Denmark gets it right, forces bondholders to take a haircut

Note from Ben:  The following post is from John in Ottawa

Denmark Makes History with Bondholder Haircut

A lot of the controversy surrounding the financial crisis is that bank senior bondholders have not suffered any losses throughout this financial crisis. You have probably heard the expression, “Privatize the profits and socialize the losses.”

Today, two extraordinary things happened. First, Bloomberg reports that a Danish bank that has already been bailed out once, to the tune of $2 billion will be allowed to fail and bondholders and uninsured depositors will take a haircut.

From Bloomberg:

Amagerbanken A/S, the insolvent Danish lender seized by the government, is the first European bank to be rescued under new regulations designed to ensure senior bondholders suffer losses in a bailout.

Investors in about 2 billion kroner ($360 million) of notes face losing almost half face value after the transfer of 15 billion kroner of the Copenhagen-based bank’s assets to a state- owned company, Bloomberg data show.

Liabilities staying at the failed bank total about 13 billion kroner and include subordinated and hybrid debt, about 5.6 billion kroner of bonds backed by the government, as well as senior unsecured bonds. Denmark is dealing with Amagerbanken under regulations introduced in October designed to ensure taxpayers don’t have to meet the bill when lenders fail.

The bank estimates its assets amount to about 59 percent of liabilities, meaning that creditors, including holders of senior unsecured bonds on which a government guarantee expired Sept. 30 and depositors with more than the insured maximum in their accounts, will face write-offs of about 41 percent.

“The bank hasn’t collapsed and gone into bankruptcy like the Icelandic banks, but has been selectively bailed out with a transfer of assets and a partial transfer of liabilities,” said Simon Adamson, an analyst at CreditSights Inc. in London. “Normally when this happens, senior debt and deposits are protected, such is the sensitivity around them, but this is bank resolution with debt and deposit haircuts, rather than a simple liquidation.”

Iceland’s three biggest banks collapsed and were wound up with debt amounting to more than $61 billion, or 12 times Iceland’s economy.

The second extraordinary thing in my view is that Amergerbanken’s assets are reported as being less than their liabilities. That is, the value of the loans outstanding is less than the deposits.

I’ll get to why this is extraordinary in a bit, but by way of background for those of you not familiar with bank balance sheets, here is what is going on. It may, at first blush, sound just fine that the bank appears to have loaned out less money than they have on hand in deposits. It appears that the deposits can easily cover the outstanding loans. But this isn’t how bank balance sheets work.

Deposits are liabilities because customers can come into the bank and ask for their deposit back. Loans are assets because the bank expects loans to be repaid. Here is the rub. The deposits (liabilities) on the bank balance sheet don’t equate to cash in the teller’s drawer.

When a customer makes a deposit, two entries go onto the bank balance sheet; the deposits (liabilities) are increased and cash (assets) are increased. When the cash is loaned out, cash (asset) is decreased and loan (asset) is increased. Deposit (liability) stays the same. When a banks assets (the sum of their cash and loans due) becomes worth less than their liabilities (deposits) and equity (bank capital), they are technically bankrupt. This is the reported case with this bank.

Their equity was wiped out last year and even the $2 billion bailout has been wiped out, and their reported assets are worth less than their remaining liabilities. The last part of the last sentence is the extraordinary part. Here is why. You may already be familiar with “Bank Failure Fridays.” Every Friday, virtually without fail, the FDIC in the US shuts down three or four or more banks. These are smaller regional and community banks with loan portfolios that are mainly commercial real estate. Strip malls and the like. They have shut down several hundred since the crisis began and there are nearly 1000 banks on their “troubled bank list.”

In every case, and I follow this closely, when the FDIC shuts down a bank they list the assets (loans outstanding) as being greater than the liabilities (deposits). Then they go on to say that the cost to the FDIC, and ultimately the taxpayer because the FDIC has long since gone broke, will be about 50% of the reported value of the assets.

For instance, they may report that the bank had $100 million in assets, $70 million in deposits, and the cost to the FDIC is estimated to be $50 million! Now, just forgetting for a second about equity or bank capital, our example bank should be in the green to the tune of $30 million, but the FDIC is saying that it going to cost them (the bank is in the red) $50 million.

Those loans on the bank’s books and reported on their balance sheets and annual reports aren’t worth $100 million, they must only be worth $20 million ($20 million assets plus $50 million bail out equals $70 million to pay back the depositors).

So, thanks to the Federal Accounting Standards Board suspending “mark to market” rules at the beginning of the crisis (which require banks to fairly report what their loans are actually worth each month) these regional and community banks can pretend they are solvent until the teller’s tray really does simply run out of cash. Then the FDIC obfuscates the situation by representing to the public that the bank has more assets than liabilities when the truth of the matter is, the FDIC has had to write off as much as 80% of the loans.

The second extraordinary item in this Bloomberg report is that the Danish authority marked the assets to market and reported the “marked to market” value of the assets. They didn’t hide the truth! This failure to mark to market is not restricted to regional and community banks. It is the reason that the financial crisis lingers and will continue to linger for years as “to big to fail” banks report that they are solvent, but keep running out of cash because their loans are non-performing and not worth half of what is recorded on their balance sheets.

Oh, and by the way, as long as banks are allowed to report that their balance sheets are healthy, and as long as they keep being bailed out by the Fed, the bankers can keep paying themselves huge bonuses.

John in Ottawa

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14 Responses to Denmark gets it right, forces bondholders to take a haircut

  1. raf says:

    At last we see some proper action. If only the US had allowed bank equity to be wiped out and then converted bond holders to equity.

