurozone debt typically yielded more than (had some spread over) German debt.
Or as Ryan puts it:
The central conceit of the Euro was that all its participants would become more ‘German’ in productivity, fiscal probity and therefore credit risk. The spread of non-German Euro paper could therefore be captured as profit by those with German funding costs and patience. If we are learning through bail-ins that convergence is a thing of the past, the owners of much non-German Euro paper are likely to continue to incur losses and fade away. For non-German Eurozone countries with any credit risk, this makes financing rollovers, much less ongoing deficits, ever more challenging.
Sweet dreams, eurozone banks.
Related links:
EU stance shifts on Greece default - FT
Defaults as a state of normalcy – FT Alphaville
The eurozone ‘convergence carry unwind’ - FT Alphaville