Wednesday, March 11, 2009

Banks’ Bondholders May Be Next to Share Bailout Pain

On Bloomberg by David Mildenberg and Bryan Keogh:

Citigroup Inc. and Bank of America Corp.’s bond prices are sliding on concern that owners of debt issued by U.S. financial firms will be forced to swallow losses if the industry needs another bailout.

U.S. bank debt has lost 7.6 percent and yields have jumped to record levels compared with benchmark rates in the past month, even after taxpayers committed more than $11.6 trillion to prop up financial firms. With shareholders almost wiped out at banks like Citigroup and lawmakers resisting more rescues, holders may be asked to swap bonds for new debt that offers reduced interest rates or lower face values, analysts said.

“The bond market is getting more scared every day,” said Gary Austin of PDR Advisors in Charlotte, North Carolina, who manages $450 million in fixed-income securities. “At some time, the government is going to say enough is enough, the only way we will give you more cash is if the bondholders have to be hit.”

Debt investors are an attractive target because of the size of their holdings -- more than $1 trillion just at the four largest U.S. banks -- and because they’ve emerged almost unscathed so far. Since any reduction in debt at a bank helps boost capital ratios, members of Congress including U.S. Representative Brad Sherman, a California Democrat, say it’s time for bondholders to share the pain.

“These banks can go into receivership, shed their shareholders, shed or reduce the amount they owe to their bondholders and come back out much stronger institutions,” said Sherman, who sits on the House Financial Services Committee, in a statement to Bloomberg News. More U.S. capital might be offered as part of the package, he said.

Record Spread

Yields relative to benchmark rates on bank bonds average a record 8.23 percentage points, 3.65 percentage points more than industrial companies’ debt, according to Merrill Lynch index data. Before August 2007, when the credit crisis began, bank bonds paid spreads less than industrial-related debt.

Standard & Poor’s, which cut Bank of America’s credit rating this month to A from A+, expects the Charlotte, North Carolina-based company to break even this year because it’s hobbled by losses on credit cards and home loans. If it posts a loss this year, more government assistance may be required, raising “the possibility that debt holders could then be required to participate,” S&P said in a report.

“It’s only intuitive that the government would contemplate the thought, ‘Why are we only putting this on the taxpayer?’” S&P credit analyst John Bartko said in a telephone interview.

Sagging Prices

Scott Silvestri of Bank of America and Danielle Romero Apsilos of Citigroup declined to comment. Bank of America won’t need further government assistance, Chief Executive Officer Kenneth Lewis said in a Feb. 25 interview. The U.S. government is examining ways to further stabilize New York-based Citigroup if needed, the Wall Street Journal reported yesterday, citing people it didn’t identify.

The concern among debt holders is reflected in Citigroup’s $789 million outstanding in 7.25 percent subordinated notes due in October 2010, which fell 7 cents today to 70 cents on the dollar and have lost 23.7 cents in the past three weeks, according to Trace, the bond-pricing service of the Financial Industry Regulatory Authority. That puts the spread over Treasuries of similar maturity at 32.7 percentage points. Bank of America’s 7.4 percent senior subordinated debt due in January 2011 rose 3.4 cents, to 83.5 cents on the dollar. They traded at 98.9 cents about a month ago.


Trust-preferred shares of Bank of America and Citigroup were trading at less than 30 cents on the dollar and yielding more than 25 percent because investors anticipate restructuring, said Tim Anderson, chief fixed-income officer at Riverfront Investment Group in Richmond, Virginia.

“The current prices imply that the companies’ equity is worthless, the government’s investment is worthless and subordinated debt holders will lose some of their investment,” said David Darst, an analyst at FTN Equity Capital Markets in Nashville, Tennessee.

Citigroup, once the world’s biggest bank by market value, dropped below $1 in New York trading for the first time on March 6. The bank jumped 38 percent yesterday in New York Stock Exchange composite trading after saying it was having its best quarter since 2007. The stock added 6.2 percent today to $1.54, and Bank of America rose 2.9 percent to $4.93.

GMAC Debt Swap

Investors have been losing confidence that Citigroup can fully recover after more than $37.5 billion in losses and a government rescue involving $52 billion in preferred shares to boost capital and $301 billion of guarantees on mortgages, junk- grade loans and subprime-tainted securities. The Treasury on Feb. 27 agreed to convert the preferred stock it owned in Citigroup to common shares, gaining a 36 percent stake.

The sell-off in senior bank debt is “completely baseless,” according to Tim Bond, head of global asset allocation at Barclays Capital, who told clients in a note today that prices are reacting to “inchoate, illogical and poorly reasoned fear of political risk.” Prices are “cheap,” creating an opportunity to lock in attractive yields on senior bank debt that has been made more creditworthy than a few weeks ago because of the added government support, he wrote.

Any so-called “haircut” to bondholders might be patterned after the $38 billion debt swap at GMAC LLC last December, in which investors including Dodge & Cox accepted as little as 60 cents on the dollar. Reducing the debt was supposed to boost the auto and home lender’s capital ratios so it could qualify to become a bank and get access to federal bailout funds.

Debt Holders

The debt swap achieved only part of its goal after some holders refused to participate, betting correctly that the U.S. would save the Detroit-based lender anyway because its auto loans were needed to keep General Motors Corp. in business.

Most U.S. bank debt is held by insurers and foreign investors, with a small portion owned by mutual funds, said FTN’s Darst. The Investment Company Institute, a trade group representing mutual funds, doesn’t keep statistics on fund ownership of bank debt, spokeswoman Ianthe Zabel said.

Investors shouldn’t increase holdings that lack explicit government guarantees because “extreme losses” could force senior creditors to share in bailout costs, JPMorgan Chase & Co. said in a March 6 report by Srini Ramaswamy. While the scenario remains remote, owning the banks’ senior debt isn’t attractive when there’s concern about systemic risk, Ramaswamy wrote.

“We’re seeing the start of the next leg of the crisis and that’s going to be financial bondholders taking a haircut as lenders default,” Mehernosh Engineer, a London-based strategist at BNP Paribas SA, said this week. “There’s been a perception that banks’ senior bondholders are untouchable, but that’s going to change.”

Systemic Stress

Contracts on the Markit iTraxx Financial index of credit- default swaps linked to the senior debt of 25 banks and insurers were more expensive today than the Markit iTraxx Europe corporate index. That hasn’t happened since Lehman Brothers Holdings Inc. went bankrupt in September and, before that, JPMorgan’s takeover of Bear Stearns, according to BNP Paribas. It reflects “systemic stress” in the financial system.

Forcing bondholders to take losses could drive the cost of capital higher for banks, said Thomas Atteberry, a portfolio manager at First Pacific Advisors in Los Angeles with $3.5 billion in fixed-income assets. That’s not all bad, he said, because it may help ensure banks don’t do the same kind of “sloppy” underwriting that set off the credit crisis.

Investors who choose to lend money to banks like Citigroup, which Atteberry said was poorly run, “should share the pain of a business that’s having to write things off,” he said.

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