Right up to the point when Germanys lower house of parliament passed a Restrukturierungsgesetz (restructuring law) at the end of October, the lower tier two debt of the countrys troubled banks was trading as far as it can be said of any banks sub-bonds in the post-crisis markets normally.
But the imminent implementation of the legislation despite having been in the works for many months was the catalyst for a renewed bout of selling pressure. Commerzbank lower tier two bonds lost five points in a week, while HSH Nordbanks plummeted 14 points. Subordinated CDS spreads also ballooned WestLB went from 205bp to 330bp, for instance.
But what was it that investors found so frightening?
"We think that for any failing bank, ie for a bank that would normally have needed a bailout, there is a material risk that bondholders could end up sharing the burden under the new legislation," wrote analysts at BNP Paribas.
The Restrukturierungsgesetz is Germanys answer to the problem that has bedevilled governments around the world when dealing with failing banks. Its all very well to bail out banks even most voters understand that some sort of financial system needs to remain intact in a crisis but spending public money while private investors go unscathed is a public relations disaster. Its also bad for the business of banking rewarding financial failure and creating moral hazard. And nowhere in the capital structure is that problem worse than it is with lower tier two debt.
After all, the LT2 asset class has always been broadly defined as gone concern capital. That is, holders take losses when the issuer is no longer a going concern. But when struggling banks are kept alive on government capital then LT2 is, in effect, never triggered.
The Restrukturierungsgesetz provides a new resolution regime for German banks in which creditors including perhaps senior debt holders as well as subordinated bondholders are called on to take on a share of the burden of recapitalisation. A first, voluntary restructuring stage would involve the appointment of a restructuring adviser who would help implement a restructuring plan with the German financial regulator, BaFin.
This stage does not include any changes to the rights of creditors although the failing bank could be propped up by new loans which would rank super-senior to existing creditors.
Step two, which would take place if the voluntary proceedings failed if agreement cannot take place involves the failing bank becoming subject to Reorganisationsverfahren (reorganisation). This is similar to insolvency but, crucially for a failing bank, is faster and there are fewer legal options for those affected. Creditors could be swapped into equity and assets could have their claims transferred into a new entity creating a good bank/bad bank. The focus would be on spinning off the systematically important parts of an institution and if these cannot be sold to a private buyer, then the institution can be transferred temporarily to a bridge bank backed by the Federal Agency for Financial Market Stabilisation (FMSA).
This stage is subject to a vote by each class of creditor but if it fails to secure support, the regulator can push through the reorganisation anyway.
The upshot is that investors in bank subordinated debt are a lot more likely than previously to suffer some form of haircut whether conversion into equity, or permanent writedown when a bank approaches failure. And bonds that have until now had their ratings supported by the likelihood of state support will soon be cut adrift implying multi-notch downgrades for many.
"Most at risk would be IKB, Depfa, Eurohypo, Deutsche Postbank, HSH Nordbank and Commerzbank," wrote the BNP Paribas analysts.
Moodys is expected by some to cut its ratings on many securities, even before the bill comes into effect likely on January 1 but the agency itself has not yet committed.
"We are currently analysing the potential impact of the new law," said Katharina Barten, senior analyst at Moodys in Frankfurt. "This includes assessing the probability of the law being used and which type of debt may be affected by it. The process involves talking to a range of market participants and legal experts.
"We mentioned several times before in our research that subordinated debt will likely be under somewhat higher pressure because of the new law, and we maintain that view," said Barten. "If we conclude that the law will have a material impact on certain ratings, we would need to decide on a course of action that is globally consistent."
Where Germany goes, Europe often follows and the Restrukturierungsgesetz is no exception. The European Commission is also now looking at introducing some form of burden-sharing arrangements across the single market.
Towards the end of October it published a framework document for crisis management that floated the idea of a debt writedown mechanism for systemically important institutions."We think that there is no longer a political or public acceptance for bailouts in Europe," said the BNP Paribas analysts. "Therefore, countries pushing such insolvency legislation are bound to use it at some point. We think that this justifies being more cautious on the weaker issuers cross Europe, and more so in the countries where such resolution regime exists."
|The bank they love to hate|
WestLB and crisis go together like Westphalian beer and sausages and yet the institution has managed to maintain its independence through a long history of mishaps. Now, it faces its toughest battle yet as the European Commission pushes for an answer that will mean it will never have to take state aid again. Nick Jacob reports.|
Poor old WestLB. It hasnt taken as much state money as BayernLB. It hasnt suffered total meltdown like IKB. Its dabbling in off-balance sheet subprime was minor in relation to its size when compared to Landesbank Sachsen. It never had quite the same ambition to be in the global investment banking big league like Dresdner Bank. And it didnt even transfer hundreds of millions of euros to post-bankruptcy Lehman Brothers as did KfW. And yet...
