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Tomorrow, June 30th, all payday loan stores will shut down in State of Arizona resulting in thousands of jobs being lost. That is because a payday loans will be banned in this State starting July 1st 2010.

But loss of jobs is not the only concern. The major concern is that many Arizona residents who normally rely on these type of loans to get by, will not be able to take payday loans from their local payday loan stores or their online payday loan lender because of this ban. US economy recovery process has been very slow, and in some States such as Arizona too slow that it is almost not noticeable. That is why payday advances are so much in demand but it seems that these type of loans are frowned up with politicians and State legislators despite the fact payday lending industry had nothing to do with downfall of US economy. It was in fact the big banks and lenders who caused the recession and failed Americans people except at the end they were bailed out by tax payer’s money.

And another concern is its impact on Arizona’s economy as a whole. Arizona has been home to hundreds of payday lenders for past ten years that created jobs and paid high taxes and licensing fees to the State. All these revenues will be gone as payday loan lenders are forced to call it quite starting July.

The European Tier 1 market is dominated by issues from highly rated and rather large banks. While one can imagine one of these banks getting into trouble over the longer term, a sudden credit crisis seems unlikely. Bearing in mind the series of various cases of fraud of corporate issuers, a
similar event in the European banking sector could be a real stress test for the Tier 1 market. It is realistic to assume that in this case investors would not only face a repricing of the market, but also that there may be a period without a bid for the issues. With regard to the different structures of Tier 1 issues we believe that bonds with equity settlement features are most likely to be called, even if the issuer is in serious financial problems at the call date. Therefore, one can ask why banks do not issue common equity instead of Tier 1. The simple answer is that it is cheaper for them.

From historical experience we can see again that the real risk for bank capital investors is not coupon deferral or liquidation, but a temporary liquidity crisis that leads to spread widening and mark-to-market losses. Of course, Tier 1 and Upper Tier 2 issues are more likely to suffer a massive spread widening than less subordinated Lower Tier 2 bonds. The examples above show that in crises prices are driven by traders, not by investors. Therefore, in the short term, fundamental arguments do not play any role. The immediate target for a spread widening is set by historic experiences. Hence, stress testing based on historic data does make sense to create worst-case scenarios and estimate the possible loss that is not exceeded with a high probability.

In 2002 and 2003, the spread differential between Tier 1 preferred and Upper Tier 2 has exceeded the spread differential between Upper Tier 2 and Lower Tier 2 in the Euro market for most of the time, as we can see. This observation does not correspond with S&P’s methodology for rating bank capital. Investors seem to disagree with the rating agency that the step from dated to perpetuity justifies a larger increase of the risk premium than the step from cumulative to noncumulative. It also highlights that the spread differentials between Upper Tier 2 versus Lower Tier 2 and Tier 1 versus Upper Tier 2 do not necessarily move in tandem. However, these observations should be interpreted with caution, because the indices that we have used to construct the time series are based on differing issuer universes.

Generally, we believe that the spread difference between Lower Tier 2 and Tier 1 bonds of the same issuer should primarily reflect the maturity –
or rather call date – extension associated with switching out of a Lower Tier 2 into a Tier 1 bond of the same issuer, and the risk premium required
to move down the capital structure. As a proxy for the risk premium we use the implied equity volatility of the bank’s common stock. A switch from a Lower Tier 2 to Tier 1 may involve issues with different maturity and call dates, respectively. Hence, the subordination premium should be greater between securities of different tenors. Since investors are usually more comfortable holding Tier 1 debt of highly rated banks which normally have a stable equity base, the subordination premiums tend to vary by the issuer’s rating and the issuer’s implied equity volatility. Typically, the more highly rated an institution, the lower one would expect the subordination premium to be, and vice versa. This relative value analysis is therefore most effective for comparisons of similarly rated banks.

