Commentaries

The EC bank smackdown

Dexia and ING’s recent decisions to call some of their subordinated debt has puzzled market observers, as they seem to fly in the face of the European Commission and its crusade on burden-sharing for banks that have received state aid.

The Commission wants junior creditors of bailed-out banks to share some of the pain along with the public sector, and wants to make sure public funds aren’t used to repay equity or junior debt if a bank can’t. Holders of some of RBS’ subordinated debt recently found this out to their horror when the bank chose not to call the bonds at the first opportunity. The Dexia and ING bondholders, by contrast, will have had a nice pay day. The Dexia upper tier 2 bond was trading below par in the mid 70s area, according to CreditSights.

It looks like the EC wasn’t too pleased with Dexia and ING’s generosity, as last night it issued a stiff press release reminding banks of its rules. That’s not good news for any bondholders who had been hoping that the Dexia and ING calls may have signalled a thawing in the EC’s stance.

Here’s the EC statement:

State aid: Commission recalls rules concerning Tier 1 and Tier 2 capital transactions for banks subject to a restructuring aid investigation

Following questions from market operators regarding the possibility  for banks which are the subject of pending European Commission investigations regarding the grant of restructuring aid to repay bonds before maturity, the Commission would like to recall that its Communication on restructuring aid to financial institutions of July 2009 (see IP/09/1180 and MEMO/09/350) sets out that “banks should not use state aid to remunerate own funds (equity and subordinated debt) when their activities do not generate sufficient profits”. In a restructuring context, measures which reduce the total amount of own funds (payments on hybrid instruments, avoidance of loss absorption, buy-backs, exercise of call options) are in principle not compatible with the objective of “burden sharing” (i.e. banks must pay a significant share of the costs of restructuring) and the “minimum necessary” requirement (i.e. the amount of state aid must not exceed the minimum necessary to allow the bank to restructure). For that reason, banks subject to a state aid investigation should consult the Commission before making announcements to the market concerning Tier 1 and Tier 2 capital transactions.

Transactions such as coupon payments, buy-backs and the exercise of call-options of Tier 1 and Tier 2 capital instruments reduce the total regulatory capital of a financial institution and put into question whether granted state resources were limited to the minimum necessary. Moreover, such measures may infringe the principle of burden sharing in so far as they protect the Tier 1 and Tier 2 capital holders from their exposure to the inherent risk of the investment.

Such transactions by financial institutions subject to restructuring obligations may therefore have implications for the compatibility of the aid received. On the other hand, the Commission may accept these transactions on the basis of a case by case assessment, after balancing the above mentioned principles of burden sharing and limiting aid to the minimum against the contribution of the transaction to the refinancing capability and return to viability of the institution. For that reason, banks subject to a state aid investigation should consult the Commission before making announcements to the market concerning Tier 1 and Tier 2 capital transactions.

Fed knows transparency when it sees it

From the start of the financial crisis, the Federal Reserve has fought to keep secret the many measures it has taken to prop-up the banking system.

The Fed has opposed releasing information about the trillions of dollars in loans it made during the crisis or the tens of billions of dollars in troubled assets it has taken on its balance sheet. For instance, the Fed still won’t say just what it acquired, when it took on some $29 billion in troubled assets from Bear Stearns last year.

Yet the Fed has no trouble demanding transparency from others. In the bankruptcy case for Extended Stay Hotels, in which the Fed is a big creditor after assuming some of Bear’s assets, the central bank came out for the appointment of an examiner.

Why? Well, according to court papers filed in the bankrupty case, the Fed says:

Given the likelihood that the New York Fed will be called upong to publicly explain any loss, the New York Fed would be remiss if it did not acknowledge to the Court its own independent interest in obtaining transparency into the collapse of the Debtors.

Isn’t that rich? Now I have no problem with the Fed throwing its support behind the appointment of a bankruptcy examiner–something the judge in the Extended Stay case did recently approve. Examiners often bring a pair of fresh and untained eyes to the process.

But for the Fed to argue the merits of transparency, while it prevents the public from looking into its own affairs, is simply hypocritical.

The EC bank debt riddle

The European Commission seems to enjoy messing with bankers’ and investors’ heads in its crusade against subordinated bank debt.

Earlier this year the EC roiled markets by insisting holders of bank subordinated debt securities should suffer along with the taxpayer for bailouts. It stopped RBS from calling some tier 2 bonds, and also cracked down on KBC.

