Creditor Participation in Eurozone Bank Restructurings

A Corner Turned June 2013

Hans-Joachim DuebelFinpolconsult, Berlin

Discussion TopicsChanging definitions of bank capitalBasel III migration and its impact on gone concern banksCreditor participation before restructuringVoluntary Liability Management ExercisesShare buybacks, early bond callsCreditor participation during restructuring/resolutionMandatory Liability Management Exercises / Bail-inGood Bank resolution approach (vs. Bad Bank)Fiscal expenditure vs. costLaw-making processConclusion for the Banking Union project

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Re-definition of Bank CapitalRight Strategy, But A Big Tactical Problem*Basel II reform needsEUR 1 trillion in subordi-nated debt and hybrid capital per 2007. Most of which was not used for recapitalization. Germany: EUR 50 (hybrid) + 60 (sub) bln investors lost a fraction only.Reasons: weak instruments create legal ambiguity (contractual, revaluation and termination clauses, tied to GAAP), connected insiders demand Open Bank Assistance (Unser /nuestro / Lehman), Insufficient options for bank supervisors outside the insolvency scenario.

Basel III (Dec 2010)New Core Tier 1 definition: no revaluation, all capital is permanent, hybrid is limited. Strongly rising CT 1 demands while second leg of financial crisis unfolds. Incentivizes buybacks, early calls of Tier 2 and non-eligible Tier 1 instru-ments.The PROBLEM: This is all fine for going concern banks .... while it somehow ignores progress in bank restructu-ring / resolution law (UK, DE).But what happens, when a gone concern bank starts buying core capital by selling extended capital?

Source: FitchRatings (2010)

When Gone Concerns Buy Core Tier 1 Liability Management Exercises in GreeceSources: Alpha Bank, Finpolconsult LME deal analysis. Rationale for the Offers, May 2013:Eurogroup announcement of Nov 2012: liability management exercises should be conducted in respect of remaining subordinated debt holders so as to ensure a fair burden sharingThe Offers are made in order to provide investors with an opportunity to monetise their investments at the relevant Purchase Price on a voluntary basis.Is offering 48% in cash on subs and hybrids in entirely voluntary LME fair burden sharing? Greek government to replace 85% of this lost capital (ca EUR 390 million, if 2013 full partic.).Sub and hybrid investors are largely exempt from GGB losses.

Alpha Bank 2012 and 2013 LME (assuming full exercise of 2013 offers)

Alpha Bank Liability Structure

Greek Bank Subordinated DebtPull to Par !

*Source: Onvista.de.*Nationalized EFT Eurobank is the only core bank that has offered a debt equity swap per May 2013 to sub bond investors, but it was voluntary. Other banks offered cash LME (Alpha 55c, Piraeus 55c). Alpha, Piraeus and NBG also offered cash to hybrid capital investors (35-40c).EFG Eurobank*

Alpha Bank

Piraeus Bank

Expected gross 600 million CT1 effect (disregarding the opportunity cost) from voluntary LME looks ambitious. Piraeus May sub LME had 10% acceptance.

Compare to Anglo Irish 2010 sub LME : investors demanded 35-40%, government offered 20%, demanding exit consent to punish holdouts.Comparable legal situation (offshore trust SPV-Issued)Liquidity management exercises (Nov 12 CB report)

When Gone Concerns Buy Core Tier 1 Liability Management Exercises in CyprusSources: Laiki Bank, Finpolconsult LME deal analysis. June 2012 highly concessionary offersBond offer: 72.5% exchange into senior bond with twice the interest level of deposits (MTM~85) i.e. de-facto PAR payout, assuming SUC remained uncut; similar deal: MPS in Italy mid-12.Cash offer: 55% cash offer ca Alpha Bank (but without a far-reaching Eurozone promise!)Cypriotic government put EUR 1.8 billion (>10% GDP) into share capital to supportGovernment injected before hybrids and subs (both temporal and in terms of insolvency rank).Hybrid investors in June 2012 were given a voluntary equity swap offer and too many shares.In September 2012, EUR 330 million in senior bonds matured.Bank of Cyprus: in May 2011 called a subordinated bond of EUR 200 million at par, at the first possible date (Deuba broke with this policy 2008). Laiki Bank Subordinated Eurobond with 2016 maturity 2012 voluntary LME followed by 2013 restructuring (mandatory LME, SLE)

Laiki Bank Sub Bond LME Capital Impact

*Source: Laiki Bank Reporting, Finpolconsult.June 12 LME deal was partially clawed back in March 13 through debt-equity swapsHowever, the loss of SLE (and senior bond) capital hit Laiki depositors disproportionally through the credit enhancement effect.German Kreditwesengesetz has added to pre-restructuring intervention options, including into LME. Apparently this is still not universally an option for regulators, or options are not exercised.

