How Senior Is Senior?

In the early 1930’s Newfoundland – until that point a sovereign state – was struggling to repay its loans. Rather than default and face the wrath of the British gunboats, it was agreed that the country would be controlled directly from London. Fortunately things have moved on and debt now ranks below a nation’s sovereignty in times of default. Banks are not so fortunate; they aren’t protected from the wrath of their creditors.

Typically if a bank fails another bigger, stronger one is found to assume control. (Which, incidentally is what happened to Newfoundland after the Second World War – it was absorbed into Canada.) Bank failures are a messy business and regulators around the world have been trying to come up with new ways to stop banks from falling over and to limit the damage when they do.

Where senior debt will rank in future bank liquidations, and what the implications are for that market are some pretty serious questions thrown up by this process. Until recently it was assumed that holders of senior bank paper would be treated the same as bank depositors in a bank wind up, i.e. they would suffer no losses. Noises coming out of the western world’s various regulators have pointed to senior debt becoming loss participating in future. I guess if you make a loan to a badly run bank, why should you expect all of your principal back when things go wrong?

Pension funds and insurance companies have thus far held a large number of these securities because of the perceived low risk of capital loss. If they still wish to maintain credit and duration exposure to the banks at the top of the capital structure they will be inclined to switch out of senior paper and into covered bonds.

Covered bonds are secured on a pool of mortgages. Therefore, if a bank fails, you should still receive your interest and principal payments, assuming the underlying mortgage holders continue to make the payments on their homes. In a fortunate coincidence, the new capital requirements that are being imposed on banks incentivises them to issue covered bonds as they require less capital to be held against them under Basel 3.

At the other end of the capital structure will sit contingent capital (CoCo) type notes, such as those issued at the end of 2009 and earlier this year by Lloyds and Rabobank. Regulators are very keen for banks to have this sort of countercyclical capital in their balance sheets. Once the capital position (currently the tier one ratio) of a bank hits a predetermined trigger level,  these bonds convert into equity and therefore increase the portion of the capital structure that was designed to be loss absorbing all along.

The traditional subordinated notes in a bank’s capital structure – Lower Tier 2, Upper Tier 2 and Tier 1 – according to some, will effectively cease to exist under the new regime. This implies a bank’s capital structure will in future be made up of deposits, covered bonds, senior notes, CoCo’s and equity.

Purely from a bond investor’s perspective – setting equity and deposits to one side – it feels to me as though senior debt will become a rather esoteric asset class. Risk averse investors will buy the covered bonds that the banks are keen to issue, while those looking for higher yields will opt for CoCo’s which they will be forced to issue. If you imagine a situation (shouldn’t be too hard) where a bank gets into difficulty, its CoCo’s are triggered but still falls into bankruptcy. The equity will be wiped out leaving a senior debt holder not only at the bottom of the pile in a liquidation, but also with a claim over fewer assets than they historically would have had, since most of the mortgages would have been pledged to the covered bond pools. Unless they invest in some gunboats, I can’t help feeling that investors in senior bank debt might be in for a rather rough time in the years to come.