The word 'encumbrance' has received a lot of headlines in the last few months - and rightfully so - after we pointed out the impact that LTROs had in subordinating senior creditors of European banks. As Morgan Stanley points out, this is a considerable problem for bondholders as 'in a wind-down scenario, senior unsecured holders have recourse to fewer assets and hence face a higher loss given default (LGD)'. In understanding just how bad things are for European banks, it is important to focus on 'how much loss-absorbing capital there is beneath you in the bank’s liability stack, as this is the capital that will take losses before senior creditors in the event of a bail-in' which means looking at Deposits as well as encumbrance.
Last night we showed the Loan-to-Deposit ratios for various banks across Europe and Morgan Stanley takes up the offensive noting that the encumbrance effect from depositor preference changes (i.e. withdrawal) is the real threat. While the relative size of the deposit bases of the dozen or so banks that are analyzed below is stunning (with MS estimating best-case recovery in a bank default at around 80% and worst-case a total loss - implying of course that equity is entirely worthless - which we largely knew) and what is very apparent from the pictorial representations of banks’ liability structures is that rather than encumbrance from covered bonds/LTRO etc. the bigger issue for encumbrance of senior unsecured investors is the potential threat from depositor 'runs'.
The key is that all the hope of another LTRO is limited by collateral as policy-makers are well aware that, in a world where failing banks are to be resolved through resolution frameworks and senior creditors are to take losses to shield taxpayers’ funds, banks may not have enough ‘bail-in-able’ debt, given their growing reliance on secured funding sources.
With deposits increasingly impaired - and/or the potential for contagious bank runs if we see Grexit, Europe's problem is 'all about the bank runs' now and we were told yesterday how far off that is.
We would suspect though that was Greece to leave then the move to a Euro-wide deposit scheme - and its implicit exchange of sovereignty for monetary support - would evolve quicker; but the crisis has to come first for European leaders to do anything other than talk.
or as Jefferies' David Zervos recently noted:
"Once mom and pop in the rest of EMU see the Greek banks shuttered, there will be a southern European run. The imbalances in Target2 will shift massively against Germany and their only chance will be to cave in and accept mutual liability bond issuance and deposit insurance.
Basically, we are on the fast track to a Europe with a pan mutual socialized downside, backed by the Germans and ultimately the ECB. It will be a bumpy ride, and we will lose the Greeks and maybe some others along the way. But a smaller, more sound, more stable, more fiscally profligate and more socialist Europe is coming quickly to the global capital markets. And its about freakin' time!"
Deposits and Encumbered/Secured Assets...
[14]
[15]
[16]
[17]
Source: Morgan Stanley