Good News for Savers and Bad News for Bank Bondholders

LONDON -- On top of resolving the ongoing sovereign-debt crisis, the European Union must also aid ailing banks in certain eurozone states.

Pain in Spain and grief in Greece
In particular, banks in Spain and Greece are experiencing what's being described as a "bank jog." In this slow-motion variation on a fully fledged bank run, savers pull out more and more cash from weaker banks. As a result, these sickly Spanish and Greek banks rely increasingly on cheap loans from the European Central Bank.

German Chancellor Angela Merkel has refused to allow the ECB to recapitalize these iffy lenders through direct cash bailouts. This forces heavily indebted governments to use their own limited resources to come to the rescue of their banks, putting more strain on their creaking national balance sheets.

Putting savers before bondholders
However, in a desperate search to come up with a low-cost way to avert a full-blown European banking crisis, the European Commission has come up with one new idea to make banks safer.

At present, when a bank gets into trouble and becomes insolvent or fails, its shareholders get wiped out first. Then savers take a hit -- though most are protected by national savings "safety nets" similar to the U.K.'s Financial Services Compensation Scheme -- which means that bondholders rarely lose out. In other words, the hierarchy of protection for bank stakeholders goes: bondholders (and secured creditors) first, depositors second, and shareholders last.

The big problem for regulators and politicians is that this hierarchy meant that, during the global financial crash of 2007 to 2009, governments bailed out banks in order to rescue both savers and bondholders. Thus, while shareholders took a beating, hardly any bondholders took "haircuts," thanks to the generosity of taxpayers. Hence, this morning, the EC announced that it is considering plans to alter this hierarchy so as to place bondholders second, behind depositors but ahead of shareholders. By introducing this change, the Commission hopes to avoid future taxpayer-funded bailouts of risky banks -- but not before 2014 at the earliest.

A blow for bondholders
While this step would be great for savers, who would enjoy greater protection when banks collapse, it would be a bitter blow for bondholders. Being ranked behind savings -- instead of ahead of them -- makes bank bonds a much riskier proposition for investors.

Thus, while the EC loves this latest proposal, bond buyers are deeply unhappy. Relegating bonds behind deposits makes them inherently more risky. As a result, bond yields would need to rise -- and prices fall -- to compensate for this increased risk of loss.

Right now, it's estimated that Spanish banks crippled by toxic property loans need to find at least 80 billion euros in extra capital. Some of this money could come from issuing bank bonds, which investors would be wary of buying, were this rule change to be introduced. Hence, Spain's government will surely have to save its banks, probably aided by a sovereign bailout from the EU and the International Monetary Fund.

Bad news for British bondholders
As well as being a headache for European banks desperate to increase their capital buffers, the EC's proposal would damage the value of bonds issued by British banks.

During the financial meltdown, private investors boldly bought these bonds, attracted by their plunging prices and soaring yields. Consequently, today brings worrying news for investors in high-yielding bonds issued by the likes of FTSE 100 giants Barclays, Lloyds Banking Group (NYS: LYG) , and Royal Bank of Scotland. Indeed, were this EC proposal to be introduced retrospectively and thus apply to all bonds, it would depress the value of U.K. bank bonds already in issue, producing considerable losses for existing bondholders.

In summary, I agree with the European Commission's desire to make banks' owners, bondholders, and unsecured creditors bear the cost of future bailouts, rather than governments and taxpayers. Then again, these Eurocrats need to put more thought into how this step could hit current bondholders. Otherwise, I suspect a raft of class-action lawsuits would follow this regulatory change!

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