Recession-Depression, Banks, Buckle Up, Bail-In

Banks say that they are in great condition to manage through the current economic havoc. It’s true until it’s not true. Banks also said that in May 2008, and we know how that fantasy ended. Don’t believe for even one second that Canadian banks were immune in 2008 thanks to their superlative virtues; Canadian banks were restrained from their American inspired desires by Canadian government regulations and were immunized by near explicit guarantees by the Government of Canada and by open wallet support by the Bank of Canada.

Buckle Up

There will be severe flight turbulence for the next 30 months.

The inflated condo market in Toronto removed condos as a competitive brake on inflation in the duplex and small single-family home markets; of course, inflation in those segments followed. Now, condo unit sales and unit prices are slipping. Rental vacancy rates are rising. “…Capital [Capital Economics] said and it calculates that a 4.5% vacancy rate for Toronto could translate into a “whopping 15% drop in rents.” ”[1] That will deflate all residential markets.  Residential mortgages in all segments as an asset class are at risk.

US major department stores are closing all or some mall locations, with an inevitable ripple effect on secondary mall tenants, which means a crisis for mall owners. If large companies allow many knowledge workers to work from home, they will reduce their occupancy of office towers. Both will have a direct impact on holdcos, REITs and municipal property tax collections. Canada will follow. Commercial mortgages as an asset class are at risk.

One retired bank executive vice president told me that 20% - 25% of small businesses would not reopen. My view is that the ‘not re-open’ and the ‘open and fail within one year’ will be closer to 50%, especially in the low barrier to entry segments. Small business loans as an asset class are at risk.

In January 2020, consumers had high debt levels - and jobs. Five months later, consumers have high debt levels and far fewer jobs. Personal loans as an asset class are at risk.

Large companies want subsidies. It is not just Air Canada! Large companies will attack labour contracts and health and safety regulations. Some will use the Bankruptcy and Insolvency Act to wipe out unsecured creditors and to purge pension plan obligations, meaning seize the net present value of pensions to retired workers to give the money to executives, bond holders and banks. Banks are usually secured but security values are soft. Large business loans as an asset class are at risk.

Sovereign debt (debts owed by national governments) is a recurring crisis, about every decade or so. “According to Fitch Ratings, 2020 is going to be a record year for sovereign debt defaults. ....” [2] Rating agencies have a great track record of identifying the obvious. Sovereign loans as an asset class are at risk.

In the US, “One landlord reported that 80 percent of retail tenants missed rent. The drop in commercial rent payments could imperil property tax collections that pay for city services.”[3] Can Toronto, Vancouver, Edmonton, Montreal and Ottawa withstand lost property tax revenues? Universities and colleges are afraid of enrolment and revenue crashes in the Fall 2020 and Spring 2021 semesters. The MUSH (Municipalities, Universities, Schools and Hospitals) sector as a source of fee income for banks is at risk, and segments of the MUSH sector face turbulence.

Banks cannot get money from the hopelessly insolvent so they will turn a stern gaze and outstretched hand to weak but viable businesses – and that will sink many that might otherwise survive. There will be a glut of liquidated assets. Net realizable values of commercial assets will plummet. Commercial, industrial and personal assets as loan security are at risk. 

The banks must try to save themselves by deleveraging. As the banks attempt to convert advances to customers to cash to pay the banks’ liabilities, there will be a credit drought – funding will dry up. That will further imperil all companies and all Canadians.

Aggressive bank actions to wrestle cash from borrowers are logical and justified in isolation but highly damaging to society and economic activity in aggregate. We should not sacrifice survival of the many to protect the wealth of the few. We already have more than enough inequality. 

Bail-In

Banks will have two problems – liquidity and solvency. Liquidity is having enough cash to pay liabilities. In 2008 – 2009 Canada and other national governments printed money and gave massive cash / liquidity to the big banks.  The Bank of Canada can do it again. That solves the liquidity problem.

