Thursday, March 5, 2009

Some guarantees are more equal than others

By Richard Barley (Wall Street Journal):

At least that is what traumatized investors have decided following the scramble by governments to prop up the financial system last year.

Just look at the market for government-guaranteed bank debt, an asset class created in October after the collapse of Lehman Brothers.

[Government-guaranteed bank debt issuance]

The moves have successfully provided a route to financing for banks. In the U.S., issuance under the Federal Deposit Insurance Corp.'s Temporary Liquidity Guarantee Program stood at $158 billion by the end of February, according to Dealogic. In Europe, €104.7 billion ($131.8 billion) of euro-denominated guaranteed paper was issued between October and March. That compares with only €18.4 billion of unguaranteed senior bank debt, according to Société Générale. There also was some guaranteed dollar-denominated issuance by European banks.

And even that small amount of unguaranteed paper probably wouldn't have been possible without the large banks having implicit government support, an important benefit of the packages.

But the playing field is far from level. First, there is the perceived strength of the sovereign providing the guarantee. Hence, German-guaranteed bank bonds trade at much tighter spreads over the German government's bunds than their Irish peers. Ireland's sweeping bank guarantees total more than twice its gross domestic product, putting pressure on its triple-A status and its own government bonds.

Second, and more strangely, the market is differentiating between banks from the same country. In Germany, Commerzbank's January 2012 bond trades at 0.78 percentage point over bunds, while IKB Deutsche Industriebank's bond, also due January 2012, is at 0.97 percentage point over. One reason may be concerns about liquidity, given that banks are large buyers of this type of paper. Commerzbank's bond is €5 billion in size, while IKB's is just €2 billion.

Also, despite the guarantee, the market still has concerns about relative credit risk. IKB is rated at the bottom of investment grade, and investors may shy away from the headline risk associated with a possible downgrade to junk status, even if it doesn't affect the triple-A rating on guaranteed debt.

But perhaps France has found the most elegant solution. It has created an agency, the Société de Financement de l'Economie Française, or SFEF, which issues large, liquid bonds and then lends the proceeds to banks. This structure mitigates liquidity risk and removes the ability to discriminate between banks. Investors, meanwhile, benefit as they have to analyze only one issuer.

The French banking system is reaping the reward: SFEF is achieving the lowest funding costs of all European government-guaranteed bank issuers -- some 0.2 to 0.25 percentage point less than German banks.

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