But now, the sphinxlike Commission has allowed both Dexia and ING – both recipients of state-aid – to call some tier 2 bonds at the first opportunity, giving bopndholders a nice payday.

Is the EC mellowing? Perhaps. Here is the somewhat exasperated comment from analysts at BNP Paribas :

Our job is already hard enough trying to second guess governments and the EC, without having to deal on top of it with actions that do not seem comprehensible. We think that the picture on EC intervention in call approvals is blurry, but that the recent call approvals by Dexia and ING are encouraging for other banks, even for RBS.

European Commission defanged by hybrid debt

Fans of the weird and wonderful world of hybrid debt will have enjoyed the European Commission’s U-turn with Belgian bank KBC.

The EC wants banks that have benefitted from state aid to “burden share’’ with private sector investors by deferring optional coupons on their subordinated bonds. That sounds simple enough — after all the essence of subordinated debt is that it can defer interest without counting as a default. Burden sharing, whether imposed by the EC or not, is what hybrid debt is all about.

However, after saying that KBC should defer coupons on certain securities the EC has now backtracked because the Belgian bank and third party lawyers were able to pick through the docs and argue that the coupons weren’t optional after all. 

It looks like the EC is going to need to do some hardcore analysis of its own to work out exactly which coupons can be legally deferred. Perhaps it will conclude there are easier ways to `burden share’.

CreditSights analysts point out that KBC isn’t the first bank to be able to get round the EC’s demands, following Commerzbank and Bayerische Landesbank.

The EC will continue to try to restrict discretionary coupon payments, but it is “likely to find that many of the hybrids have mandatory payments,’’ CreditSights analysts wrote in a report.

This should all be good news for hybrid capital investors, who have been fretting over the risk of coupon deferral ever since the EC got tough earlier this year.

The big Fed news

A federal judge’s ruling that the mighty Federal Reserve must release information about some $2 trillion in “emergency” loans made during the financial crisis is a big blow to the central bank’s self-styled image as an impenetrable shrine.

US District Judge Loretta Preska should be applauded for not taking the Fed’s bait that to release information about the banks and financial institutions that received those loans would imperil the financial system. Preska rightfully concludes that the Fed’s fear is based on mere speculation and “conjecture.”

A big tip of the hat also goes to Bloomberg News for pursuing this lawsuit, after the Fed denied the media outlet’s Freedom of Information Act request seeking the loan information. Thanks to Bloomberg, the public’s right to know all the ins-and-outs of the federal government’s effort to bailout the banks has been preserved.

Of course, I fully expect the Fed to appeal this decision. So I don’t expect these loan documents to be released anytime soon. And that’s a shame because throughout the financial crisis the Fed has shown it is tone deaf when it comes to the issue of accountablity and public disclosure.

Remember, the Fed fought against releasing the names of the banks that got an indirect bailout from the federal government’s rescue of American International Group. And the Fed has been less then forthcoming in providing information about the $30 billion in ailing assets it took on from Bear Stearns as part of the forced sale of the failing investment bank to JPMorgan Chase.

The Fed’s arrogance only has emboldened its critics and given ammunition to those on Capitol Hill who oppose the Obama administration’s plan to turn the Fed into some sort of uber-regulator.

Now that President Obama has rewarded Fed Chairman Bernanke with a new term (subject to Congressional approval), maybe the nation’s top money-man will move to breakdown the Fed’s historic wall of silence.

Trust still matters

Trust is one of those touchy-feely words that gets thrown around a lot, but whose true value isn’t felt until it’s lost.

The Congressional Oversight Panel’s latest report on the troubled assets still embedded in bank balance sheets reminds us that one of the first casualties of the credit crisis, trust, is still up for grabs.

Those toxic assets that started the whole mess, culminating in last fall’s financial market meltdown, are still there — they’re just harder to see.

This is so even after the government has pumped trillions of dollars into the financial system, including the $700 billion of funds initially targeted at removing those assets, but redeployed to vulnerable financial institutions themselves.

Trust is one of those things that bind financial markets together. When it’s breached it can get ugly, with last year’s maelstrom one of the worst examples.

While it’s unlikely we’ll see again the likes of the mayhem last fall, the persistence of toxic assets on bank balance sheets means some financial institutions remain vulnerable should they lose the trust of the investors and taxpayers who have kindly supported them so far.

