Investors Viewing European Banks With a Wary Eye

BOND STRATEGIST: Spreads are widening among European-bank bonds, while holders of Cypriot bonds are now at a greater risk of impairment in future bailouts

Dave Sekera, CFA 3 April, 2013 | 6:16PM

Credit indices weakened slightly last week as the markets digested the broader potential impact of the Cyprus bank restructuring. The average spread of the Morningstar Corporate Bond Index widened 1 basis point to +140 and the average spread of the Morningstar Eurobond Corporate Index widened 3 basis points to +141, whereas the credit spreads of European banks widened significantly. For example, Markit's iTraxx Senior Financial credit default swap index widened almost 50 basis points to +205. 

The impetus for this spread widening is the market's realisation that future bank bailouts will be conducted at the expense of shareholders, bondholders and uninsured depositors (in that order), instead of being offloaded onto taxpayers. Under this new bank restructuring template, bondholders are now at a greater risk of impairment in future bailouts and are thus requiring a higher return. Another implication of this restructuring is that local politicians will have little, if any, say in a banking restructuring. While the original Cyprus proposal to "tax" the depositors required parliamentary approval, no such government approval was needed to effect the terms of the final restructuring.

Cyprus Losses Cut Deep Into Banks' Capital Structure

It appears that the Cyprus banks have been struggling with losses incurred from the Greek debt restructuring as well as substantial nonperforming loans for quite some time. It wasn't until deposits began to flee the country in earnest during February that a liquidity crunch quickly became a solvency issue. This highlights how a crisis can build over a longer time than you would expect; however, once liquidity begins to dry up for a financial institution, it can quickly become insolvent. We were surprised at the depth of the impairment into the capital structure and the severity of haircuts suffered (estimated between 40% and 80%) by the uninsured depositors. 

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Intesa Sanpaolo1.40 EUR-1.33

About Author

Dave Sekera, CFA  is a senior securities analyst with Morningstar.

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