Spare a thought for bondholders. In the first phase of the crunch, credit markets were crushed mainly because of mark-to-market volatility – as illustrated by the rating agencies’ actions. Standard & Poor’s downgrades in the financial sector this year amount to $1.2 trillion – outweighing the number of upgrades by a factor of 20 to 1.
This financial crisis is also widely known as the sub-prime crisis but at the moment the real losses, of the kind that arise through a bond actually defaulting, have been relatively limited. The losses in sub-prime RMBS and their resecuritization into ABS CDOs will be substantial. S&P estimates sub-prime RMBS and ABS CDO losses will amount to $378 billion but that is projected losses not defaults.
The demise of Lehman and WaMu has clearly had a dramatic impact on the actual number of defaults that investors have suffered – losses of $150 billion – with who knows what likelihood of recovery.
Ever since the Enron/WorldCom debacle, investors in high-grade bonds had thought that buying regulated bank assets would protect them from jump-to-default risk. To some extent the market had priced in the likelihood that Lehman and WaMu could default. But the response of regulators has been muddled. Why were only WaMu’s covered bond investors brought into the fold and all the others thrown to the wolves? It all dramatically changes the incentives to buying bank debt.
As if that were not enough, things are about to get really interesting for investors in subordinated bank debt and hybrid capital and the banks’ regulators. When the boom in hybrids took off in Europe some nine years ago the sales pitch to investors went thus: "If you like the bank credit you should buy the credit in its most subordinated form". The rationale was that these were highly regulated entities and the extra spread one was paid for owning this paper was largely unwarranted. Few would be under that misapprehension now.
The next year or two will be seminal for bank capital provision. European regulators have made clear their preference for real equity as opposed to the hybrid form. Most of these hybrids have coupons that step up by 100 basis points at the call date. This feature is something that so-called real-money bond investors demanded to ensure that there is an economic incentive for issuers to call.
Given elevated spreads, and the fact that these are unlikely to contract substantially in the near future, any decision to call will not be based on economics but on sentiment and the fear of shutting an avenue for capital-raising. Is it wise to upset investors by not calling, even though to do so would mean leaving institutions short of capital (many banks would be shunned in the current environment) or force them to raise capital afresh at great expense?