A recent conversation with Prof. Edward Kane of Boston College and today’s news that Royal Bank of Scotland PLC had the most actively traded bond in the US of any European Union issuer prompted us to open up the Kamakura Corporation archives from the credit crisis.
We did a study in 2009 showing how the probability of a government rescue causes traded credit spreads and reduced form probabilities of failure to diverge, using the examples of FNMA and Citigroup. Prompted by research from Prof. Kane, a perusal of the credit spread and default probability histories for a large number of banks in Europe showed the pattern we see below in the case of the senior non-call U.S. dollar bonds due 2021 from the Royal Bank of Scotland PLC (RBS) (RBSPF).
Default probabilities at 1 year (in orange) and 10 years (in green) are beginning to push through the credit spreads (in blue) as we observed so often in the heart of the credit crisis. The term structure of senior non-call credit spreads in U.S. dollars for RBS shows the phenomenon clearly.
The chart above is a cross sectional view as of Friday’s close of the annualized default probabilities from Kamakura Corporation in orange versus the (annualized) senior non-call U.S. dollar credit spreads for Royal Bank of Scotland. We’ve re-entered an era where, for a broad array of European financials, bond prices are pricing in a positive probability of a bail-out of senior debt holders. As we saw with FNMA and FHLMC, where the ISDA auction to resolve the credit event of the conservatorship resulted in a par payout on senior debt, preferred stock holders and common holders can be wiped out even when senior debt holders are rescued. Indeed, that was the standard outcome for many firms in the financial crisis.