Laiki Bank Loss of Bail-inable CapitalRole of ECB Liquidity Policy*Source: http://static.cyprus.com/Laiki-ELA.jpg, Central Bank of Cyprus, Finpolconsult computations.Some 50% of ELA that Laiki received can be estimated to have used to pay out mostly large deposits (IBU), senior and subordinated bond holders.Letter from Anastasiades to Draghi strongly criticizes ECBs role. Asmussen: did not reach 2/3 majority in board to block.The insider run preceeded the bail-in debate (Nov12-Mar13)!De-facto deposit insurance? (analogy to US 1933 Emergency Banking Act)Laiki Bank ELA UsesLaiki Bank Deposits by Source

When Gone Concerns Buy Core Tier 1 Liability Management Exercises in SpainSources: Banco de Valencia, Bankia reporting, Finpolconsult computations. Note: senior bonds include covered bonds, which however largely disappear from reporting as a technical effect from large scale repo with the ECB.Voluntary LMEs became a popular sport in SpainLate 2011 to June 2012 all banks got involved. Great diversity of offers.Private banks partly aggressive (Santander with lg. haircuts) partly concessionary (Popular). Some Cajas rather aggressive (Bankia voluntary DES, overleaf).Yet, many Cajas offered or tried to offer concessionary deals to investorsLiberbank with EUR 1.2 billion capital gap in October offered in June 2012 to swap EUR 627 mln hybrids (preferentes) into 5 year deposits without haircut. Late sweet Caja LME offers can be seen as having shifted mood in banking program sponsor countries in direction of SLE. Liberbank LMEs were intercepted by the Spain MoU.

Bankia Liability Structure

Banco de Valencia Liability Structure

Share Buyback as a Costly Policy to Support Equity LMESources: http://ftalphaville.ft.com/2012/06/26/1056401/the-spanish-bank-buy-back-riddle/Onvista.de. March 2012 large Spanish banks offered debt-equity swaps (into shares or cocos) during an intermezzo of stable share prices:

Stabilizing LTRO-effect in Q I 2012Own share buybacks multiplying previous treasury share holdings.

For gone concern banks, these operations may both destroy investor trust and cut bail-inable capital.

Case 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.

Restructuring Mandatory LMESpanish or Dutch SLE version?Sources: FinpolconsultSpain - Haircut & DESGroup 1 mandatory SLEGroup 2 first voluntary, then mandatory SLE- Pricing approach: market price (first law draft permitted 10% over) liquidation valueUltimately negotiated?Netherlands, SNS Reaal expropriation based on - liquidation value determined by regulator (evidence?).

BOTH approaches lead to same desired Core Tier 1 effect, yet Spain leaves possible economic value on the table for investors.

Parallel to Coco debate:0-1 (insurance) instruments bear significant legal risk, if triggers are regulatoryDES as dilution or thin additional capital layer? Re-swapping/warrants?Central question: how do we best map uncertainty over asset values into liability performance? Laiki Authors SLE Simulation of Feb 13

Bankia SLE, Expected Loss

Restructuring Comprehensive Debt Equity SwapBank of Cyprus = extension of Spanish SLE, with more granular rankingNo initial haircuts outside shares (hybrids), uninsured deposit swap (37.5% + x)Allocation of sub, senior unsec, large deposits to thin equity classes, NO dilution (BIS!), Full voting rights for these classes,Could be combined with warrants, to avoid memory share classes, concentrate voting,Minimal OSI; initially negative, regarding ad-hoc rank changes of public sector deposits.Comparable U.S. case - CIT Group FDIC-supported pre-pack (2009); FSB Recs.Model applicable to going concerns, rather uncertain moderate-sized loss.

