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The Market for Non-Guaranteed Bank Debt and Non-Bank Financial Debt: Some Options
This note provides some initial thoughts on the issues that we raised in our discussion with you a
few days ago. We try to lay out the problem we see in the market for investment grade bank and
non-bank bank debt. We then define some objectives we think that the authorities would want to
keep in mind in assessing potential actions to try and limit the extent of selling pressure in the
market for these liabilities. We would stress that the market wants better definition on the extent
of government support for various parts of the capital structure of systemically important banks.
This document is very preliminary and via the capital market area of Citi we have developed
much more extensive proposals in the cases of policy options 2 and 3 of this document.
The Problem:
• We see increasing dysfunctionality in the market for non-guaranteed bank debt and non-bank
financial debt (GECC and Amex).
• The counterpart to the sell-off in equity of banks and other entities has been growing concern
by end investors about possible future impairment of claims they own further up in the debt
structure.
• Pricing for 10 year sub debt of banks is in the 53-71 cent range and prices for hybrid debt are
now 25-35 cents on the dollar. Even senior debt is getting discounted ranging from 82 cents
to 96 cents on the dollar for 10 year debt across the sector.
• CDS for all banks have been widening (see Figure 1) as equities have been selling off as
shown in Figure 1 below. Cash bonds have also sold off (see spreads in the case of senior
debt Figure 2 below). Importantly, with the exception of GECC, cash spread widening has
lead CDS wider a fact that suggest that we are not seeing shorts drive this sell off—rather it
is more structural in nature. This negative feedback loop between credit and equities and
vice versa can be damaging for confidence.
• The uncertainty over treatment of claim holders higher in the capital structure after the Citi
transaction and the recent revisiting of value of claims in the case of the Bradford & Bingley
transaction in the UK have deeply worried investors. In US markets the cases of FNM/FRE,
Wamu, Lehman, and most recently the treatment of hybrid debt have all made investors
extremely wary (some have noted that the asset class of bank debt is not worth the job
insecurity risk versus investing in other assets).
• Investors and their credit departments have been systematically trying to reduce notional
exposure to these forms of debt which is putting continued technical pressure on prices of
cash bonds and CDS spreads. In a recent limited survey of key large accounts two-thirds
said they were neutral to overweight financials suggesting selling pressure could continue.
• The value of all outstanding debt and loans out to a set of the largest banks and non-bank
financial entities (e.g. GECC and Amex) is on the order of US$ 2.0 trillion (see Figure 3). The
outstanding amount swamps the capacity to buy this debt under current market conditions
where confidence in government statements about support to systemic institutions is
increasingly not viewed as extending to the debt portion of the capital structure.
• A more detailed breakdown of the value of outstanding senior and subordinated debt (not
including hybrid debt) is about US$ 1.6 trillion. The recent experience in hybrid debt markets
(preferred shares) is causing many end investors to revisit the extent of exposure they want
to have to sub and senior debt in the existing capital structure (see Figure 4 below for the
breakdown).
• Key risks of inaction include:
Figure 1: Selected Spreads and Equity Valuations for US Banks and Non-bank Banks and
Insurance
Spread on Spread on Spread on Stock Px on Stock Px on Stock Px on
Current Spread 3/10/2009 2/17/2009 12/17/2008 Current Stock Px 3/10/2009 2/17/2009 12/17/2008
Banks
American Express 658 648 310 358 13.09 12.17 13.96 19.81
BBVA 150 170 150 102 5.76 5.12 6.05 8.61
BNP 125 127 91 78 30.46 26.65 24.00 34.22
Banco Santander 145 170 153 108 5.18 4.50 5.12 6.70
Bank of America 300 333 205 160 5.76 4.79 4.90 14.62
Barclays 230 235 208 169 89.70 67.50 96.60 145.00
Citigroup 500 570 340 235 1.78 1.45 3.06 7.83
Commerzbank 125 130 87 87 2.88 2.60 2.82 6.09
Credit Agricole 130 130 96 85 7.81 6.90 7.82 8.34
Credit Suisse 240 260 180 187 32.18 25.60 29.18 29.06
Deutsche Bank 155 165 114 145 27.29 22.53 20.08 25.98
Goldman 290 333 265 340 98.80 85.28 85.71 78.78
HSBC 160 160 140 107 429.50 399.00 494.50 672.00
ING 155 170 125 133 3.56 2.96 5.17 6.96
JPM 175 213 138 140 23.75 19.50 21.65 31.86
Lloyds 200 210 175 116 47.80 50.80 51.50 125.20
Morgan Stanley 388 438 355 455 25.43 20.84 19.76 16.50
RBS 215 220 180 138 22.40 21.00 20.70 50.50
SocGen 125 130 132 115 25.28 21.00 22.75 34.81
UBS 335 360 280 220 11.75 9.79 12.17 14.57
