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Europe Will Try To Make Its Banks' Creditors Play Nicer With Each Other

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Today the EU issued a discussion paper about how it plans to forcibly write down the debts of shaky banks if it ever comes to that, which for some reason is called a "bail-in," I guess in the sense that the bailing is coming from creditors who are already in the bank's credit rather than from taxpayers who aren't. It's pretty interesting, go read it, or read Bloomberg's piece about various bits of squabbling over it and also somewhat counterintuitively a statement from EU guy Michel Barnier (left!) that “There’s a big international consensus on the principle.”

Actually there probably is; the principle is pretty sensible, which is that there comes a time in many companies' lives where the best way to preserve value not only for the enterprise but also for the creditors is to write down some of the debt to allow the company to continue as a going concern that can pay off the rest of the debt. This is why we have bankruptcy, but bankruptcy seems to be too slow and scary for banks. The worry is, you have a bank and it's got like $15 of equity and $100 of debt and its assets go from $115 to $90 and all of the debt holders start looking at their watches and being all "hey this has been fun but I'm actually late for this thing so would it be too much trouble for you to give me my money back?" and the bank has to sell a bunch of stuff to meet those demands then that looks like a fire sale and people figure it out and all of a sudden that $90 becomes, like, $60, and the debtholders get back 60 cents on the dollar instead of the 90 cents, and they're like "crap, if I'd just said 'I'll take $90, and also whenever you have it is fine, no rush,' I'd have much more money."

Of course that's all sort of obvious so one thing that the creditors could do is just not do that, and voluntarily and quickly write down their debt so that the bank wouldn't have to have a fire sale to meet their claims, but, knowing creditors, that's not what would happen, so you need some sort of resolution mechanism to protect them from themselves.

So there's this EU proposal, which says basically that there can be a quick brutal forced write-down of debt. But, sort of necessarily, it exempts from the bail-in:
(1) insured deposits (obvs),
(2) secured liabilities to the extent of security, including repos and stuff (also obvs), and
(3) liabilities with an original maturity of less than one month, which, much less obvs, but you can see the point of it, which is basically that banks fund cheaply (from politically favored and/or systemically important quasi-depositors) in short-term markets, in part because of expectations that a failure of those markets would trigger a bailout, which expectations are kind of being confirmed by this proposal no?

So that kind of excludes a lot actually. Like, Deutsche Bank has €163bn in "long-term debt," which I guess is a plausible proxy for "things not excluded from the bail-in," versus €2.1tn in total liabilities that are mostly deposits and derivatives liabilities some of which I guess would be long-term and un-/undersecured but a lot of which wouldn't be. But "Barnier is considering forcing lenders to issue at least 10 percent of their debt in securities that would be eligible for bail-ins" so that would be more then.

One piece of mystery is, you're going along and you're a creditor of a bank and your instrument falls at say Seniority N in the bank's massive capital structure. To start, you're pretty sure everyone of Seniority A (most senior overnight secured guaranteed deposit whatevers) to Seniority Z (most junior perpetual subordinated deferrable quasi-equity nonsense) is going to get all of their money back. But then facts change and Z is underwater, and then Y is underwater, and you're like "wait, will this stop before it reaches me?" And you can't really ask anyone, least of all the bank. And if you could know for certain that it would stop at Seniority Q and you'd be fine, then you'd sleep well at night and not freak out when X and W and V get wiped out. But you can't know that. And if Seniority O does become impaired, it's probably too late for you - you'll be hosed already, because what are the odds it'll get to Seniority O but no further?

