More SIV trouble from Europe this time

黑山老妖

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April 10 (Bloomberg) -- Just when you thought it was safe to head back into the financial water, another market threatens to go sour, potentially leaving investors holding the bag for more than $9 billion of tarnished European bank debt.

Once again, the landmine is in a sleepy corner of the global debt markets. Once again, things that never happen are happening. And, once again, those lovely mathematical models used to measure risk may turn out to be as useful as chocolate teapots.

European banks raised a bunch of money in the past decade by selling callable notes, known as LT2s. The clue to their ability to turn toxic is the word ``callable,'' meaning borrowers have the option to repay the bonds early, on preset dates.

Because investors expect to get their money back on the earliest call date, they treat the securities as less risky than if they had to wait until the later maturity date. Moreover, there's an alternative flavor of these bonds called perpetuals that don't even have maturity dates -- if the borrowers choose not to exercise the call options, investors never get repaid, instead receiving interest in perpetuity.

The market is at risk because one borrower has broken ranks. Credito Valtellinese Scrl ignored the April 30 call date on its 150 million euros ($236 million) of notes. As a result, the bank will pay a penalty interest rate of 160 basis points more than money-market rates -- higher than the 100-basis-point premium it paid for the past five years, though still lower than it would probably pay to refinance.

In Denial

The financial community is in denial about the implications of this never-happened-before event, much like it has tried to ignore the parade of unprecedented black swans landing on the lake of finance for the past year.

Analysts at Royal Bank of Scotland Group Plc said in a research note it would be a mistake to get ``spooked just yet by the actions of a small bank that doesn't have a lot of issuance out there.''

``We expect large, strong banks to continue to redeem LT2 at the call date, no matter what the cost of replacement capital would be,'' the analysts wrote. ``We expect more pressure on those smaller banks with low-capital ratios. Second-tier banks face difficulty in raising new bank capital right now regardless of offered spreads.''

Extension Risk

The risk of not getting paid when expected is called extension risk, and it affects your investments because of a feature called duration. Put simply, if you own two bonds that are identical except for their maturity dates, the one that has longer to repayment is more risky than the one that is shorter.

There are almost 8 billion euros of LT2 notes that are callable this year, according to analysts at BNP Paribas SA in London, with a further 1.2 billion euros of similar notes called upper tier II capital notes.

Guess where a chunk of this debt ended up? Stashed away in the $400 billion market for structured investment vehicles. SIVs are already suffering after the trick of selling cheap commercial paper and using the proceeds to buy higher-yielding debt turned out to be unsustainable. Another dollop of unpleasant surprise is just what that market doesn't need.

The structure of the LT2 notes supposedly made the call dates sacrosanct. The interest-rate jump was designed to motivate early repayment. That fails, though, when it becomes more expensive to refinance the debt than pay the penalty premium. The jump in bank finance costs in recent months takes away much of the presumed pain of not retiring the debt.

Reputation Risk

Reputation risk is also supposed to protect investors. The theory goes that no bank would risk irking its bondholders by disregarding the call date, for fear of being penalized, if not rejected, on its next attempt to tap the market for fresh cash. Again, that's not much of a stick when the reputation of the banking community is already in tatters and investors are demanding usurious rates to provide new capital.

There's another twist to the tale. Because exercising the call option messes with a bank's capital structure, the repayment has to be sanctioned by regulators. Banca Antonveneta SpA, an Italian lender bought by Banca Monte dei Paschi di Siena SpA last year, has asked the Bank of Italy to agree to its repaying 450 million euros of notes at the April 23 call date.

The authorities, though, may be reluctant to allow firms to weaken their finances in the current environment. Credito Valtellinese's heresy may swiftly become commonplace.

``The banks and treasurers we spoke to surely don't want to be the first to miss a call,'' wrote Olivia Frieser and Axel Swenden, analysts at BNP Paribas in London, in a note published yesterday. ``However, if banks start more generally to miss calls, so will they.''

One borrower missing its call option is a one-time event; two begins to look like a trend, in which case the herd mentality of financial markets might kick in. If enlightened self-interest among banks is all that stands between investors and another debt tsunami, the track record of recent months suggests bondholders should prepare to batten down the hatches for another battering in this credit-market storm.

(Mark Gilbert is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Mark Gilbert in London at magilbert@bloomberg.net