Different degrees of subordination, not only in relation to the position in the capital structure but also to the structure of a banking group, of course, have a substantial impact on spread levels. At the same credit spread, we would prefer to own debt from the operating company rather than from the holding company. When it comes to the different types of subordinated bank debt, one may try to estimate fair spread differentials between Lower Tier 2, Upper Tier 2 and Tier 1 preferred. Yet, this proves extremely difficult. Since the data on defaults in the banking sector is scarce, the only way to estimate the fair spread differential for two bonds of a certain issuer is to impose assumptions with respect to default probability and loss given default to value the embedded options of extension, step-up, coupon deferral and cancellation of coupons. While sophisticated models may come up with an estimate of fair value spread differentials, liquidity as well as supply and demand can lead to substantial deviations of the actual spread differential from fair value, even in the longer term.

To gauge the effect of severe exogenous shocks it is helpful to look at historical spread levels. The most recent events that might have had a large impact on Tier 1 spreads were September 11, 2001, and the Worldcom collapse at the end of June 2002. Both events caused corporate spreads across all sectors to widen, but being one of the most volatile market segments Tier 1 spreads suffered far more than other sectors. After September 11, Tier 1 spreads widened about 70 bp on average, while Lower Tier 2 spreads widened a scant 20 bp. Although there was virtually no
trading going on for two weeks, traders marked their books wider. When trading resumed, Euro Tier 1 spreads quickly retraced half of their widening.

Thus the liquidity crisis was short-lived, which was a sign of the high confidence of investors in the strength of the issuers. A quick glance at the
Euro subordination chart clearly shows how much spread compression Tier 1 and Upper Tier 2 bonds have experienced during 2003.

No coupons on Tier 1 preferred have ever been canceled, and no bank with Tier 1 issues outstanding has ever gone bankrupt. However, some issuers have experienced significant problems that questioned their ability to pay coupons. There are two major reasons why there has been no default on payments of interest or principal so far:

Access to capital markets is vital for any bank. Therefore, it would do anything possible to avoid coupon deferrals or default.

Governments tend to support major banking groups when financial resources are exhausted. Prominent examples for government support are Banesto and Crédit Lyonnais in 1993/94. With that in mind, the primary risk does not seem to be coupon deferral, that the issue is not called at the first opportunity or even that the issuer defaults, it is rather the possibility of incurring substantial mark-to-market losses because of issuer-specific or economy-wide problems. Consequently, the risk budget and the degree of risk aversion of the portfolio manager essentially determine his ability and willingness to invest in Tier 1 preferred, and to hold onto these investments even in phases of high volatility and severe spread widening. Investors concerned with short-term mark-tomarket losses may tend to prefer Lower Tier 2 issues.

Confidence in structures and regulatory supervision as well as in the financial strength of the issuers have contributed to a remarkably resilient Tier 1 market. External shocks like September 11 nevertheless will impact the spreads of Tier 1 issues more than other types of bank debt. So far the market has benefited substantially from the discipline of the issuers. No Tier 1 issuer has ever knowingly allowed a Tier 1 preferred to step-up. While from the perspective of the issuer the risk of letting an issue step-up is rather reputational, we believe that it could impact the confidence of investors in the overall ability of issuers to pay coupons significantly. With respect to the overall sentiment for the market segment it will be important to monitor the ability and willingness of bank issuers to call not only their Tier 1 preferred issues, but also Upper and Lower Tier 2 instruments at the first opportunity. Especially, the Lower Tier 2 market is considered a fairly attractive and liquid market segment by many European investors. We see that there is sufficient market breadth and depth to implement relative value trades and to generate a variety of risk/return profiles.

After the introduction of the Euro the Tier 1 market has become a fairly large and liquid market with an established investor base. Between 1998 and 2003, the volume of the Tier 1 universe has increased from 1.5 billion Euro to more than 60 billion Euro. European investor demand for Tier 1 product has been supported by a diminished ability to generate outperformance by playing the differences in interest rates and currencies after the introduction of the Euro, falling government bond yields, and a recognition that credit will be the primary means by which to add value in fixed income
portfolios. The inclusion of bank capital in major European credit indices In 2002 also contributed to broadening the investor base.