"The SNS case this week has had some major significant risks to the "House of pain" in the European banking sector that warrants additional close attention for the remaining subordinated bondholders.
If the recovery rate for SNS LT2 subordinated bonds is zero, the significance for the European subordinated CDS market is not neutral given the assumed recovery rate factored in to calculate the value of the CDS spread is assumed to be 20% for single name subordinated CDS and 40% for senior financial CDS. On top of that, a nationalization, such as SNS case, is not by itself a credit event trigger. Appointing an insolvency official is.
As far as delivery of LT2 underlying subordinated bonds referenced in any CDS contract referencing SNS, you would have to ask the Dutch state for delivery (if the subordinated bonds are not simply cancelled or converted into equity...).
So what's the value of your subordinated single name CDS on SNS? Could it mean single name subordinated CDS are a "House of cards"? We wonder. Oh well..."
At current market pricing, this corresponds to a senior recovery rate of 30-40%. This does not strike us as too low, especially when we consider that (i) the Moody’s average historical senior corporate recovery rate is around 38%; (ii) further developments towards resolution regimes and senior bail-in should increase the senior credit event probability relative to the sub probability; (iii) depositor preference, if forthcoming, would reduce the senior expected recovery rate; and (iv) the recent SNS event highlights a growing likelihood of events with a significantly higher sub recovery rate (for the existing contracts) than 0-20%." - source BNP Paribas.
We disagree with BNP Paribas on the implied recovery rate of 30-40%. It is not too low, it is not low enough at least on the "old contracts" because it relies on Moody's average historical senior recovery so this analysis is backward looking. The senior expected recovery rate due to the evolution of resolution regimes and senior bail-in implies lower recovery rates and wider spread levels in the new contract.
"To examine the difference between these spread measures, we priced a 5-year bond with a 5% coupon in an environment where the default-free yield curve is assumed flat at 3% and the Libor risk-free curve is also assumed to be flat at 3.5%. We considered two cases - first an expected recovery rate of 40% and second an expected recovery of 0%. We then varied the 5-year survival probability assuming a flat term structure of default rates11 and calculated the implied bond price and spread measures. In all cases we assumed k = 1.
Figure 2 Comparison of the model-implied CDS, bond yield-spread and par asset swap spread measures as a function of the full price of a 5-year bond with a 6% coupon. We show this for an expected recovery of 40% (above) and 0% (below).":
Moving back to the subject of the evolution ISDA Credit Events and the impact of expected changes recovery rates on financials, the impact of the new CDS contracts would make the CDS market in the financial space more relevant as per a note from Societe Generale from the 24th of May on the subject:
CDS protection may be more valuable should reported proposals for amending credit derivative definitions be accepted. The proposal is to amend credit derivative definitions for banks and comprises three main points. First, it adds a credit event to capture government enforced bail-in. Second, it expands the list of deliverables in the new credit event and keeps current deliverables available for old events, despite their potential loss-absorption ability in the future. And third, it improves successor provisions to keep CDS protection attached to the debt. Taken together, these may help to avoid a repeat of the CDS insurance failure of SNS while capturing the increased tool-kit available for governments to restructure banks out of bankruptcy. We do not expect these provisions to be retrospectively applied to existing contracts; however the amendments suggest much less value in outstanding sub contracts.
ISDA’s proposed changes would make CDS protection more robust and, therefore, valuable. First, a new ‘hard’ credit event would capture government-enforced bail-in. This would be broadly defined as an action taken by government authorities that alters creditor rights under bank restructuring and resolution laws. By our understanding, this does not include the institution triggering Tier 2 contingent capital (CoCo) clauses, as this is an action undertaken by the entity itself, but it would capture Bankia-type events. If the new credit event trigger is a write-down, the event would not occur until the write-down is permanent or there is nonpayment under prior contract terms. A ‘hard’ event eliminates the maturity buckets of restructuring events. Second, deliverables in the new credit event auction may include the written-down or conversion/exchange proceeds. Again, this is Bankia-event type protection. In the event of complete write-off, à la SNS, par payment would be received by the protection buyer. In addition, deliverables under a current or new credit event could include Tier 2 or more senior securities with write-down provisions as mandated by legislation, provided they are not yet written down. This would enable most Lower Tier 2 debt to be deliverable even if it is loss absorbing Basel III-compliant via legislation. CoCos could be delivered in the new credit event provided they have not yet triggered. This captures many bail-in eventualities. Third, successor provisions would track the debt, enabling subordinated and senior CDS to succeed to different entities. This would keep CDS viable in a good bank/bad bank situation. Also, importantly, the new credit event could occur on subordinated CDS without triggering senior CDS. This may have implications for sub/snr trading levels once the new amendments are in place." - source Societe Generale
On a final note, the US equities market is increasingly being boosted by buybacks, yet another artificial jab in the on-going liquidity induced rally as indicated by Bloomberg's chart, great for CEOs and stock options and their shareholders but probably less so for the health of the balance sheet:
As the CHART OF THE DAY shows, the Nasdaq Buyback Achievers Index has more than tripled in the current bull market and has left the Standard & Poor’s 500 Index behind. The Nasdaq gauge consists of companies that repurchased at least 5 percent of their shares in the previous 12 months.
“Corporations have been aggressively buying back shares,” Jeffrey Kleintop, chief market strategist at LPL Financial Holdings Inc., wrote two days ago in a report. He added that the repurchases are largely designed “to boost earnings per share as revenue growth slows.” - source Bloomberg