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The Heta Asset Non-Event

Earlier this month, the government of Austria announced that Heta Asset Resolution, the “bad bank” that resulted from the restructuring of failed Hypo Group Alde Adria, would no longer make principal and interest payments on its senior bonds. Austria took this action after it was revealed that Heta had a €7.6bn capital shortfall. The clear implication is that it is not just subordinated debt that can be bailed-in by governments.

Headlines were ringing with tag lines like “The End of too Big to Fail”, or “The Paradigm Shift in Bank Debt” or something like it. I guess the market doesn’t read the headlines, because iTraxx Senior financials widened 2 basis points the day after. Which means it couldn’t care less about Heta Asset Resolution being a floating corpse.

That doesn’t stop people from freaking out about Heta. Please stop freaking out about Heta.

Senior bank creditors had a hypocritical free ride out of the credit crisis. True. Tax payers have ended up on the hook almost every time a bank has wobbled. They are understandably so done with this. The alternative we are seeing is the bail-in. To wit: when a bank that gets into difficulties it will be recapitalised from within the capital structure– first by AT1 holders (who take the prearranged convert into common), then owners of common (who are wiped out), then by subordinate creditor (who effectively have little recovery option), and finally by senior creditors (who hold the recovery option). In that order: note that AT1 bonds are not sub debt.

Why not just go through a wind-up? After all, creditors should stand to lose their invested funds when the investment fails because that’s what happens to creditors sometimes. Let them lose funds in bankruptcy proceedings (or in administration or insolvency or any other country-specific protocol), and press for recovery based on recovery. In other words, let the banks fail and let the market sort out the losses.

The answer is that bankruptcy works great if we are talking about a single bank within a financial ecosystem. The problem is banking systems are prone to contagion. What works for one insolvent bank will not work when half the banking system is insolvent. To arrest a landslide from talking hold, the Fed “bailed in” Bear Sterns via a compulsory takeover by JP Morgan that wiped out equity holders. These deals with competitors may be compulsory but to make them so the terms are extremely buyer favorable. The favoritism and unfairness of the deal-making is palpable and invites adjudication.

The crucial matter in a structured bail-in process is when to trigger a bail-in. It is not straightforward to determine when a bank’s struggle for viability is a hopeless cause and to go ahead and haircut capital instruments. Intervene too soon and other banks will suffer much higher spread to compensate for the perceived whims of a regulator-gone-rouge. Act too late and a bank’s return to viability is too costly for the value breaks anywhere in the capital stack.

Something with the flavor of a prepackaged BK is probably how bail-ins will develop. Creditors will adapt covenants to include necessary information disclosure to assess solvency in a rough and ready way. Banks will know full well that somehow they are going to have to achieve a series of demanding round of balance sheet reduction in a tight time-frame.

The most straightforward tactical solution is to look to unwind trades. For conservatively managed banks the reserves released should help make unwinds reasonably palatable; and where a counterparty is also a bank it, too, may be motivated to unwind. For resolution facilities like Heta and other dogs, the release of accrued reserves is little comfort.

In the case of the latter, when unwind opportunities have been exhausted or are impossible, they will have to try selling off their whole book. If they can find a willing buyer, or a provider of exactly matching hedges to all open trades in their book, then, capital charges would be exchanged for credit charges associated with the hedge provider.

Fail to hit these targets and they get promoted to customer. The next step is either a Fed cram-down where one bank absorbs another over the course of a weekend in a closed-door meeting. It goes to a wind-up and bondholders will have to fill the breach, maybe losing recovery. Or systemic meltdown that draws in taxpayer bail-outs yet again.

Don’t count any of these possibilities out.

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