The following is a long piece, but we feel it has potentially dramatic implications for the bank bond market.
Last week saw the much anticipated capital raisings from Lloyds-HBOS and RBS. Lloyds has managed to raise £13.5 billion in new shares with HMT’s holdings remaining at 43%, whilst RBS has raised £25.5 billion from the Treasury, and a further £8 billion from the Treasury in the form of contingent capital notes. This sees the taxpayer’s economic interest in RBS rise to 84%. Lloyds is also raising between £7.5 billion and £9 billion from the exchange of old subordinated bonds (upper tier 2, tier 1 and preference shares) into new contingent capital notes.
Lloyds’ total capital raising sees it avoid the Government Asset Protection Scheme, wherein HMT guarantees 90% of losses incurred on a book of toxic assets, although it will have to pay £2.5 billion in break-up fee for the confidence boosting that the implicit support provided by the scheme has given to the company over the last 9 months or so. RBS, though, has not managed to avoid entrance into this scheme, but managed to reduce the amount of assets going into the protection scheme from £325 billion to £282 billion. As a sign of the toxicity of these assets, though, RBS’ first loss piece was increased by £20 billion to £60 billion.
But there is a cost to both these companies for their needing substantial government support, and for, indeed, almost bringing down the UK economy. Indeed, last week’s actions clearly indicate that RBS remains entirely reliant on the government money for its survival. The EC has ordered Lloyds to shed 4.6% of its current account market share, and 19% of its UK mortgage market share, by 2013, with a clear drive to try to reduce concentration in the banking system and to avoid banks being ‘too big to fail’. RBS once again comes off worse from this part of the restructuring: RBS will be forced to sell its insurance businesses, arguably the most attractive part of the group at the moment, as well as large numbers of branches in the UK, its payment processing business and its interest in a commodity trading arm. Ultimately, we feel that it is in some way right that Lloyds is given the chance to make a clean break from the APS, given that it bailed out HBOS at the height of the UK banking sector’s woes and at the same time decimated its theretofore strong franchise. RBS, in contrast, was not so much a solution as a large part of the problem, and in some way has been and will continue to be treated as the UK banking sector’s whipping boy.
But the most relevant part of all this to us as bondholders, aside from the clear and much-needed improvements in the equity positions of the two banks, is the liability management exercise being undertaken by Lloyds to generate £7.5 billion in contingent capital from exchanging existing subordinated noteholders. On top of ordering the two banks to sell parts of the businesses, the EC has also ordered that the two banks cease payments of all discretionary coupons on subordinated debt (to not pay coupons on senior debt or lower tier 2 is, currently, an event of default) from January 2010 to January 2012. This is a very substantial development, and one that we have been expecting to be imposed on problematic banks for quite some time. It appears that large numbers of deeply subordinated bank bonds are going to become non-coupon paying for the next two years, and there will be no calls over that period either. We are a step nearer to zero coupon paying perpetuals!
So the response from Lloyds? Astonishingly, the bond exchange has been designed to take out some of the bonds that the EC would have enforced non-payment on, swapping instead into a must-pay security. But the EC’s push to enforce non-payment of coupons was presumably justified by the need to preserve cash within the business rather than leaving it? So either you hold your old Lloyds hybrid notes and take a 2 year payment and call holiday, or you exchange into the new contingent capital, or CoCo, bonds, that must pay coupons unless converted to shares. And in our view, from the banks’, regulators’ and the taxpayers’ perspectives, the new capital notes are a very good idea. Simply put, you get a bond that must pay coupons each year, and that have a definite maturity of 10 to 20 years (like a senior bank bond or a corporate bond). But: if the bank gets into trouble, and its core capital falls below a certain level (5%), then your bond gets automatically converted to common stock. We here think that this is the future of the hybrid capital note market. In times of trouble these subordinated bonds will actually convert to equity (just when banks need it most!). We got into this banking crisis thinking the banks were ‘well capitalised’, and we soon found out that most of their capital was more bond-like than equity-like, which wasn’t much of a help at all to a severely under-capitalised banking system. These CoCo’s would correct that. Good.
But there is a plethora of problems and inconsistencies with these new bonds. Regulators have agreed to allow these CoCos to be mandatory pay securities, so cash will continue to exit the business to pay coupons, which is exactly what the EC wanted to stop. Furthermore, to entice old bondholders to exchange into the new notes, and to reflect the increased risk of a mandatory conversion to common equity, Lloyds is offering coupons on the CoCos that are 1% to 2% higher than the old subordinated bonds. So even more cash will be leaving the business than before! Moreover, the bonds have been classified as lower tier 2 for purposes of seniority of payment and in liquidation, but regulators will consider them at the same time as contingent core tier 1 capital: isn’t that a contradiction in terms? It seems to us that regulators are being overly accommodative to get this deal done, and to help recapitalise Lloyds, and to open this new CoCo market. We do expect other banks to explore the feasibility of similar issuances once the market has got used to this one. From bond investors’ points of view, though, these look like bonds until distress, in which case you are automatically converted to common stock (unlike convertible bonds, where it is generally your right, not obligation, to convert). So they don’t naturally fit into the fixed income universe. At the point of conversion, given distress, the shares will be worth very very little. And the risk of Lloyds-HBOS’ core capital falling to or below 5% is non-negligible, in our view, especially in the next 3 years. Finally, given how high the coupons are going to be, isn’t a management team or regulator at some point going to be incentivised to manipulate their capital levels to force conversion of this expensive debt into cheap equity?
We don’t think that these bonds naturally fit into the fixed income space, although the yields do look attractive. Thus, if other, stronger banks bring similar deals, where there is a premium paid for potential equity conversion over existing tier 1 yields, and where we feel the risk of exchange to equity is sufficiently remote, we will consider them carefully. However, there are still several potentially large issues for these notes, nicely exemplified by a certain index provider’s excluding them from the index on Tuesday, then re-including them, and then yesterday re-excluding them. This shows how difficult is it to know whether they should be classified as fixed income or equity. And that would suggest that the powers that be are worried about who exactly will buy these new CoCo The Clown notes. Are these clowns happy, or are they sad? Are they bonds or are they shares?