*Bank of Cyprus DES ApproachBank of Cyprus Bail-inable Capital* and Capital GapSource: Finpolconsult. *10% standard assumption for European bail-inable deposits, Cyprus ratio ca 50%.

Restructuring Good Bank ModelCasesLaiki Bank, standard FDIC P&A, FSB recs; combined with super-seniority of insured deposits.Denmark standard (Amagerbanken & other small banks with property losses).Greece (ATE, Hellenic Postbank), Ireland (Anglo Irish), only with subordinated debt bail-in.Problem as with all P&A is determination of sales price in stress. The larger the bank, the greater valuation risk (Washington Mutual). Response: Iceland - bridge banks capitalized by existing low-rank creditors/shareholders, alternatively warrants. Cyprus: Role of ELA backed by dubious assets? Internal hierarchies in unwinding vehicle? Model applicable to gone concerns, rather certain large loss.

*Laiki Good Bank & P&ALaiki Bail-inable Capital* and Capital GapSource: Finpolconsult. *see Bank of Cyprus.

Restructuring -A Critique of the European Bad Bank ModelBad Bank = Asset Swap. European standard until Cyprus. Spain fiscal accounting:EUR 51 bln in full faith-and-credit sovereign-guaranteed bonds.What is the insolvency status of hybrid capital prioritized by private banks?Reduced transfer prices as a result of SLE, compared e.g. to Germany 2009 (initial Spain) (90% transfer price with gaps to be amortized by selling bank over 20 years).Beyond fiscal arbitrage, the bad bank model is problematic with regard to bail-inable creditor subsidies, esp in a low asset price inflation environment Major price appreciation differences between the 2010s and Sweden 1990s. Model is basically not practiced in the United States. There are less issues with a bad bank defined as a special (NPL) servicer .

*Sareb: A Public or Private Bad Bank?

Standard Bad Bank Model (Germany)

Fiscal Expenditure for Bank ResolutionCase Bank OSI/PSI Ratios*Source: Central banks, Analistas Financieras Institucionales, Finpolconsult. Gap based on target CT1, internal includes proceeds from sales, accounting issues (DTA) *pre-Sareb, **without impact of Good Bank-Bad Bank splits on non-core banks, ***assumes some OSI in debt-equity swaps.2012/13 summary: three countries, three approaches..Complete individual path-dependency, only MoU changed was Cyprus.Greek central bank in Nov inflated creditor participation ->10% PSI target since Jan (reached only by 2/4 core banks).Greek OSI/PSI ratios >> Spain.Cyprus outlier (but not for smaller banks).

Greek Banking Program**

Spanish Banking Program, Group 1*

Cyprus Banking Program***

Fiscal Expenditure vs. Fiscal CostLoss Expectation of Recaps

*Source: Bank reporting, national central banks, Finpolconsult.Methodology:Subtract 2012-target date pre-provision income assumption from target CT1 2014/15.Note: pre-provision income estimates in Greece are systematically higher than in Spain.Question: what value of shares does government buy with a given fiscal expenditure?Chart assumes 100% price/book ratio of acquired bank stock. European average bank price/book ratio, however, is only 60% (and that might still be optimistic for this sample).Result: 7 sample bank aggregate fiscal loss would have eaten up 30%-35% of ESM capital, depending on the price-book ratio assumption (EUR 24.0 bln under 100% and EUR 28.2 bln under 60%).

Fiscal Loss Based on 2012 CT1 Book Value

Holding on or Selling Now?Greek Warrant Policy for Core Banks

*Source: Bank Reporting, national central banks, Finpolconsult.Target CT 1 includes pre-provision income estimate for 2012 2014/15.Greek banks have optimistic PPI estimates compared to Spain, prompting government to price warrants above stressed book values. E.g. Alphabank at target CT 1 level + 10% (44c) = 150% 2012 book (30c).Is forgiving a potentially large upside optimal fiscal policy? Greek government locks in recapitalization losses.High multipliers of warrants attract hedge funds.GGB haircuts treated as if they were an external shock to banks.