UniCredit 225 265 205 132 0.98 0.82 1.12 1.57
Wells Fargo 220 273 153 140 13.94 11.81 13.69 29.98
2
Figure 2: Benchmark Cash Spreads for Senior Bank Debt: Ten Year Maturities
WFC 5.625 17 JPM 6 18 C 6.125 18 GE 5.625 18 GS 6.15 18 BAC 5.65 18
700
600
500
400
300
200
100
Sep 08 Oct 08 Nov 08 Dec 08 Jan 09 Feb 09 Mar 09
Source: Citi
Figure 3: Aggregate Debt Data for Banks and Key Non-Bank Financial Debt –Selected
Institutions
TLGP as % of
Issuer Bonds Loan Total TLGP Bonds + Loans
Bofa-MER $394,767 $38,475 $433,242 $41,700 11%
BoNY $16,778 $705 $17,483 $0 0%
Citi $235,097 $5,281 $240,378 $20,600 9%
GS $187,539 $3,636 $191,175 $14,530 8%
JPM $264,584 $1,519 $266,103 $32,037 12%
MS $187,791 $1,787 $189,578 $18,519 10%
STT $5,100 $0 $5,100 $1,500 29%
WFC $184,604 $1,968 $186,572 $6,000 3%
AXP $50,074 $11,017 $61,091 $5,900 12%
GE $366,251 $22,804 $389,055 $34,721 9%
Total $1,892,585 $87,192 $1,979,777 $175,505 9%
*Value in Millions
Source: Bloomberg
3
Figure 4: Breakdown of Outstanding Bank and Non-Bank Financial Debt as of March 2009--
Selected Institutions
Several objectives we kept in mind in laying out the options below include:
• Speed of action given the need to end the negative feedback loop that is undermining
confidence further and also preserve the gains in normalization of US corporate credit
markets
• Preserve an orderly market for non-guaranteed bank funding until markets return to health.
• Reduce funding costs for bank issuers.
• Reassure bondholders, for whom banks are a major concentration, that their risk is controlled,
their investments still sound, and that there can be orderly exit.
• Find a solution that offers the best cost benefit for taxpayers and promotes reasonable and
fair burden sharing
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• Is admirably international in scope (will fund foreign corporates… but only up to
the unspecified cap linked both to the need for diversification but also the extent
of the corporate's activities in the UK
• This approach in the UK did not require acts of parliament
• Cons:
• Sizeable credit risk from willingness to take exposure down to BBB
• Difficulty of eventual exit strategy, especially on longer-maturity bonds, given
market illiquidity
• In light of urgency we discuss three alternatives. Although not entirely mutually exclusive we
describe their pros and cons and we present these in an order that reflects our view of
urgency. We discuss alternatives where actions can be implemented that have immediate
effects.
• Options to address this near term technical selling pressure include the following:
• Government would guarantee the vast majority of non-guaranteed debt outstanding and
would clarify the standing of different claim holders sooner rather than later.
• The insurance wrap could be full or still partial but would be designed to assure confidence
about the standing of claim holders in some well defined portion of the banks and non-bank
banks capital structure (e.g. Sub debt to Senior debt)
• A clear statement that there would be a commitment to phase out this guarantee as
conditions normalize as has been the case in many countries suffering systemic financial
crises
• One way to create a natural exit strategy would be to have triggers (such as achievement of
an A+ stable rating) that would eliminate the guarantee or alternatively one could charge a
progressively higher fee for this guarantee to assure incentives for exit.
• Pros:
• Heads off the current uncertainty about rights and obligations of those in
different places in the capital structure of these entities
• Requires little/no cash outlay and can be implemented immediately (as in the
case of money market mutual funds)
• Stabilizes the funding markets for such institutions and reduces the need for end
investors to have to reduce notional exposures
• There is precedent for this type of action in light of need to prevent collateral
damage to the corporate credit markets and financial stability at a critical stage
in the recovery
• Can reduce the prospect for systemic risks in near term
• Puts US systemic entities on more equal footing with foreign international banks,
where spreads are inside many US entities given the understanding that
governments more firmly stand behind all debt holders (see Figure 1)
5
• Cons:
• Moves one in a direction where government will be perceived as one step closer
to outright nationalization--as the press would play this up.
• There would be political controversy if this treatment is provided to a subset of
systemic banks vis a vis smaller regional and community banks. However these
deposits could be included as they are relatively small.
• Some would argue that Information value from valuations in debt securities is
lost, as the technicals in this market are creating the appearance of greater
fundamental problems than that which exists in a vicious cycle. Equity prices
could still act as a barometer.
