World economy

the 20 billion manager who won after the crisis is buying

It is odd how quickly things can change in modern financial markets: what was considered a safe investments mere couple of months ago has just turned into one of the biggest mistakes a bond investor could possibly make – bank debt.

European bank debt was considered one of the safest “risky” investment on the market, until the quotation marks suddenly became redundant. In less than a month and a half, the generous returns reaching as high as eight percent have virtually all but ceased to exist, interest payments or not. In fact, the earnings have been so slim this year that investors are looking at some serious losses, should these major banks not recover in time to pay their interest rates as promised.

Those who opted for the bonds have even more reasons to be worried, as thanks to their choice of financial instruments, banks can safely ‘omit’ payments without technically defaulting, at least from a legal standpoint. This means that, in the worst case scenario, they will be the first to lose money, as this would be the least painful worst case scenario that banks are still in denial over. Should anything go wrong, these bonds can be simply converted to equity and the world keeps  turning.

Some analysts (from CreditSights, for instance) have suggested that Deutsche Bank AG and several others may face some difficulties in meeting all of their obligations for another year or two, although investors and employees alike have received assurances that everything is in perfect order and that there is still plenty of money to go around and nobody will end up short-changed, at least in the next two years, so they should not lose any sleep over such matters after all.

But these concerns are all but imaginary, as European banking system has proven itself vulnerable over and over. The worst part is that it acts as a hub for a huge portion of the global market, and thanks to its connections that stretch the globe, any effect originating from there or just passing through will be felt. At this rate, even the ‘safe’ bank bonds are losing their moniker as people are trying to put as much distance as possible between them and anything that might expose them to unnecessary financial risk – and these banks would certainly qualify.

Investors used to rely on the fact that banks that were too big to fail are a foolproof investment, but it would seem that costs of keeping them in business may soon change all that, if they haven’t done so already. Protection against default has never seemed costlier, not even in 2013, when that was actually the case. But back then there weren’t as many laws and regulations that constricted banks’ free reign over the world of finances.

The latest earnings reports do not look good. Deutsche Bank and Credit Suisse seem to have taken the brunt of the losses, although the shares have dropped across the board, so no major bank has remained unaffected. And when Swiss banks start having troubles, that is usually the sign to steer clear for some time. Still having doubts? The combined bank debt of $102 billion in additional Tier 1 bonds should sort it out then.

A ticking timebomb

The worst part is that these securities are a source of great uncertainty, and potential recipe for disaster. The moment one bank fails to make good on their promise will spark a full-blown stampede across the market, as every single security holder will switch into damage control mode and try to pass their troubles to someone else – and thanks to the reduced liquidity, there may not be anyone willing to take that chance.

Even if it never comes to that, portfolios still get managed from time to time, and when it comes to removing unnecessary risks, these things are usually among the first to go. And since nobody seems to be in a hurry to pick them up, it is a buyer’s market already. This may seem odd at first, considering that the notes in question have some of the highest returns on the market, 7 percent on average, which is actually higher than that of junk credits.

Furthermore, banks missing an interest payment or two is not even the only concern plaguing their investors. Any rise in borrowing costs makes it less feasible to redeem these notes. In simpler terms, it means a bank may even force investors to hold on to bonds until it is more convenient for the bank to cash them out, which is a dangerous precedent. Losing an interest payment is one thing, but getting a significant portion of one’s capital trapped in such unsolicited manner may be the final straw for some. It happened before, and it may happen again.

 

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