Alpha Bank HFSF Warrant Pricing

Fiscal Loss Based on Target CT1 Book Value

Fiscal Cost of Bank ResolutionAccounting Issues, Spain

*Source: FROB, Bank of Spain, Autonomous Research, Finpolconsult assumptions and computations.Public debate constantly mixes up expenditure and cost. Examples:ECB is both super-senior and collateralizedELA at least super-seniorFiscal HT 1 injection is safer than pari passu shares.Fiscal share injection after bail-in differs from share injection before bail-in (Laiki). Economic values for PSI will differ from regulatory values (debt equity swaps).Spain observationsHistoric expenditure inflated by vast guarantees (reduced during restructurings) and early recaps.Very large ECB/ELA exposure, e.g. Bankia alone EUR 74.5 blnHigh fiscal cost/expenditure ratio through tendency to take first loss positions.Potentially large Sareb fiscal burden not properly accounted for (guarantees).

Spain, Banking Program Accounting under Authors Subjective Expected Loss Assumptions

Fiscal Cost of Bank ResolutionQuasi PSI-Reversal in Greece, Cyprus MoUs

*Source: Bank and press reporting, Finpolconsult assumptions and computations. Note: very limited data officially provided by HFSF. Without bond guarantees.Greek program has produced both far higher cost / GDP and even higher cost / expenditure than Spain.Cost expenditure inflated by clear political intention to shield system from GGB PSI losses.Calculatory PSI reimbursement between 60% (NBG) and 100% (rest, based on 2012 CT1)Result will likely be OSI.

Cyprus MoU II (Mar 13) saved ca half of the fiscal cost over MoU I (Nov 12)EUR 5 bln under MoU II (mostly smaller banks & EUR 1.8 bln Laiki) compared to EUR 10 bln under MoU I.Subject to additional evaluation of large Cypriotic banks Q II 2013.

Greece, Banking Program Accounting under Authors Subjective Expected Loss Assumptions

Some CounterfactualsEarly Intervention is Key to Protect Government and Depositors*Source: 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 2010EFG Eurobank Q IV 2011Alphabank Q I 2012Laiki 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

Bank Restructuring & Resolution LawWhy does it take so long?European regional bank crisis is comparable to U.S. S&L crisisIn the U.S, the 1991 FDIC Improvement Act marked the turning point a full 9 years after Garn St Germain:De-facto abolition of Open Bank Assistance (direct recapitalization by the Eurozone)Adaptation of Least Cost Resolution Approach (in theory, never mind the RTC).ALL deposits became super-senior in a separate act, but FDIC was only required to transfer insured deposits in a P&A.Europe: IKB to Cyprus is 5.5 years.. (but there was a template!)

*Still, the legal/regulatory delay in Europe is disappointing:By mid-2012, only UK, Germany, Ireland had specific bank resolution lawCrisis countries had to be forced through programs to adopt law 2012/13. Speculation on Eurozone?Greek law highly unsatisfactory (only SLE for non-core banks),Spanish law moderately unsatisfactory (too many regulator options),Cyprus law possibly goes too far.FDIC Least Cost Resolution Game Changer 1991

Conclusion for Banking UnionDefinition of bank capitalReconcile Basel III and Eurozone-fiscal definitions of bank capital, Revoking excessive focus on Core Tier 1 for gone concern banks is sine-qua non (Slovenia!!), rules for voluntary LME policies.

Banking Union architecture Build the Second Pillar now (European FDIC, starting with resolution), cross-border supervision approach,ECB has massive conflicts of interest and cannot be the monopoly bank regulator from a fiscal perspective.

Crisis management and restructuring/resolution (R&R) policiesDirect recapitalization so far means transfers. Establish clear rules for open bank assistance.Rationalization of bail-in can only come from clearer and more granularly structured liability side (dichotomy: capital vs liabilities is too simple), Avoid ad-hoc rank changes in the neighborhood of mandatory liability management.

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Conclusion for Banking UnionCrisis mgt ctd..With a view on the scale of problems and the need to tap foreign investors (Spain!) should include covered bonds into R&R (at least overcollateralization).Should include reconversion options to map asset value uncertainty. Optimal class for senior bonds/uninsured deposits would be dated Upper Tier 2.Expropriation of subordinated debt problematic. Preferable separate share or coco class.Super-seniority of deposits problematic. If so, volume should be reduced