Martin Sibileau: ..Far from being a unique situation, the fragile exposure of unsecured depositors across the Euro zone is the norm…A quick view of a bank’s capital structure
There are multiple issues on the Cyprus event. Perhaps
the most relevant is the fact that unsecured depositors were sacrificed
because their banks did not have enough subordinated debt to bail in. For this reason, the official story goes, Cyprus is a special case.
Let me explain this point. In the figure below, I show the stylized
version of the capital structure of a bank. From top to bottom, every
portion of it is subordinated to the one immediately above it. It is
clear that the least subordinated should be the deposits that finance a
bank.
What is clear to us was not clear to
leaders of the European Union.
At closed doors, they first decided that deposits above EUR100M would arbitrarily lose 9% (in spite of existing subordinated debt to bail in) and put the matter to vote….only to revise this figure a week later up to 40% and without voting. It was hardly an ordinary bankruptcy proceeding; banks did not go through an ordinary liquidation and nobody could see an actual market appraisal of recovery values across the capital structure. The portion of such structure, which was supposed to be the most protected, saw its recovery value fluctuate between 9% and 40% within days because folks who live far away from this drama decided so over a weekend. On the other hand, those who held deposits of amounts below EUR100M are only entitled to them nominally. Effectively, they cannot withdraw their monies, let alone send them outside Cyprus. If they hold demand deposits believing that they can serve as medium of indirect exchange and they cannot use them precisely for that function, their property was affected, regardless of what the official story says.
At closed doors, they first decided that deposits above EUR100M would arbitrarily lose 9% (in spite of existing subordinated debt to bail in) and put the matter to vote….only to revise this figure a week later up to 40% and without voting. It was hardly an ordinary bankruptcy proceeding; banks did not go through an ordinary liquidation and nobody could see an actual market appraisal of recovery values across the capital structure. The portion of such structure, which was supposed to be the most protected, saw its recovery value fluctuate between 9% and 40% within days because folks who live far away from this drama decided so over a weekend. On the other hand, those who held deposits of amounts below EUR100M are only entitled to them nominally. Effectively, they cannot withdraw their monies, let alone send them outside Cyprus. If they hold demand deposits believing that they can serve as medium of indirect exchange and they cannot use them precisely for that function, their property was affected, regardless of what the official story says.
Let’s return then to the thesis that
Cyprus is a special case because the subordinated debt of its banks did
not provide with enough cushion in the liquidation. As you can see from
the figure above, the thicker the subordinated debt tranche is they
lower the likelihood that unsecured senior debt and depositors will be
affected. If Cyprus is a special case and it is not a template for
the rest of the Euro zone banks, then it must be true that the rest of
the Euro zone banks have stronger tranches below that of depositors. The sections below will show that during the last year (since March 2012):
a) The same Euro zone authorities that
imposed the loss on unsecured depositors were the ones who enabled a
cash-out of subordinated debt holders, leaving depositors exposed to the
firing squad,
b) The Fed has been the ultimate enabler of this situation, and
c) The fate of the US dollar is indirectly coupled with the fate of the Euro zone = There is no place to hide.
How the ECB financed the exit of subordinated debt holders
In December of 2011 and February 2012,
the European Central Bank (ECB) extended longer-term refinancing
operations to provide liquidity to euro zone banks. The liquidity, in
euros and at a below market price, was against sovereign debt held by
the banks, as collateral. Part of this liquidity was used for what is
called “liability management” exercises, where the banks changed the
composition of their liabilities: They borrowed from the ECB to repay
their subordinated debt holders. This is the reason why Cyprus should
actually be a template for the rest of the Euro zone. Because across the
Euro zone, subordinated debt was reduced, leaving unsecured depositors
exposed….again, across the Euro zone. The figure below, with the
aggregate balance sheets of the main players, should help visualize what
happened during the last twelve months:
In step 1, we see the focused
balance sheet of the Euro zone banks and their subordinated investors
(i.e. holders of subordinated debt), with regards to the subordinated
debt. The same is a liability to the banks and an asset to the
investors.
In step 2, we see the aggregate
change caused by the extension of the LTRO Loans (i.e. loans issued
under longer-term refinancing operations, by the ECB). These loans are
an asset of the ECB and a liability to the banks.
Against these loans, the ECB issued Euros, which are an asset of the banks and a liability to the ECB.
In step 3, we see the transaction
that I hold responsible for allowing unsecured depositors to be fair
game across the Euro zone. With the Euros loaned by the ECB, banks
bought out subordinated investors. Unfortunately, I have not had the
time to quantify the exact impact of this transfer to date. However,
reviewing past research notes released at that time (March 2012), my
point will be clarified. (ADDENDUM: I HAVE BEEN GENEROUSLY FORWARDED TO THIS LINK, WHERE ZEROHEDGE.COM DID THE MATH ON THIS POINT, PROVIDING AN UPDATED STATUS OF THE ISSUE)
On March 28th, 2012, Barclays’ Credit Research team had published a report titled “European Banks: Liability management shrinks the bank capital market”. In it, it was estimated that at the end of March (only one month after the second LTRO), about 20% of the subordinated debt (equivalent to EUR97BN) had been targeted for exchange. The average exchange ratio of the transactions had been calculated at 82% of par
(74% for Tier 1 and 89% for Lower Tier 2). The reductions were split
as follows: Close to 35% of cash out in the Tier 1 market (EUR54BN), 12%
reduction of the Lower-Tier 2 (EUR37BN), and 18% reduction in
Upper-Tier 2 (EUR6BN).
