Last week the Financial Times reported that investors in Spanish bank hybrids might be about to suffer the fate of the Irish. According to the report the conditions for any banks seeking bailout funds is that they write off their preference shares and subordinated debt first.
A quote from the draft memorandum of understanding says:
“Banks and their shareholders will take losses before state aid measures are granted and ensure loss absorption of equity and hybrid capital instruments to the full(est) extent possible."
In short, the first source of cash to cover bank losses are the amounts invested by shareholders (ordinary and preference) and subordinated debt holders. On the other side of the 'great wall' dividing the various forms of credit risk on banks there is to be no pain for the 'protected species' - senior debt, depositors and cover bond holders.
Now hybrid fans are probably getting ready to launch into their arguments about why Spain, a developed western economy with high levels of foreign debt and a love of (and over-exposure to) residential property, is so vastly different to Australia. The Spanish case is certainly another lesson that local 'first loss takers' (aka hybrid investors) might look to when assessing the downside risks associated with taking the lowest form of credit risk on a financial institution. But that isn't the point of this post.
The interesting conundrum that has arisen for the Spanish is the identity of their 'first loss takers' - largely mum and dad investors convinced by their bank 'adviser' to switch from deposits for the higher interest rates. Just as in Australia, institutions tended to steer clear, leaving small investors (with the aid of their adviser) to take up the slack.
Spain is in the middle of trying to recover from deep recession (or, more precisely, steer clear of financial oblivion). The last thing they need is to be imposing billions of dollars in losses on local mums and dads. Rightly, this is both a political nightmare for the Spanish Government and has lead to all sorts of enlightened thinking on the issue.
According to the Financial Times, the Spanish finance minister, Luis de Guindos has 'admitted that investors should not have been sold the savings products' and stated 'it was an error to sell the preference shares'. What a genius. The time comes to rely on the hybrids to absorb losses (the whole point of them) and the financial ignoramuses in the Spanish Government have just worked out that protecting small depositors by having a bunch of bank employed con-men convincing them to switch to a 'first loss' position might be somewhat defeating the point.
Given the cloud over the selling techniques and the political pressure is there a chance the Spanish Govt will simply fold and compensate small investors for their losses? And, if the Spanish succumb, could it play out the same way if there was an Australian crisis?
Australia has taken the same approach as the Spanish. With a helping hand from the Government regulator (APRA) the banks have worked to protect depositors funds by having their sales force convince a portion of them to switch their funds into 'first loss (and second loss) positions' via convertibles and subordinated notes.
We've made the case that hybrids present investors with a binary outcome. In the vast bulk of cases you will get your high interest and your money back, but in a small percentage you will lose the lot (or the vast bulk of it).
But could it be, in practice, that in that 'small percentage' scenario mums and dads will get bailed out by the Government in some way anyway? The Government may not like self-funded retirees much but could the political pressure of having assisted the banks sell 'higher margin term deposits' be too much to bear?
While the Spanish needed to be smacked in the face with billions of dollars worth of lost votes to recognize the issue, the Australian Government are, at least, on to it. Through their highly effective corporate regulator ASIC (I almost managed to get that down without laughing) they came out 8 months ago and told everyone they were 'worried' that investors might not understand all the risks. At about the same time the Government, through APRA, has been encouraging banks to sell them. Is it any wonder we regularly see Storm Financial style disasters?
Our regulators are all over the shop on the issue. So could there be a chance, when push comes to shove, imposing losses on small investors will be a tough road to take? Could a binary win/lose it all proposition actually be win/bailed out instead?
The actions of the Government and a couple of regulators who've finally woken up, after years asleep at the wheel, are not something on which I'd personally make a financial bet. Government action, often random and illogical, doesn't lend itself to probabilistic thinking. And we would never advise someone on the basis that contractual terms are unlikely to be enforced.
But if you're prepared to back the 'they'll never be able to go through with it' line of thinking then hybrids, or at least the safer subordinated note variants, could arguably stack up.
Of course, hopefully this is not something any of us will ever have to worry about. The Spanish went over the top with their foreign debt, property prices and residential mortgage lending. We're different. We'd never do that.