Perhaps this helps explain the significant underperformance of European and US bank credit today as tonight we get the full downgrade watch treatment for all European bank subordinated debt. Moody's will review 87 banks in 15 countries with the view that average downgrades will be two notches for sub debt. The initial premise for the actions is the removal of government guarantees as they believe systemic support for subordinated debt is more uncertain. The greatest number of ratings to be reviewed are in Spain, Italy, Austria and France. The EURUSD is down around 20 pips on the news and ES 4-5pts.
The market (seen here with the spread between Sub and senior financials) has been pricing in some kind of notable differentiation between senior and sub debt for a while and perhaps this helps explain the modest reaction in EURUSD for now. The systemic bias is worrisome though and we wonder how ISDA will react to any credit events that impair sub debt and leave senior unaffected.
It is very noteworthy that there is a natural capital structure arbitrage between Senior and sub debt for the same entity (or entities). Given the zero floor on recovery and the identical probability of default (i.e. if sub debt triggers an event then senior must), then this leaves senior with an implied maximum recovery rate. As an example, the currrent ITRX SubFin trades 574bps and Senior trades 334bps, this implies (given the same implied default risk and some simple math) that if Senior Debt recovers more than 42%, then Sub debt will recover ZERO. Also of note is both the sub and senior index levels trade notably rich (tight) to their intrinsics (underlying value) - having rallied notably since early Friday - we suspect this will revert rapidly.
Moody's Full Statement:
Moody's reviews European banks' subordinated, junior and Tier 3 debt for downgrade
Review focuses on reassessment of government support assumptions
London, 29 November 2011 -- Moody's Investors Service has today placed on review for downgrade all subordinated, junior subordinated and Tier 3 debt ratings of banks in those European countries where the subordinated debt still incorporates some ratings uplift from Moody's assumptions of government support, with the potential complete removal of government support in these ratings. The review will affect 87 banks in 15 countries in Europe with average potential downgrades of subordinated debt by two notches and junior subordinated debt and Tier 3 debt by one notch. The greatest number of ratings to be reviewed are in Spain, Italy, Austria and France. For issuers whose ratings were already under review prior to today's rating action, the completion of the existing review will now incorporate these additional considerations for subordinated, Tier 3 and junior subordinated debt.
Today's rating announcements follow on from the removal of systemic support from subordinated debt in systems including Denmark, UK, Ireland, Germany and Moody's report "Moody's to re-assess government support in bank sub debt ratings globally" published February 2011.
The review has been caused by the rating agency's view that within Europe, systemic support for subordinated debt may no longer be sufficiently predictable or reliable to be a sound basis for incorporating uplift into Moody's ratings.
This concern is driven by (i) the more limited financial flexibility of many European sovereigns that will increasingly be required to make difficult decisions regarding fiscal consolidation policies; and (ii) the resolution frameworks being discussed by both national and supra-national authorities (for example by the European Commission, which is expected to announce its proposals shortly).
The frameworks have the common objective of reducing very significantly the support provided to creditors and leave subordinated debt holders particularly exposed to exclusion from any support received.
During the review period, Moody's will (i) review the outcome of the expected European Commission proposals on bank resolutions and the implications for burden-sharing with subordinated debtholders; and (ii) interact with regulators and authorities to see if there is any additional information that would lead Moody's to maintain an assumption of support in the subordinated debt ratings.
Moody's believes that systemic support for subordinated debt in Europe is becoming ever more unpredictable, due to a combination of anticipated changes in policy and financial constraints. Policy makers are increasingly unwilling and/or constrained in their support for all classes of creditors, in particular for subordinated debt holders. Moody's notes that there have been recent instances where losses have been imposed on subordinated debt holders without any significant contagion to other liability classes (e.g., in Ireland). Consequently, there would need to be very clear reasons for Moody's to consider retaining an assumption of support in subordinated debt ratings.
For some time, the policy debate and framework within Europe has been moving in favour of imposing losses on subordinated debt holders outside of an insolvency scenario. Proposals and legislative changes to permit this include statutory writedown mechanisms, or mechanisms which enable authorities to either transfer debt between institutions or split up a bank and impose losses on subordinated debtholders. Some countries have already changed their legal or regulatory frameworks to incorporate this policy objective (e.g. UK, Denmark, Germany). There have also been cases where an ostensibly supportive legal framework has been quickly changed to an unsupportive framework, following a weakening of the sovereign and banking system (e.g., in Ireland).
Moody's awaits the European Commission's proposed framework on resolution regimes -- originally anticipated this summer but now delayed -- which the rating agency believes is likely to result in an explicitly less supportive framework for subordinated debt across the EU. However, even if there is a further delay in the publication of the framework, Moody's considers the evidence that sovereigns can quickly change the existing legal framework as reason to continue with the review of systemic support in subordinated debt, given the other pressures on sovereigns in the current environment.
Many of the above concerns were already expressed in Moody's February 2011 publication "Supported Bank Debt Ratings at Risk of Downgrade Due to New Approaches to Bank Resolution". Since that publication, however, many euro-area sovereigns have become increasingly constrained in their financial flexibility and consequently in their ability to support their banking systems. In several cases, the sovereign has faced an increasingly stark trade-off between the need to preserve confidence in their banking systems and the need to protect their own balance sheets.
While the need to preserve confidence may imply some continuing (though potentially declining) support for senior debt -- given the potential for contagion across the banking system -- the rationale for continuing to assume the willingness and ability to provide support for subordinated debt holders is much weaker. Moody's has seen clear precedents that losses can be imposed on subordinated debt holders without any significant contagion to other liability classes. Moody's view is that these pressures go beyond the euro area to encompass all EU members; Moody's will also review to what extent other closely integrated markets outside the EU, such as Norway or Switzerland, are affected by this change in its support assumptions.
IMPACT OF REVIEW
The banking systems and number of banks affected by the review are in the following countries: Austria (9), Belgium (3), Cyprus (2), Finland (3), France (7), Italy (17), Luxembourg (3), Netherlands (6), Norway (5), Poland (1), Portugal (2), Slovenia (2), Spain (21), Sweden (4),Switzerland (2). A list of affected institutions is here:
A full analysis of the effect of the review is set out in the Special Comment published today "Reassessment of Government Support Assumptions in European Bank Subordinated Debt". For the latest details on Moody's global approach to incorporating systemic support in Moody's bank debt ratings please see, "Status Report on Systemic Support Incorporated in Moody's Bank Debt Ratings Globally." Both reports were published today and can be found on www.moodys.com .