So what you want when you're negotiating to buy the Seniority N thing in the first place is a provision that lets you get out - at par - well before you are hosed. And maybe "well before" means when Seniority P is impaired, but maybe it means "as soon as someone looks at Seniority Z funny." And maybe you've read the EU discussion paper and think "hmm, I see the problem with demanding my money in a way that forces a fire sale," but then your lawyer is like "well, we can negotiate this contract to trigger whenever debt that is pari passu with you defaults, but that means that any time it does trigger you lose money - or we can put the trigger all the way over at Seniority Z, and then if that triggers there's probably still enough money to go around," and you are seduced by his law degree, and getting off a sinking ship earlier seems better than getting off later, and you think "yes, I would like to get back par as soon as anyone is impaired, that would be safer for me," and then all of a sudden that thing happens where there's a fire sale and ooh Lehman-AIG-MF-Global and your pleasant little secured claim is blown up.

This is not entirely fixable. US bankruptcy law has lots of clever attempts to fix it, like bans on ipso facto clauses* and clawbacks of preferential transfers, but there are also clever ways around those fixes. Similarly you can bet that the secured or short-dated creditors of European banks will want to ... well, take it away EU discussion paper:

All necessary measures should be taken to prevent institutions from including in the contractual terms of an excluded liability any termination right that is exercisable as a result of the application of the debt write-down tool to the institution or an affiliated entity.

Any provision of the contractual terms of an excluded liability that purports to confer termination rights in contravention with what has been mentioned before should be void.

Right, that - that's what they'll want to do - get "termination rights in contravention with what has been mentioned." Fortunately, those termination rights "should be void." I guess! But remember how banks being downgraded by Moody's may trigger additional collateral requirements for their derivatives? That is not entirely unlike what I described above as "I get my money back as soon as someone looks at Seniority Z funny." Paradoxically, if you void attempts to give creditors a put right when more junior debt is written down, that pushes them to look for a put right that triggers before more junior debt is written down: that is, when the bank gets near the bail-in trigger. Or when Moody's says it might. Given the EU's hatred for the ratings agencies they'll be pretty sad if the bail-in mechanism gives the agencies more clout over the fate of European banks.

Bondholder Losses Debated by EU to Avoid Bank Rescues [Bloomberg]
Discussion paper on the debt write-down tool – bail-in [EU DG Internal Market]

* Don't worry. Nobody knows what this means.


Citi Will Try The Stress Test Again With A $9bn Stock Buyback

More stress tests, bleargh. I guess the news is that Citi "failed", though I can't get all that excited by that because it didn't exactly "fail" in the sense of now it's being forced to raise capital / broken up / burned to the ground. Instead it failed assuming it follows the capital plan it submitted to the Fed, which is clearly a capital-lowering rather than capital-raising plan. I ballpark it at $10bn of share repurchases and dividends,* which is ... well, it's pretty big for Citi. So they can just not do that then. Or not do quite as much of that, which seems to be their plan: In light of the Federal Reserve’s actions, Citi will submit a revised Capital Plan to the Federal Reserve later this year, as required by the applicable regulations. The Federal Reserve advised Citi that it has no objection to our continuing the existing dividend levels on our preferred stock and our common stock, and we plan to do so, subject to approval by the Board of Directors each quarter. The Federal Reserve also advised that it has no objection to Citi redeeming certain series of outstanding trust preferred securities, as Citi proposed in its Capital Plan. We plan to engage further with the Federal Reserve to understand their new stress loss models. We strongly encourage the public release of these models and the associated benchmarks and assumptions. We believe greater transparency in this process will best serve all banking institutions and their shareholders as well as the international regulatory community and market participants, and will encourage a level playing field globally. There are at least two ha! moments in that snotty last paragraph. First there's the fact that the Fed had planned to release the stress test results on Thursday and got gun-jumped by Jamie Dimon. So much for Fed transparency. But also, specifically, as people are all running around suing each other about the Fed maybe kind of encouraging bank CEOs to hide material information from investors, it is odd that the Fed would have the stress test results and sit on them for two days. Imagine the scenario where Jamie Dimon, Vikram Pandit, and the Fed all know that JPM passed and was going to do a largeish buyback, while Citi failed and was going to do a ... I guess somewhat smaller buyback - and they didn't tell anyone from today until Thursday. If you sold JPM to buy C today, wouldn't you be kind of annoyed?**