Creditor Participation in European Bank Restructurings

A Corner Turned ?A Corner Turned ?

Directorate General CompetitionEuropean Commission

BrusselsJanuary 23, 2014

Hans-Joachim DübelFinpolconsult, Berlin

What have we done?What have we done?8 Bank Sample8 Bank Sample

2Source: Finpolconsult.

Creditor participation ratios increasing over time , however outliers:

•Amagerbanken an early case (Fall 2010) with senior unsecured creditor participation, Note: Ireland was not permitted to pursue same approach,

•Dexia a late case (Nov/Dec 2012) bailing out juniors, months after Spain.

Estimated Private Sector Involvement in Capital Gap Financing

BailoutBailoutIreland/Denmark Guaranteed Current Ireland/Denmark Guaranteed Current Bondholders, Meanwhile in the U.S. ..Bondholders, Meanwhile in the U.S. ..

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“I showed up at Hank’s office at ten, still not knowing what the meeting was about… it was an ambush.

They told me they wanted me to publicly announce that the FDIC would guarantee the liabilities of the banking system.

It was an overreach of the worst sort, and there was no doubt on my mind that Tim Geithner was the instigator.

On the following Friday, October 10, I sent Hank a counterproposal. We would guarantee the newly issued debt of the banks we insured at 90 percent of the face value.

Current bondholders did not need our protection.”

Sheila Bair ‘Bull by the Horns’

BailoutBailoutLME as a Bailout VehicleLME as a Bailout Vehicle

4Source: Finpolconsult.

Buybacks/swaps (LME) and calls are popular bailout instruments.

Understood by very few in government, high fees for investment banks.

Basel II->III arbitrage (increase in core tier 1<<decrease in sum of tier 1 and tier 2).

Dexia S.A. Junior Debt Structure

Bail-out and Basel III ArbitrageBail-out and Basel III ArbitrageLaiki Bank Subordinated Bond LME Laiki Bank Subordinated Bond LME

5Source: Laiki Bank Reporting, Finpolconsult.

BailoutBailoutCan Greece Afford These LME?Can Greece Afford These LME?

Sources: bank reporting, Finpolconsult LME deal analysis.

• Is offering between 40 and 60% in cash ‘fair burden sharing’?government recap effectively replaces some 70% of GGB losses,

• Once government is invested in shares, subordinated debt investors expect to be paid parCa EUR 2 out of 3.5 billion per Q IV 2011 get cash.

Greek Bank Junior Debt RepurchasesCash offer conditions to investors 2012, 2013

1: National Bank of Greece, 2: Alpha Bank, 3: EFG Eurobank, 4: Piraeus Bank. EFG Eurobank DES – debt equity swap.

Bailout Bailout Bad Banks As Creditor Subsidy VehicleBad Banks As Creditor Subsidy Vehicle

Systematically unties the fate of junior / senior unsecured debt from the fate of assets,Transfer pricing chosen may be right or wrong.

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Bad Bank Model (Asset Swap Model)

BailoutBailout..very wrong, indeed..very wrong, indeed

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Bad Bank of Hypo Real EstateoBy October 2010 with entire Greek exposure at PAR !!oNo transfer of junior debt (despite law): = de-fact third – and most expensive - public recapitalization.

BailoutBailoutHRE left with large Junior Debt ExposureHRE left with large Junior Debt Exposure

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o Junior creditors got almost entirely protected, except

• Hybrid capital coupons (KOM rule)

• UT2 haircuts (held by retail),

o Full cash payout expected with reprivatization.

o By 2013 we can still not intercept subordinated debt coupon payments outside insolvency !

Source: bank reporting, Finpolconsult.

HRE Junior Debt Structure

BailoutBailoutSlovenia – the LME - Bad Bank ConnectionSlovenia – the LME - Bad Bank Connection

Large LMEs of the two largest Slovenian banks during 2012 in parallel to creation of bad bank (Swedish involvement).

2013 - insufficient subordinated and senior unsecured debt, ex deposits, by restructuring date to support bail-in.