According to Barclays too, all the transactions had been bondholder-friendly, with an average 7pt (i.e. 7%) premium to secondary market
across all issues (9pts for Tier 1, 5pts for Lower Tier 2). The main
motivation behind all the transactions was capital optimization. They
created capital gains to the banks. Except for two transactions in which
the subordinated debt was exchanged for common stock or new Lower Tier
2, the rest were all tenders for cash. Greek banks in particular (i.e.
National Bank of Greece, EFG Eurobank and Piraeus Bank) also
participated in this liability management exercise; in some cases (i.e.
Piraeus’s Prefs at 37 and LT2 floater at 50, announced on Mar 7/12) at
premiums ranging 10 to 17pts.
In other words, both banks and
subordinated debt holders enjoyed great capital gains, leaving unsecured
depositors exposed to higher risk. This played out in the context of a
virtuous cycle, where the cheaper funding improved the risk profile of
the financial institutions and attracted capital back to the Euro zone.
In the process, both the Euro appreciated and the EURUSD basis
tightened, which furthered strengthened the equity of the financial
system. The depositors of course, continued to receive mere basis points
for their trust. On May 29th and later on June 25th, I had warned about the danger of this outcome.
But the story did not end here. In steps 4 and 5
of the figure above, I show the impact the Fed had in all this with its
quantitative easing policy. By literally printing money in US
Treasuries purchases, it added fuel to the fire, because Euro zone banks
took advantage of the situation to borrow cheap US dollars, helping
them repay their LTRO loans. Zerohedge.com has explained this with more
detail than I can provide in this note, (in chronological order) here, here and here. I recommend that you read these articles in detail, if you want to understand how the game is going to end.
Step 6 seeks to show the status
quo after the party. If the Cyprus situation is contained (which I
doubt), going forward we should see the reduction in both assets (i.e.
LTRO loans) and liabilities (i.e. Euros) at the balance sheet of the ECB
and the banks, with banks replacing LTRO repaid loans with unsecured
USD funding.
The Fed as the ultimate enabler tied the fate of the USD to the Euro
If you noticed, I circled the US Dollars
held at the balance sheet of the Euro banks in step 6 of the figure
above, as an asset. I did this because I want to emphasize a point I
have been making for a long, long time: The collapse of the Yankee bond
market (i.e. the market for bonds denominated in US dollars, where the
borrowers are non-US resident corporations), caused by corporate
defaults in the Euro zone will unmask the exposure that the Fed has to
the fate of the Euro zone. The dollars that end up with the Euro zone
banks get recycled in multiple ways and one of them is via the Yankee
market (another one is of course the USD loan market).
It should be clear therefore that this
whole transfer of wealth will ultimately (and irresponsibly by the Fed)
end up exponentially (through leverage) affecting those holding their
savings in US dollars.
Final words
I am confident that the story above
shows that far from being a unique situation, the fragile exposure of
unsecured depositors across the Euro zone is the norm; and that their
fragility was further increased in the last twelve months thanks to
policies created by the same authorities who now refuse to honor their
promise of a banking union, and instead impose capital controls, which
have effectively destroyed any credibility on the safety of capital in
the Euro zone.
One last word of caution: I think
it would be wrong to interpret from the process depicted above that
there was a premeditated conspiracy on the part of policy makers to
weaken the position of depositors. This outcome, I believe, was simply
an unintended consequence in their efforts to sustain the Euro zone.
However, even if one accepts my view, the unintended outcome begs the
following question: Why was there cheap money available for
subordinated debt holders to cash out, but there is none now to protect
the savings of depositors? Nobody can answer that question but with
speculation, and as such, intellectual honesty demands that I keep mine
to myself, because as Mark Antony said in Shakespeare’s “Julius Caesar”:
“…You are not wood, you are not stones, but men; and being men, it will
inflame you, it will make you mad”.
Please, click here to read this article in pdf format: March 29 2013
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ECB Backs Dijsselbloem's Liquidation Policy "Template"
It seems that in 2012 the ECB split was between the Germans and Draghi on unlimited inflation threats; in 2013 it will be between those who want bail-ins and bail-outs.
Via Reuters,
And now, once more, this time with feeling: Diesel-BOOM.European Central Bank Governing Council member Klaas Knot said on Friday there was "little wrong" with Eurogroup chair Jeroen Dijsselbloem's recipe for dealing with future euro zone banking crises, a newspaper reported.
...
Those comments - which Dijsselbloem later rowed back on -prompted a market selloff and led two other ECB policymakers, including executive board member Benoit Coeure, to say on Tuesday that Cyprus was a unique case.
But Knot, who sits on the bank's main decision-making body, said: "There is little wrong with Dijsselbloem's remarks.
"The content of his remarks comes down to an approach which has been on the table for a longer time in Europe. This approach will be part of the European liquidation policy."
...
In a speech on Thursday night in Amsterdam, Knot said euro zone banks needed to clean up their balance sheets by winding down loss-making operations.
"Firstly, there has to be transparency about losses in the banking sector. Secondly, banks have to wind down their loss-making operations," Knot said.
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