Co-op is another reminder of bail-in risk

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Co-op is another reminder of bail-in risk

Moody’s sudden downgrade of Co-op Bank gave investors a very nasty shock, turning their senior debt into junk in one fell swoop. Bankers insist that this is an isolated case — but in reality it shows that investors are ignoring bail-in risk.

To anyone who was paying attention, Co-operative Bank’s troubles were plainly visible. And Moody’s certainly has some questions to answer — namely why it issued such a sudden and severe ratings action in the absence of a fresh credit event. There are plenty of reasons to cry foul.

But the case is also a reminder of how quickly banks can get into trouble. It is eerily reminiscent of SNS Reaal’s rescue, which involved a bail-in of subordinated debt, in February. It was not hard to see that the Dutch bank was heading for trouble, thanks to heavy losses in commercial real estate. But the levels at which its debt was trading told a different story.

Likewise with Co-op. Its 2024 subordinated bonds, callable in 2019, dropped from a cash price of around 85 to 61 on Friday morning, after the downgrade. Twenty points is a hell of a correction, and even though that bond had retraced to around 67 by Monday, there is still a big chance that regulators could call for its holders — as well as the holders of other Co-op sub debt — to face losses.

It happened with SNS, it happened with the Cypriot banks, and it could happen with Co-op. It’s difficult to see how people can continue arguing that every bank failure is an isolated case.

But liquidity is good, and such is the Street’s desire to keep it that way that no-one is willing to acknowledge that there still needs to be a serious pricing correction across the whole market — not only to bring senior pricing closer to subordinated to reflect the increased risk of bail-in, but also to push both curves, senior and sub, wider.

It might be in investors’ short-term interest to trot out the “isolated case” line every time a bank fails and bondholders lose out, but they’re only deceiving themselves.

There are hundreds of smaller banks like Co-op all over Europe struggling to deal with problematic legacy portfolios — without the name recognition or the profit generation to build up the capital needed to cushion against losses.

As the market prepares for the deluge of loss absorbing capital issuance that will inevitably come as banks prepare to comply with CRD IV and the CRR, investors need to take control and start demanding more bang for their increasingly fragile buck.

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