• Timing before issuance of stress test results might compromise government
options in ways they do not want at this point in the process
• Government may view announcement of better earnings at quarter end as the
key and not wish to intervene at this point. However, we think the issue at hand
is not about Q1, but rather the remainder of '09 and '10). There's been enough
disclosure regarding Q1 (JPM, BAC, WFC, Citi, Deutsche Bank, Barclays, etc)
yet spreads are still languishing. Investors will ironically use strength to reduce
exposures.
• Many would argue that a blanket guarantee does not involve sufficient burden
sharing between investors, banks and taxpayers. Hence the issue of how to
structure a guarantee facility and its pricing to meet some kind of test of "political
fairness" would be an issue many would raise.
2) Modify and Expand the TLGP and Set a Floor for Debt Prices--A Partial Guarantee
Approach to allow orderly exit of end investors
• The FDIC would get some backing from the US Treasury (possible allocation of TARP funds)
to expand the scope and duration of the TLGP program and allow eligible financial
institutions to make a one time buyback of their own debt under a special form of Debt
Exchange.
• Banks and non-bank banks would be allowed a window to issue larger and longer maturity
guaranteed debt between 5-10 years with call features that allow issuers to refinance after a
period of some years
• The proceeds of issues could only be used to repurchase existing non-guaranteed liabilities
of the issuing bank, but not at full face value, but rather at prices (spreads) that would be
offered by end investors to reduce their exposures to non-guaranteed debt (perhaps via use
of a reverse auction).
• Eligible FIs would have to pay a fee to the FDIC to participate in this program of say 150
basis points per annum up front for the amount of debt issued under the program
• The maturity of the new FDIC guaranteed debt must be longer than that of the portfolio of
debt being retired to improve the financial position of the bank
• Pros:
• Eligible FIs increase core capital by partially internalizing the market discount of
their outstanding debt securities--this improves Tier 1, reduces systemic risks,
and reduces FDIC's overall risks
• FDIC and taxpayers share in savings by charging the eligible FI an up front
assessment
• Extends the weighted average maturity of the overall debt portfolio by a
minimum of 2 years.
• Existing holders get a more liquid instrument if structured as an exchange--and
the haircut they take in getting this new instrument should reflect the premium
they pay for the improvement in liquidity and credit risk to some degree--but less
egregious than what they would get if sold into a market where few bids exist
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• Allows for sharing of burden between taxpayers, investors and banks so more
politically palatable
• Cons:
• Speed of this kind of approach not immediate as estimating costs to taxpayer
could cause delay
• FDIC and US Treasury may not agree on the terms and conditions
(intergovernmental sharing of credit and other risks)
3) Make corporate debt at or above a certain rating thresh-hold eligible for the TALF
• The expansion of the TALF with appropriate haircuts and terms to allow for use of corporate
debt as collateral could help generate demand for bank and non-bank bank debt (GECC and
Amex etc)
• Current TALF guidelines could accommodate corporate debt but the specific rating thresh-
hold in current market conditions will pose challenges, but evidence exists that the authorities
can be flexible in this program
• There is enough flexibility in the design of the TALF that one could scale the architecture to
purchase of non-guaranteed debt, eligibility criteria (e.g. which names should be included,
haircuts etc.)
• There is likely going to be enough credit differentiation across banks in the US market to
make pooling of debt securities an interesting aspect of this approach if wanted. This could
reduce credit risks overall but certainly would not be required
• Pros:
• This program is very flexible and practical and can be adjusted to the
idiosyncrasies of corporate debt
• Leverage is already present, up to US$ 1 trillion with US$ 100 billion of TARP
money committed (a lot of capacity in light of the amounts needed in markets
already identified under the program)
• The secondary market for corporate debt and its functioning could be improved
and the illiquidity premium in our markets reduced like the UK. One would not
need $US 1.5 trillion at all to do this—the likely amount needed would be far
smaller to effectively place a floor on prices in this market for some period
• No act of Congress or Senate would be needed
• US corporate market is very large so impact could be significant--bell weather
paper
• Cons:
• Not timely as TALF program just starting for other assets and time to expand to
corporates, even if the right direction, will not be immediate with with the
possibilities of delays too execution
• Not clear that the participant in TALF will find a ready way to meet the credit
conditions for issuance of paper
• No real track record given TALF program overall is just starting as opposed to
TLGP that is operational now.
In sum, all three of these options need not be seen as mutually exclusive. One could
envision modifying the TLGP to allow for longer term issues and also provide a whole or partial
insurance wrap on non-guaranteed bank and non-bank financial liabilities as complementary
actions to stabilize the market. Allowing for corporate debt to be eligible under the TALF could as
in Britain have advantages independent of the specific and immediate need to stabilize the US
markets for bank debt. Also any actions need to be transitory and contemplate the best natural
means of phase down as market sentiment and conditions normalize.