Novo Ljubljanska Banka Liability Structure

Source: Bank Reporting, Finpolconsult.

BailoutBailoutLiability Management Exercises in SloveniaLiability Management Exercises in Slovenia

Source: Bank Reporting, Finpolconsult.

Novo Ljubljanska Banka Cash Flow

Bail-out Followed by Bail-inBail-out Followed by Bail-inCreditor Rotation in SpainCreditor Rotation in Spain

Sources: bank reporting, Finpolconsult computations.

• Cash payments to (largely professional) subordinated investors in 2010 and 2011 of ca. EUR 2 billion,

• In parallel new subordinated debt and equity was issued, at this time mostly to retail investors/households,

• 2012 cash paid had to be reinvested in equity (LME). But Bankia bought back common stock !

Bankia Cash Flow

Bail-out Followed by Bail-inBail-out Followed by Bail-inBuyback StrawfireBuyback Strawfire

Sources: http://ftalphaville.ft.com/2012/06/26/1056401/the-spanish-bank-buy-back-riddle/Onvista.de.

ECB:Stabilizing LTRO-effect in Q I 2012 for share prices was used by Spanish banks for share buybacks.

Bankia:

-Offered hybrid investors shares at high exercise prices into collapsing share price trajectory, benefiting insiders who sold immediately.

-Bank may have lost EUR three-digit millions in cash (Core Tier 1)

-Reports for total year 2012 75 million loss from own share dealing operations.

Bail-out Followed by Bail-inBail-out Followed by Bail-inCreditor Rotation Senior Unsecured & CoveredCreditor Rotation Senior Unsecured & Covered

Sources: bank reporting, Finpolconsult computations.

Bankia Funding Structure

Bankia•Large volumes of senior unsecured and covered bonds (mostly 5yrs) sold to foreign investors, these investors rotated with the ECB,•This would not have happened with self-liquidating pass-throughs!

Bail-out Followed by Bail-inBail-out Followed by Bail-inCreditor Rotation in the NetherlandsCreditor Rotation in the Netherlands

Sources: bank reporting, Finpolconsult computations.

2008 public (senior) hybrid capital injection, followed in 2009 by large buy backsIn 2010, SNS Bank placed a new EUR 500 million subordinated bond,

2011 large cash LME over EUR 420 million of old subordinated debt,2012 first possible call of 2003 issued hybrid capital securities exercised.

SNS Reaal Cash Flow

Bailout followed by Bail-inBailout followed by Bail-inCentral Bank GovernanceCentral Bank Governance

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Source: Central Bank of Cyprus, Finpolconsult computations.

ELA – Emergency Liquidity Assistance,IBU – International Business Unit.

Large ECB ELA borrower, at peak EUR 9.8 billion (33% of assets),

Some 50% can be estimated to have used to pay out mostly large deposits (IBU), senior and subordinated bond holders,

Asmussen: ‘did not reach 2/3 majority in Gov Council to block Laiki ELA’,

some tightening of ELA rules Oct 2013 (reporting on borrower/collateral.

Laiki Bank Deposits by Source 2010-2012

Central Bank Governance in the Central Bank Governance in the U.S.U.S.

The Fed Shoots FastThe Fed Shoots FastUSD crisis (of European banks..)•2008 SIV/ABCP after pullout of US MMFs,

•Ongoing: European banks’ role in the global China/Petrodollar recycling,

•The Fed shoots fast !!

o After 2008 Steinbrueck interview closed window for HRE/Depfa,

o After the 2011 US MMF run on French banks, the Fed passed on credit risk to the ECB (EUR-USD swap agreement).

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NY Fed Term Auction Facility Lending to German Banks, 2007-2010

Source: Federal Reserve Bank of New York, Finpolconsult computations. Cumulative lending.

SIV – Structured Investment Vehicles,ABCP – Asset-backed Commercial Paper,MMF – Money Market Funds.