    On the point about bank balance sheets: if a bank’s balance sheet was reported in the same way a business was then we could see easily how insolvent they are. Their cash balances are always way below their current liabilities and therefore would not qualify as a going concern.

  2. ATP says:

    Thanks, John, for a very informative piece.

    Here’s an excerpt from a column by Mike Pettis on non-performing loans. The whole article is well worth a read.

    “Throughout modern history, and in nearly every economic system, whether we are talking about China, the US, France, Brazil or any other country, there has really only been one meaningful way to resolve banking crises. Whenever non-performing loans or contingent liabilities surge to the point where the solvency of the banking system is threatened, the regulators ensure that wealth is transferred in sufficient amounts from the household sector to borrowers or banks to replenish bank capital and bring them back to solvency. The household sector, in other words, always pays to clean up the banks.”

  3. debunking says:

    I have no issues with bondholders taking a haircut.
    However I dont feel is right for thousand of depositors to get wiped out of any amount above the goverment insured limit.
    In our society you have no real alternative to puting your money in a bank, yet interest rates are close to zero, and if the banks screw up, tough luck for the depositors.
    In my opinion, all depositors must be made whole , especially in this 0% rate enviroment. Bondholders are taking risks and being paid for it, therefore it is only natural that they take a haircut as well.

    • John in Ottawa says:

      I agree that depositors should be made whole. As far as I am concerned, depositors are simply hiring the bank for a service. It’s hard not to see it that way if you take a moment to add up monthly fees.

      The US increased the depositor insurance to $250,000 from $100,000 primarily because small businesses were having their payrolls wiped out when a bank failed.

  4. raf says:

    debunking: absolutely but as john points out above depositors are unsecured creditors. the reasons governments have deposit guarantees is to maintain confidence in the financial system.

    remember the sad fact that nearly all of the “money” in the financial system is debt. so your bank deposit which you believe to be cash, is actually debt. someone else owes it to you.

    the more you peel apart the reality the more ridiculous it all looks.

  5. jesse says:

    Good post, John. Denmark has some history behind it warranting such action, notably its neighbour’s (i.e. Sweden’s) bank failures in the ’90s. I equate bondholder haircuts to removing farm subsidies. Nobody really wants them but neither can many countries hope to remove them without political fallout.

    As for depositors being made “whole”, at some point a limit on deposit insurance needs to breed proper behaviour. In Canada, for one, it is relatively simple for 99% of the population to keep under the limit by using different lending institutions and joint accounts. Using a bank without understanding what it is — and how it’s near impossible for a government to rescue everyone at once — should be required reading for anyone with NW above $1MM. If the bank looks like it’s doing risky things with your money and you’re above the deposit insurance limit, don’t put your money there!

  6. debunking says:

    Agreed, when you put money on a bank, you are lending it to them, that is why they pay interest to compensate for the risk you take by lending them the money. Hoever inthis enviroment with 0% interest, you are just subsidising the bank without getting any comensation at all.
    And if you have more money than the insured limit, how are you supposed to manage it?
    Lets say you have 2million. Opening 20 accounts does not seem to be a reasonable solution.
    I am not talking about individuals only, but most small to medium businesses have this kind of money just to meet payroll obligations and other liabilities at the end of the month.
    It is not practical to open so many accounts.
    Maybe that is why real estate is not a bad asset after all, it is better that you owe the bank rather than vice versa. The risk is on the bank and interest rates are low, it works both ways I guess.

    • buff_butler says:

      I think you have a good point that it would be a good idea to raise the limit. One way arround this limit is I think cash equivalents such as tresuries are titled so they don’t need to be insured by CDIC because you own them directly.

  7. Mango says:

    Who were the bond holders? Local pensions or asset managers, society bears the cost anyway. No real point here and the number is really small

  8. jesse says:

    @debunking: “you are just subsidising the bank without getting any comensation at all”

    Are you sure? Even a 0% return can be viewed as positive if deflation prevails. The point is if you think your bank is exposed to risk that means it could go belly-up, there are other banks you can use instead.

    Take it the other way and look what happened in Ireland. The government took on a blanket guarantee of its banks and now itself has significant risk of defaulting. How about Canada? Are banks exposed to the point where they will default on deposits? Maybe it’s hubris but I don’t see it as likely. Dividends may take a dive and maybe shares might take haircuts but I’d be surprised if it spread to first tier and deposits.

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  10. John in Ottawa says:

    I don’t think very many high net worth individuals lose a lot of sleep over the quantum of deposit insurance. Most of their money is invested in stocks, bonds, ventures, etc.

    Big business has its money in too big to fail banks. Of course, all of Canada’s chartered banks are too big to fail.

    But lots of small business in the US has its money in regional banks. I was in business for a long time and my bank, the Royal Bank, offered me all sorts of services that I considered essential to my ability to do business. Extending me credit was the least of it. They provided me with foreign exchange services, payroll services, accounts receivable discounting services, and so forth. I viewed my relationship with the bank as one of a service organization providing me with essential business services for fee.

    At no time did I consider it possible that the working cash and payroll I kept with the bank could possibly be in danger. It just never crossed my mind that I should consider the deposit insurance limits in conjunction with the amount of cash I kept at the Royal.

    That’s not the case in the US. Businesses in the US choose regional banks to do business with because, in addition to providing the essential business services I mentioned above, the also extend credit; usually a line of credit against current accounts receivable. It’s a good relationship. However, in return for the line of credit, which is extremely valuable to a small business for managing cash flow, the bank will usually insist that they get all the business services. Small business can’t spread their deposits across multiple banks.

    All this must keep American small businessmen awake at night. Is their payroll deposit along with their working cash safe? The most powerful, richest nation in history and this is something their entrepreneurs have to worry about? Damn!

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