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Tuesday, 29 November 2011

Moody’s: Is your subordinated debt not implicitely warranted by the government anymore? There goes your rating!

Moody’s is on the warpath again. The credit rating agency – together with its competing colleagues S&P’s and Fitch – rather wants to be accused of being (too) early than being too late with their warnings on bad or deteriorating credit. Therefore Moody’s is firing at will at all forms of credit that give the company a hunch of possible deterioration in the future.

Today’s target of choice was subordinated debt held by banks. The victims were 87 European banks, of which six in The Netherlands (click this link for the complete list of banks and debt ratings): ING Bank,  ABN AMRO Bank, Rabobank Nederland, SNS Bank, Friesland Bank and Royal Bank of Scotland.

The debt group referred to as ´subordinated debt´ doesn’t count anymore as Core tier one capital under the new Basel III rules and also the (implicit) government guarantee on this kind of debt is likely to vanish.

In other words: people or companies that bought this subordinated debt cannot assume anymore that the banks that issued it will be saved by governments at all costs, saving this people´s subordinated debt in the process. Therefore Moody’s is intending to downgrade this debt at banks where it was upgraded a few notches earlier, due to the earlier mentioned implicit government guarantee. Banks that cannot use this subordinated debt as core tier one capital anymore might want to get rid of it too and exchange it for normal bonds.

Moody's Investors Service has today placed on review for downgrade all subordinated, junior subordinated and Tier 3 debt ratings of banks in those European countries where the subordinated debt still incorporates some ratings uplift from Moody's assumptions of government support, with the potential complete removal of government support in these ratings.

The review will affect 87 banks in 15 countries in Europe with average potential downgrades of subordinated debt by two notches and junior subordinated debt and Tier 3 debt by one notch.

The greatest number of ratings to be reviewed are in Spain, Italy, Austria and France. For issuers whose ratings were already under review prior to today's rating action, the completion of the existing review will now incorporate these additional considerations for subordinated, Tier 3 and junior subordinated debt.

The review has been caused by the rating agency's view that within Europe, systemic support for subordinated debt may no longer be sufficiently predictable or reliable to be a sound basis for incorporating uplift into Moody's ratings.

This concern is driven by (i) the more limited financial flexibility of many European sovereigns that will increasingly be required to make difficult decisions regarding fiscal consolidation policies; and (ii) the resolution frameworks being discussed by both national and supra-national authorities (for example by the European Commission, which is expected to announce its proposals shortly).

The frameworks have the common objective of reducing very significantly the support provided to creditors and leave subordinated debt holders particularly exposed to exclusion from any support received.


Moody's believes that systemic support for subordinated debt in Europe is becoming ever more unpredictable, due to a combination of anticipated changes in policy and financial constraints. Policy makers are increasingly unwilling and/or constrained in their support for all classes of creditors, in particular for subordinated debt holders. Moody's notes that there have been recent instances where losses have been imposed on subordinated debt holders without any significant contagion to other liability classes (e.g., in Ireland).

Consequently, there would need to be very clear reasons for Moody's to consider retaining an assumption of support in subordinated debt ratings.

For some time, the policy debate and framework within Europe has been moving in favour of imposing losses on subordinated debt holders outside of an insolvency scenario. Proposals and legislative changes to permit this include statutory writedown mechanisms, or mechanisms which enable authorities to either transfer debt between institutions or split up a bank and impose losses on subordinated debtholders.

The decision by Moody´s to downgrade this subordinated debt can be defended very well: governments are not always able and/or willing anymore to save the banks at all costs. Read for this subject Peter Atwater at, as he wrote some fantastic articles on ability and willingness by governments. This puts the subordinated debt in the danger zone when the financial situation of banks deteriorates. Therefore this downgrade makes sense.  

The implications of this decision by Moody´s are clear:
  • Current holders of subordinated debt have a problem as their debt has less net worth than (f.i.) a year ago. This will bring down the sales prices for this kind of debt substantially and it might even bring the whole market for this debt at a much lower speed.
  • Banks might want to get rid of their subordinated debt, as it is more expensive than normal bonds (higher risk premium), but doesn´t count for their core tier one capital anymore. This makes it virtually useless
  • Future subordinated debt will be sold at an even more expensive rate, as the lower credit ratings will be translated in an even higher risk premium.

When does the time come that the best investment seems to be: no investment at all?

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