Central Bank Governance in the U.S.Central Bank Governance in the U.S.FDIC in the Driver SeatFDIC in the Driver Seat

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“It was unlikely that WaMu would survive unless it started borrowing from the Federal Reserve Board’s discount window.

However, Fed lending .. is heavily collateralized. Meaning that the more a bank borrows from those sources, the more expensive it becomes for the FDIC to resolve.

For that reason, the law prohibits the Fed from lending to a failing institution,

and as a matter of courtesy, the Fed typically consults with us before lending to a troubled bank

and does only so with our consent.”

Sheila Bair ‘Bull by the Horns’

Bail-in TechniquesBail-in TechniquesDebt Equity Swap vs. HaircutsDebt Equity Swap vs. Haircuts

SLE – Subordinated Liability ExerciseCoco – Contingent ConvertiblesCDS – Credit Default Swaps.

Spain (Bankia)- Haircut & DES

• Group 1 – mandatory SLE,• Group 2 – first voluntary,

then mandatory SLE.- Pricing approach:

• “market price” (first law draft permitted 10% over) vs.

• liquidation value,• Ultimately ‘negotiated’.

Netherlands (SNS Reaal) – Expropriation

• 100% haircut,• liquidation value.

Both approaches lead to same desired Core Tier 1 effect.

Debt equity swap leaves possible economic upside on the table for investors, tied to asset performance.

Important for real estate related stress.

Parallel to Coco debate:•0-1 (insurance) instruments carry significant legal risk, esp. if triggers are regulatory.

Alternatives?• CDS written by bond investors on

initial bank portfolio,• Example: KfW credit-linked notes

program.

Bail-in TechniquesBail-in TechniquesBank of Cyprus – A Model?Bank of Cyprus – A Model?

- No initial haircuts of debt !! swap. Preferable in the presence of high uncertainty over losses (NL vs. Spain).

- Allocation of sub, senior unsec, large deposits to thin equity classes, - High interest rates for preferred shares if bank performs (de-facto

Coco),- Current main shareholder is Laiki Bank unwinding vehicle (18%),- Issue: permitting ad-hoc seniority - Cyprus public sector and ECB -

destroys incentives. 20

Bank of Cyprus – Debt Equity Swap

Source: Finpolconsult.

Bail-in TechniquesBail-in TechniquesGood Bank Model (FDIC Standard)Good Bank Model (FDIC Standard)

• Laiki Bank, Good Bank & P&A combined with super-seniority of insured deposits.o Denmark (Amagerbanken), Greece (ATE, Hellenic Postbank).

• Problem is determination of sales price during stress (WaMu, Laiki).

• Response: Iceland - bridge banks to be sold later. Requires public bridge funding, European bank P&A market. 21

Laiki - Good Bank, Purchase and Assumption (P&A)

Source: Finpolconsult.*

Fiscal OutcomesFiscal Outcomes7 cases = 30%-35% of ESM capital7 cases = 30%-35% of ESM capital

22Source: Bank reporting, national central banks, Finpolconsult.

Fiscal Loss Based on 2012 Book Value

What share value does government acquire with a given expenditure?

High PSI cases show high government losses, as initial recap is given up (rational).

Fiscal OutcomesFiscal OutcomesLGD – Fiscal Cost/ExposureLGD – Fiscal Cost/Exposure

23Source: Bank reporting, national central banks, Finpolconsult.

• High PSI cases (Laiki, Amagerbanken) show high loss for government as government ‘gives up’ initial recapitalization to bail in juniors/senior unsecured,

• Overall losses are maximized for low PSI cases (HRE, Anglo Irish).

Fiscal Loss Based on 2012 CT1 Book Value

Fiscal OutcomesFiscal OutcomesMethodology Example, SpainMethodology Example, Spain

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Source: FROB, Bank of Spain, Autonomous Research, Finpolconsult assumptions and computations.

