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It has been rumoured for a while and now it’s official – Lloyds is issuing contingent capital:

Lloyds Banking Group plc (‘Lloyds Banking Group’) today announces proposals intended to meet its current and long-term capital requirements which, if approved by shareholders, will mean that the Group will not participate in the Government Asset Protection Scheme (‘GAPS’).

• Fully underwritten Proposals to generate at least £21 billion of core capital1, comprising:
  • £13.5 billion rights issue. HM Treasury, advised by UKFI, has undertaken to subscribe in full for its 43 per cent entitlement
  • Exchange Offers to generate at least £7.5 billion of contingent core tier 1 and/or core tier 1 capital (core tier 1 capital capped at £1.5 billion)
• High quality, robust and efficient capital structure:
  • Immediate 230bps increase in core tier 1 capital ratio from 6.3 per cent to 8.6 per cent2
  • Significant contingent core tier 1 capital – equates to additional core tier 1 capital of 1.6 per cent3 if the Group’s published core tier 1 capital ratio falls below 5 per cent
  • Reinforces the Group’s capital ratios in stress conditions and meets FSA’s stress test
  • Higher quality capital compared to GAPS where capital benefit reduces over time

The exchange offer is a way of addressing the burden-sharing demanded by the EC.

Offering documents seem to be available, but are not accessible since the world’s regulators are protecting investors from news and foreign prospectuses are, generally, better protected than the Necronomicon. It is not clear – it never is – whether this protection is explicit, or whether they’ve introduced such a conflicting snarl of regulation that the issuers simply throw up their hands and refuse to take the chance.

However, it appears that there is a single conversion trigger based on published Tier 1 Capital Ratios, which I think is thoroughly insane. What happens if the rules for calculation of this ratio change? They’re supposed to change! Treasury and BIS are working feverishly to change them! Does Lloyds have to maintain a calculation of ratios under today’s rules? In that case, not only is there huge expense and confusion, but unintended effects when the trigger occurs under one set of rules but not another. If the rules do change in the interim, then investors are being asked to buy into a blind pool, which will make the securities even more risky than intended.

Update: The cool way to refer to this structure is CoCo:

Contingent convertible bonds differ from traditional equity-linked notes, which can be handed over for stock when a share rises to a pre-agreed “strike price.” CoCos became popular in the U.S. in 2006 as issuers took advantage of accounting rules to sell securities that could only be swapped for stock after the shares passed a threshold above the conversion price and stayed there for a set length of time.

To reach the trigger for the CoCo notes to convert after a 13.5 billion-pound rights issue, loan losses in 2009 and 2010 would have to be about 50 billion pounds, according to [Evolution Strategies’ head Gary] Jenkins.

The CoCo notes were rated at BB by Fitch Ratings today, two steps below investment grade, while Moody’s Investors Service rates the securities at an equivalent Ba2.

Update: Neil Unmack points out that this is a coercive exchange:

However, contingent capital is untested. It is not clear what price investors will demand to hold debt that carries a risk of turning into equity if things go wrong. The proposed exchange could also be problematic. Many fixed income investors aren’t allowed to buy equity-linked debt.

As a result, Lloyds is paying up to get investors on board. They get to switch out of their existing debt into the new contingent capital at par, and get a coupon that is up to 2.5 percent higher than the one they’re getting at the moment. For investors who bought the debt below par — some Lloyds bonds traded as low as 15 percent of face value last March — this means a healthy pay day.

The sweeter coupon alone probably wouldn’t clinch it. Many investors would rather stick with what they have rather than accept an untested instrument which may trade poorly and could be forcibly converted into shares at a later date.

Enter the European Commission, with which Lloyds has been negotiating over state aid. The Commission is compelling Lloyds to cut off coupon payments for up to two years on bonds where it has the right to defer interest. This should help investors with any lingering doubts to make up their minds.

A healthy appetite for the bonds will be a boon for Lloyds, but it doesn’t necessarily mean contingent capital will catch on. For one, it is very expensive: Lloyds is paying interest of up to 16 percent on its bonds. Not every bank will want to pay that.
…
Still, not every bank is in as dire a situation as Lloyds. Without mafia-style coercion, these kind of large-scale debt exchanges will be harder to pull off.

And S&P took action:

Standard & Poor’s Ratings Services said today that it affirmed its ‘A/A-1′ long- and short-term counterparty credit ratings on Lloyds Banking Group PLC (Lloyds) and its subsidiaries. The outlook remains stable. At the same time, with the exception of issues from Lloyds’ insurance subsidiaries, we lowered our ratings on hybrids with discretionary coupons to ‘CC’ from the current range of ‘B’ to ‘CCC+’. Furthermore, with the exception of issues from Lloyds’ insurance subsidiaries, we raised the ratings on hybrids without optional deferral clauses to ‘BB-‘ from ‘B-‘ in the case of holding company issues, and ‘BB’ from ‘B’ in the case of bank issues.

So the senior’s at “A” and the CoCo’s at “BB”. Six notches!

Update: Bloomberg’s John Glover notes:

Lloyds will stop making discretionary interest payments on the existing notes and won’t exercise options to redeem the debt early for two years starting Jan. 31, the bank said, citing this as a condition laid down by the European Commission. Lloyds will decide whether to call the old bonds on a purely economic basis after the two years are up, it said.
…
The price at which Lloyds’ new contingent capital bonds will convert into equity will be the greater of the volume- weighted average price in the five trading days from Nov. 11 to Nov. 17, or a calculation based on 90 percent of the stock’s closing price on Nov. 17 multiplied by a factor.

Update, 2009-11-5: Hat tip to the Fixed Income Investor website of the UK, whose post regarding Lloyds Preference Shares linked to the Non-US Exchange Offering Memorandum.

Update, 2009-11-6: The Economist observes:

“When banks get into problems, it is usually not just a marginal 1-2% addition to capital that they need,” says Elisabeth Rudman of Moody’s, a rating agency.

That could make things worse, not better. With previous hybrid instruments, banks were reluctant to halt interest payments and did all they could to buy back bonds on specified dates for fear of showing weakness to markets. Converting the new debt could also slam confidence without raising a big enough slug of equity capital to restore it. That may encourage banks to hoard capital rather than breach the trigger-point.

This entry was posted on Tuesday, November 3rd, 2009 at 1:26 pm and is filed under Contingent Capital. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.