Solvency is having more assets than liabilities. If assets are less than liabilities, then a bank, company or person is insolvent and legally bankrupt. Canada and the Bank of Canada could give strongly implied guarantees and dirt-cheap funding to the banks, as in 2008 – 2009. The alternative to bail-outs is bail-ins.

What are bail-ins? Assume that before coronavirus Big Bank had $10B of assets, $9B of liabilities and $1B of equity. Then, Big Bank losses $2B due to defaults across its asset classes. That loss changes equity to a deficit of -$1B, and the bank is insolvent / bankrupt. This triggers a bail-in: the lowest ranked liabilities are converted to equity until $2B of debt is converted to equity. The effect is that Big Bank’s equity is restored to $1B, its Liabilities: Equity ratio improves to 7: 1, and its Equity as a % of Assets improves to 13%. 

 Is it fair? Yes, of course, this happens to large companies in bankruptcy reorganizations (examples: Air Canada and Stelco about a decade ago); the shareholders get diluted or wiped out, and the large company survives.

Is it practical? After 2008 – 2009 Canadian banks were required to issue ‘contingent capital bonds’, meaning bonds that were specifically identified as subject to bail-in. They did. One example is Royal Bank of Canada’s USD $1,500,000,000, 4.650% Non-Viability Contingent Capital Subordinated Notes due 2026 which “automatically and immediately convert into common shares of the Bank (“Common Shares”) upon the occurrence of a Non-Viability Trigger Event.” A Non-Viability Trigger Event is defined as whatever the Office of the Superintendent of Financial Institutions Canada (‘OSFI’) says and whenever OFSI says.[4]

Who decides to force a bail-in? Banks will procrastinate to the cliff edge. So, OSFI should declare that all Canadian banks must immediately bail-in enough to cover maximum shortfalls predicted by OSFI’s stress tests of the banks.

But what about this being a black swan, a truly rare event? Simply not true. This is not a big asteroid strike which happens every million years or so. It is not an earthquake and tsunami hitting Vancouver Island and the BC mainland, which may happen every three or five hundred years. Within the last 20 years Canadians suffered from SARS and knew about Ebola. They have read about the Spanish Influenza, which happened one hundred years ago. Sophisticated investors and their sophisticated advisers knew the risks; and every reader of the contingent capital documents saw what contingent capital means. There are no surprises and there should be no tears for investors in contingent capital bonds or other tranches of bank debt.

What if too much contingent capital is converted? The question means ‘What if the banks are too safe?’ If a bank has excess capital after the coronavirus recession-depression passes it can, subject to OSFI approval, buy back shares.

What if banks need more than their current contingent capital? Restructuring under the Bankruptcy and Insolvency Act would address that hypothetical problem.

Conclusion

Banks, those advocates of capitalism, should drink their own medicine. Federal government regulation must lead the banks, howling and screaming, to actions that are prudential for society and Government must support the banks to achieve socially desirable objectives – a topic for the next post.

[1] Posthaste May 21: The new pandemic risk to home prices in Canada’s big cities — tumbling rent, email from Financial Post <[email protected]>, Thu, 21 May 2020 08:46:08 -0400 (EDT)

[2] https://247wallst.com/investing/2020/05/12/waves-of-sovereign-debt-defaults-coming-for-junk-bond-and-emerging-market-investors/, 2020.05.20 at 06.29 KG.

[3] https://www.nytimes.com/2020/05/21/nyregion/commercial-rent-NYC-coronavirus.html?campaign_id=2&emc=edit_th_200522&instance_id=18661&nl=todaysheadlines&regi_id=57600251&segment_id=28781&user_id=325a10f41913af714870a7a61b2c8ad2, accessed 2020.05.22 at 15.32 KG.

[4] Prospectus Supplement to Prospectus dated January 8, 2016, Filed Pursuant to Rule 424(b)(2), Registration No. 333-208507