After Popular test, investors ask: what recovery value?

In the early morning hours of 7 June joint statements from the European Central Bank, Single Resolution Board and European Commission announced the decision that Banco Popular Español had been determined as “failing or likely to fail” on the grounds of the entity being “unable to pay its debts … as they come due”.

At the same time, Santander announced the acquisition of Banco Popular for a single euro.

In the course of the overnight resolution process, the Single Resolution Board (SRB) adopted the decision to effectively wipe out the Additional Tier 1 and Tier 2 instruments of Banco Popular, whereby the loss-absorbing instruments helped avoid taxpayers contributing to the rescue.

“The decision taken today safeguards the depositors and critical functions of Banco Popular,” said Elke König (pictured), chair of the SRB, in comments echoed by the European Commission. “This shows that the tools given to resolution authorities after the crisis are effective to protect taxpayers’ money from bailing out banks.”

Indeed, the move was seen as a test case for the Bank Recovery & Resolution Directive (BRRD) and related post-crisis financial regulatory framework. And it was a test initially deemed to have been passed.

“The SRB’s effective execution of Banco Popular’s resolution adds credence to the official EU position that bank creditors will more consistently bear the cost of failure under the BRRD and that the toolkit available for authorities will allow them to deal with problem banks without using public funds,” said Simon Ainsworth, senior vice president at Moody’s.

The Spanish bank’s predicament had come to the fore in early April, when it announced revisions to already weak 2016 results, prompting a deterioration in its capital position and the search for a solution to its troubles. It gradually became clear that an outright buyer or alternative solution would not be found, whilst the bank became subject of heightened media speculation in respect of its liquidity situation and deposit outflows from 12 May onwards. Fears mounted on 31 May when reports emerged that it would likely be subject to resolution measures.

Banco Popular’s two AT1 were nevertheless still trading at a cash price of around 43 (high trigger instrument) and 52 (low trigger instrument) the day before resolution, and its Tier 2 in the 70s. However, they effectively became worthless as they were converted into equity and subsequently written off. In contrast, senior debt rallied as it was protected from bail-in and taken over by Santander — the bank had yet to issue any senior non-preferred style debt. Covered bonds — excluded from resolution tool applications per BRRD — also rallied.

“The market is relatively happy with the solution,” said Vincent Hoarau, head of FIG syndicate at Crédit Agricole CIB. “This was the first major test for BRRD and it delivers evidence that AT1 and Tier 2 instruments are here to absorb losses at the PoNV as foreseen by regulation — the regulators took action and an apparently acceptable compromise was found.”

And in spite of the AT1 wipe-out, market participants took heart from the price reaction of other Spanish securities, with contagion limited to smaller peripheral players with high Texas ratios. CaixaBank had already shown the primary market to be open with a successful debut in the midst of Banco Popular’s woes (see separate article), and other Spanish credits seen as good by the market — not just national champions such as BBVA and Santander, but, for example, Bankinter — remained close to all-time highs in the wake of their compatriot’s downfall.

However, a Banco Sabadell AT1 that was successfully launched on 5 May into a bullish market (see separate article) hit new lows after Banco Popular’s resolution.

“It appears that, post-Popular, initially there was a positive perception around second tier banks, with the level of volatility and headline risk having decreased,” said Hoarau at CACIB. “But the market realises that you can’t make the same assumptions as two days ago — on Tuesday Popular’s AT1s were quoted around 50; on Wednesday investors went home with nothing.

“This is a game-changer for valuations and we can expect credit differentiation to increase. But market participants need some more time to reassess the sector and draw final conclusions from the Popular outcome.”

One aspect of the episode that has quickly come into focus is the timing of the resolution move — before both any coupon was missed and the 5.125% or 7% CET1 triggers were formally hit.

“We, along with many AT1 analysts, have for a long time argued that the 5.125% trigger was too low and should not be relied upon as a hard threshold,” said Eoin Walsh, partner and portfolio manager at TwentyFour Asset Management. “For us, the PoNV (point of non-viability), where regulators step in to protect deposit and senior debt holders, was always regarded as being more important.”

Hoarau also said that any perceived difference in value between write-down and equity conversion loss absorption mechanisms on AT1 should fade.

“We learnt that in this case, AT1 may mean equity, but that equity conversion offers you nothing,” he said. “There have been lengthy discussions regarding the pricing differential between equity conversion and write-down, but we never fully bought the argument that ‘at least with equity conversion you are left with something’ — we always valued it at zero. The PoNV trigger is the most important one, and given the low structural thickness of the AT1 tranche, both high/low trigger and equity conversion/write-down pricing differentials should be close to zero.

“The algorithm for AT1 valuation needs to be rethought somewhat, and a more binary approach adopted,” added Hoarau. “PoNV becomes a theoretical concept, low/high trigger declines in relevance, while Texas, leverage ratio, asset quality, coupon frequency will all be looked at with greater care.”

The literal resolution of Banco Popular’s fate is expected to have manifold impacts on all loss-absorbing instruments from all issuers.

“Italian and Spanish second tier banks are coming under close scrutiny once again,” said Doncho Donchev, capital solutions, DCM, Crédit Agricole CIB, “and the episode has focused investors’ minds on the potential magnitude of losses and recapitalisation needs in resolution and loss-given-default for AT1, Tier 2 and SNP/HoldCo senior debt based on the structural thickness of the tranches and potential sources of losses, with a potential reassessment of fair value pricing across all instruments.”