For the moment, the markets don’t seem too worried, since euphoria about the expected rebound in the economy means few are thinking too much about the niceties of whether bank executives or policy makers can be trusted to do right by shareholders and taxpayers. (UPDATE: The stock market decline Tuesday and climb in Treasury yields, however, shows how fragile confidence in the recovery and the financial sector is, however.)

Managing incentives, UK banks edition

Confused about the British government’s approach to its bank investments? You’re in good company. Consider the following statements from Royal Bank of Scotland and its main shareholder(emphasis is ours):

June 23rd: Sir Philip Hampton, chairman of RBS, on the £9.6m cash-and-shares pay package awarded to Stephen Hester, the bank’s chief executive:

“We now have support for a remuneration plan that ensures the majority of Stephen’s reward is non cash and based on his performance. This means his financial interests are strongly aligned to the interests of all our shareholders in the short-term and over the coming years. “

July 13th: UK Financial Investments, 70 per cent shareholder in RBS, uses its first annual report to discuss the best way to measure its performance managing the government’s bank investments:

“Share prices alone, whilst an important factor for us to monitor, are therefore not an ideal yardstick for measuring UKFI’s overall performance, given the extent to which they are influenced by many factors outside UKFI’s control.”

Not exactly a ringing endorsement of the cult of shareholder value. Which begs the question: do bank executives and civil servants respond differently to equity incentives?

It’s a start, but AIG still needs lots of handholding

As part of the government plans to overhaul AIG’s massive bailout package (announced in March), the company said Thursday it would give the government stakes in two of its most cherished assets – American Life Insurance Company, Alico, and American International Assuarance, AIA, – in return for paying down a good portion of its loan with the central bank.

In its press release, the company was sure to say that this is “a major step toward repaying taxpayers,” which is always important to flag to help offset the anger surrounding the bonus snafu and Ben Bernanke’s public blasting of the company.  And reducing outstanding debt on the credit facility to $15 billion from $40 billion gives some comfort that little by little, the government’s AIG entanglement is getting a little less, well, twisted.

But let’s not get too excited. After all, there’s still that $15 billion balance to deal with, and stakes in two companies that policymakers would be happier handing over to the private sector.

So far, it’s been a hard slog to sell the assets. When the Fed first swooped in to rescue AIG in September, the thinking was the $85 billion loan with stiff financing terms was a stop-gap measure to get the troubled insurer through a very rough patch. After all, the company had good assets to sell and it would use proceeds to pay back the goverment.

Nine months later and they’re still at it. AIG has said that it plans to take ALICO and AIA, now in their special purpose vehicles, public but with the disclaimer that the timing of such IPOs will depend on market conditions.

But before they get to that, the special purpose vehicles and the debt paydown need to close – something not expected until the second half of the year, most likely late in the third quarter at the earliest.

The New York Fed loan is also only part of the AIG bailout package. There’s also the toxic mortgage-backed securities and collateralized debt obligations that the Fed stored away in the vehicles known as Maiden Lane II and Maiden Lane III. They stand at around $36 billion.

Lehman creditors, you didn’t lose any money

You read that right. Peter Wallison, a senior fellow at the American Enterprise Institute, a right-leaning think tank, doesn’t think Lehman’s collapse caused any “substantial losses.”

In an op-ed in The Wall Street Journal, Wallison, in criticizing the Obama administration’s financial regulatory overhaul plan, concludes that the only reason Lehman’s bankruptcy caused so much market turmoil is because no one thought the federal government would allow it to fail.

Now there is some truth to that sentiment. But it’s also true that Lehman’s collapse was such a shock to the market because it revealed just how dangerously interconnected our global banking system is and the inability of regulators to do much about it.

But i don’t really want to critique Wallison’s argument about whether “too big to fail” institutions should be allowed to fail or not. What really got me was his astonishing claim that the losses directly tied to Lehman weren’t substantial. How’s that?

Lehman’s failure itself did not cause any substantial losses, and within two weeks of its bankruptcy filing Lehman’s trustee sold its brokerage, investment banking, and investment management businesses to four different buyers. 

Yeah, those businesses were sold but at substantial discounts to what each of them might have fetched just weeks before the bankruptcy.

And is Wallison really trying tell us that Lehman’s bond holders, derivatives counterparties and trade creditors lost no money. Why is the bankruptcy proceeding still going on then?