Covering up the capital structure March 10, 2011 at 8:50 am
FT alphaville earlier in the week pointed out the continuation of a trend we discussed earlier, the increase in the use of covered bonds. Indeed, according to UBS, some Spanish banks in particular are close to their limit for issueing covereds. In other words, all the mortgages that can be used to support covereds, have been.
Now the problem with covered bonds is that they reduce the assets available to senior unsecured creditors in the event of default. If you combine higher covered issuance, then, with the (in my view reasonable) Irish burden sharing, whereby senior unsecured creditors will be on the hook to share some of the costs of a bailout, then the picture for bank senior debt is pretty bleak.
The hard part here is managing the balance between moral hazard and pragmatism. A credit spread is a return for risk, so there should actually be risk. And I don’t just mean liquidity risk. Bank bond holders should actually have capital at risk from default or restructuring (or bail in/resolution) losses. But if we dramatically change both the chances of those losses happening and the size of the loss when it does happen, then bank debt gets a lot more expensive. At a time when bank supervisors want banks to issue more long term debt (see, if you must, the Basel 3 liquidity rules), that might not be the best outcome.