And yet for many, the Dusseldorf-based institution represents everything wrong with state-supported banking. Among those critics is the European Commission which in November ramped up its dispute with the bank and started talking openly about having it wound down.
WestLB insiders are pinning their hopes on a four way tie-up to create a Landesbank Mitte, possibly in conjunction with a stake sale to an emerging markets-based institution.
But first, the struggling German lender has to deal with a new dispute over the valuation of Eu77bn of assets transferred to its bad bank which the European Commission said means that the bank received Eu3.4bn more in state aid than it previously reported.
The Competition Commission, whose demands are the driving force behind the need for WestLB to find new ownership, argued that the assets that WestLB transferred to a bad bank in the aftermath of the crisis were transferred at well above their real long term economic value, leading to a Eu6.95bn advantage for the bank.
SoFFin, the governments bank support agency, had injected Eu3bn into WestLB to capitalise the bad bank (Erste Abwicklungsanstalt), while WestLB transferred non-core assets with a nominal value of Eu77bn, representing around 30% of its balance sheet.
But the EC now claims that the assets were overvalued leading to a further Eu3.414bn of effective state support for which WestLB is not providing any remuneration.
Brussels vs Berlin
The Commission said this "further" distorted competition and put too large a burden on the shoulders of the taxpayer. The Commission is therefore extending the state aid investigation that it already had put in place regarding WestLB.
"At this stage either the German government notifies further restructuring measures to compensate for the distortion or the aid should be progressively clawed back," said Joaquín Almunia, the Commissions vice president in charge of competition.
But given that the original valuation was cleared by SoFFin, the government and the Bundesbank, it appears that relations between the Commission and the German government have deteriorated.
Even more worrying for the bank, the Commission also said that its doubts about the viability of the bank had increased. It said that WestLBs adjusted profit and loss projections showed that its business model still relied on comparatively volatile and risky activities.
WestLB, however, maintains that, shorn of its non-core assets, it has a sustainable business model that meets all the ECs previous demands. After Alumnias comments the German finance ministry spokesman was forced to say publicly that WestLB was not about to collapse. And WestLB itself pointed to the original valuations and agreement, disputing the Commissions findings.
"The Commission produced no new facts which support its position in an objective way," said Dietrich Voigtländer, chairman of the WestLB managing board. "Since the spin-off of the relevant non-strategic assets to the Erste Abwicklungsanstalt in accordance with the newly-created Financial Market Stabilisation Act in December 2009, no new facts have emerged which justify the doubts expressed by the Commission."
Piggy in the middle
The bank also expressed surprise when BayernLB pulled out of merger talks on November 4.
"The supervisory board notes that there has not been any detailed examination of the potential synergies and that the data rooms had at BayernLBs behest not been opened to allow such examination," said WestLB. "The Supervisory Board therefore finds BayernLBs decision premature and unjustified."
However, the expectation among bankers is that WestLB could instead link up with Landesbank Hessen-Thuringen (Helaba), Landesbank Berlin and, crucially for its large deposit base, Dekabank.
Meanwhile, Friedrich Merz the CDU politician and Mayer Brown partner that WestLB appointed to the position of "divestiture implementation manager" is continuing in his efforts to find a buyer. This could potentially be a bank based in an emerging market where WestLB operates to support its Mittelstand client base perhaps China, Russia or Turkey.
The thinking goes that the mooted Landesbank Mitte would offer an EM buyer a partner close to German firms active in infrastructure and development.
One banker pointed out that BayernLB announced the opening of a Dusseldorf office on the same day that it broke off its WestLB talks as indicative of the importance of the NRW-based banks corporate clients.But Merz is now working to a tight timetable. Following talks involving finance minister Wolfgang Schäuble and Almunia on November 14, WestLB was given until February 15 to prepare a new restructuring plan.