DES – Debt Equity Swap

Recovery expectation matters !!•ECB repo is both super-senior and collateralized,•ECB ELA at least super-senior (Cyprus),•Hybrid capital safer than shares,•Share injection after bail-in safer than before bail-in, •DESs share economic value with investors, haircuts don’t.

Spain-Historic expenditure inflated by large guarantees.-Very large ECB/ELA exposure, e.g. Bankia alone EUR 74.5 bln,-Potential bad bank (Sareb) fiscal cost are not properly accounted for (guarantees). fiscal accounting creates bias for policy decision (Austria et al)

Spain, Banking Program Accounting under Author’s Subjective Expected Loss Assumptions

Counterfactuals AnalysisCounterfactuals AnalysisEarly Intervention is Key to Protect Early Intervention is Key to Protect

Taxpayers and DepositorsTaxpayers and Depositors

25Source: Bank reporting. *7 caja reporting for 2010, Bankia senior bonds minus 50% assumed covered bonds, **assumed to be the average uninsured deposit ratio outside Cyprus. CT 1 needs include early gov recaps. Finpolconsult.

Assume a 10% deposit bail-in**/ zero fiscal bail-out rule. Then the break-even restructuring dates were:•Bankia – Q IV 2010 … Anglo Irish bank was nationalized in Jan 2009 !!•Banco de Valencia – Q IV 2010•EFG Eurobank – Q IV 2011•Alphabank – Q I 2012•Laiki Bank – 10% deposit threshold always missed, but the uninsured deposit ratio was 50%..•Bank of Cyprus – 10% deposit threshold always missed, but….•Piraeus – only case in a 7 bank list where the deposit insurer would have had to disburse in a super-senior rank scenario.

Bankia/BFA* Alpha Bank

Laiki Bank

Policy ConclusionsPolicy ConclusionsDeterrents to Creditor ParticipationDeterrents to Creditor Participation

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Bad reasons•First government recap often followed by second rather than bail-in –> avoids stigma of wasting taxpayer money (HRE, Dexia),

•False going concern hopes–>protection of investors for the going concern,

•Fiscal capacity, program vs. non-program country anything goes?

•Investor lobbyism: many junior bond investors in Europe are politically well plugged in, often regional.

(Semi) good reasons•Restructuring delay, may hit the wrong creditors (Bankia, SNS Reaal),

•Retail investor protection after misselling, Spain’s sacrifice for the European common good (any reaction in Brussels?).

Policy ConclusionsPolicy ConclusionsU.S. has gone through this beforeU.S. has gone through this before

1991 FDIC Improvement Act

•Abolition of ‘Open Bank Assistance (no ‘direct recapitalization’),

•Least Cost Resolution Approach

•ALL deposits became super-senior

•FDIC became only required to transfer insured deposits in a P&A.

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FDIC Least Cost Resolution Game Changer 1991

Policy ConclusionsPolicy ConclusionsGreater Speed and Depth Greater Speed and Depth

(of Creditor Participation) Needed(of Creditor Participation) Needed

28Source:: Finpolconsult.

Cash Drain to Junior Debt Investors and Policy Score

Action taken before restructuring – e.g. prohibition of LME and other prompt corrective action - is as important as sound restructuring policies!

Policy ConclusionsPolicy ConclusionsHow to Ensure Speed and Depth?How to Ensure Speed and Depth?

• Speed - BRRD by 2018 is too late !o 10 years after Lehman – exempts all likely current cases,o State aid rule (Aug 1, 2013) less effective without the Directive

(M. Nava ‘65%’).• Depth, sequencing can still be arbitragedo Always at least junior bond bail-in, no ‘precautionary government

recapitalizations’ (Draghi)o Include Covered Bonds overcollateralization, limit asset encumbrance,o Close ‘systemic risk’ backdoor main systemic risk is fiscal collapse. • Improved architecture can preserve botho European version of U.S. FDIC, with SRM as a starting point

shorter time to restructuring and deeper creditor participation,organize fiscal counterpart to monetary policy

o ECB has conflicts of interest as secured investor and lender SRM as secondary regulator to SSM!

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