Uncertainty mounts over outstanding bank bonds

By Aline van Duyn, Nicole Bullock and Paul J Davies Published: February 24 2009 02:00 Last updated: February 24 2009 02:00 Government efforts in the US to reassure investors yesterday that it stands behind the banking sector did little to alleviate uncertainty towards hundreds of billions of dollars of outstanding bank debt. Concerns about the financial strength of Citigroup, Bank of America and other large, troubled institutions have resulted in sharp falls in the value of these banks' shares. The value of bank debt has also been falling sharply - including the senior bonds traditionally regarded as least risky - amid growing concerns that bondholders might also end up taking losses. Even if the US government were forced to take over some institutions - and authorities insisted yesterday that they wanted to see the industry remain in private hands - senior bondholders do not expect to have to take any losses. US officials would be too afraid of triggering a repeat of the collapse of the credit markets that followed the bankruptcy of Lehman last year, when bondholders lost billions of dollars. Yet bond investors still are not convinced that they will not ultimately have to take losses as banks restructure. Government actions in the UK, which have been detrimental to some classes of bondholders, have highlighted the potential risks of intervention. "It's a big concern and it continues to be a big concern," said Bill Bellamy, director of fixed income at Thompson, Siegel & Walmsley. "The one thing that the government has failed to do is stabilise the fear in the bond market." Citigroup's five-year senior debt was quoted at a risk premium, or spread of 725 basis points over Treasuries, while the subordinated debt was quoted at more than 1,000 basis point over Treasuries, a level indicative of distress. Credit default swaps on the bank remained elevated, but they have fallen from the recent highs reached last week. Preferred shares - which rank in between equity and debt - are trading at 25 cents on the dollar. This is similar to preference share levels for a number of European banks, although Royal Bank of Scotland, the UK bank that is majority controlled by the government, has prefs trading as low as 10 pence in the pound. "The government appears to understand that it could completely destabilise the financial system if senior bondholders at some of the big banks are wiped out," said Greg Peters, chief US credit strategist at Morgan Stanley. "However, if the government does end up taking over large parts of the financial system, there are concerns about whether the government could take on all the liabilities. This possibility does make me more worried about senior debt than in the past." The statement on Monday would indicate that the government still aims to support the entire capital structure, a plus for senior bondholders and even those holding hybrid securities. Hundreds of billions of dollar of bank debt is held by pension funds and insurance companies where losses would affect the wealth of many individuals. But deep uncertainty remains. "Will it work, or do they have to go to Plan C, D, E or F?" asks Kathleen Shanley, a senior analyst at Gimme Credit. Letting Lehman Brothers fail last year was meant to demonstrate that the government would not reward failure, but it brought the entire financial system to the brink. "Now, [the government's] top priority is maintaining market stability," Ms Shanley said. "The problem is that insurance companies are holding a large amount of these [bonds and securities]. By letting one fail you may be just passing things on down the line." In Europe, senior bank debt remains under heavy pressure as governments struggle to restore faith in their financial systems. However, subordinated or junior debt continues to suffer more and the market was dealt a further blow by the UK government on Friday. In the credit derivatives markets, the cost of protecting junior bank bonds against default on the iTraxx index of subordinated financials rose 20 per cent on Friday to a record and rose another 15 basis points yesterday to breach 315bp, meaning it costs more than €315,000 per year to insure €10m of such debt over five years. The renewed panic was sparked by the UK government using a new bill that became law last week to alter the terms of outstanding subordinated bonds issued by Bradford & Bingley, a nationalised mortgage lender. The changed terms mean B&B can defer interest payments on these bonds. The move was condemned by investors as ill-judged and bad for sentiment in a market that has been crucial in supporting banks' balance sheets. Deutsche Bank first upset the market in December when it decided not to repay a similar bond at the first opportunity because the penalty coupon rate it would incur was less than rates in the open market. Since then a variety of actions by banks or governments have created great uncertainty about the treatment and value of banks' junior debts. Some analysts and investors thought the fresh panic was overdone. "Ultimately, if we were to be negative to the extreme, one could say that the Banking Bill 2009 allows the UK government to do what it likes," say Olivia Frieser and Axel Swenden at BNP Paribas. "However, we hope that today's events will show that the market is extremely sensitive."