Waiting for the dust to settle

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Many are praying that the euro crisis does not deteriorate even further, and among the most devout supplicants are M&A bankers. The dark cloud of uncertainty hovering over the eurozone is hardly an enticement to deal-making. Valuations depend on heroic assumptions about future growth and interest rates. Financing deals, especially if they involve more than modest leverage, is more difficult. Above all, every time investors take fright at a particular market a political crisis also erupts, as in Ireland.

The financial sector is feeling the earthquake the most. Banks are at the epicentre. Unlike Greece, the Irish debacle was not primarily caused by the government’s fiscal position. It was the commitment after 2008 to stand behind the country’s banks and the realisation that bad debts were even more massive than originally estimated that brought the European Union, the European Central Bank, the International Monetary Fund and even the United Kingdom to Dublin.

Indeed, so deep is the black hole in Irish banks’ balance sheets that fears have arisen again that Europe cannot afford its banks. The equity/asset ratios of many European banks, including giants such as Deutsche Bank, compare unfavourably with those of their US and UK counterparts. Strenuous efforts are being made to improve the capital position of European banks, but that will come too late if the wild fire really spreads.

Professor Hans-Werner Sinn, director of the CESifo economic think-tank in Munich, argues in his recent book “Casino Capitalism” that the sliver of equity on which too many banks still trade results in an indefensible distribution of gains and losses. In the good times, having only a small equity base effectively gears up profits for shareholders. In the bad times, the losses are born by the taxpayer. Even if the bank is wiped out, the event is so rare that the gains made by shareholders over the years compensate for the loss.

The asymmetry is less lop-sided if bondholders can be persuaded to share the pain. This is the logic behind the proposal floated with impeccably bad timing by Angela Merkel, the German chancellor, that bondholders take a haircut.

The European agreement on rescuing Ireland leaves open the possibility that Dublin will demand that investors in subordinate bonds issued by Irish banks accept that they will not be paid out in full. There is a precedent. Some junior bondholders in Anglo Irish Bank have agreed to a haircut on €750m of debt. Anglo Irish and Allied Irish, together have about €9bn of subordinated debt.

In the case of Anglo Irish, the haircut is more like a scalping: some bondholders will receive only 20 cents on the euro. Given that European banks are very big holders of each other’s debt, it should not be surprising that investors in financial sector companies are taking fright, leaving some bank assets to the vulture funds rather than mainstream M&A.

Concern over what might happen in other countries – Portugal, Spain, Italy, even Belgium – is consequently beginning to raise fears about insurance companies, which are also major bondholders, even though their capital regime is generally considered to be much sounder than that of the banks.

Even more scary from the investors’ point of view is the distinct possibility that sovereign bond contracts entered into with EU members from 2013 could contain a “burden sharing” clause.

The EU hopes that the crisis will have blown over by then and that it will have faced down the markets triumphantly. The clause is therefore meant to be more a statement of principle than an active provision. But European banks also hold enormous quantities of eurozone members’ sovereign debt. The chance that this debt might not be repaid in full could be a powerful deterrent to future investment, or at least raise the cost of borrowing though bond issuance.

Nevertheless, some bondholders do not deserve that much sympathy. Holders of many classes below rock solid senior debt took the risk of higher returns because they did not believe that a restructuring would happen in a month of Sundays.

They guessed wrong. And it is certainly wrong for all bank creditors to expect and demand that the taxpayer – who has no financial stake in the bank short of nationalisation – bail them out. When no less a figure than Mohammed El-Erian, chief executive of Pimco, the world’s biggest bond investor, muses publicly that bondholders should not expect to be untouchable, you know the climate is changing.

Valuing financial institutions against such a background is for the brave. Financing deals is for the very brave. There will be shotgun marriages such as those in Spain, where the government says it wants to halve the number of regional cajas to 20 by the end of the year. But the euro dust will have to settle before the financial sector is safe for M&A again.

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