PrefBlog

The Newcastle Building Society has announced a conversion of some capital instruments into contingent capital:

Newcastle Building Society (the “Society”) today announces that it has reached an agreement with holders of certain classes of the Society’s existing subordinated debt and permanent interest bearing shares (“PIBS”) which will lead to a material strengthening of the Society’s capital position (the “Capital Agreement”).

The Capital Agreement reflects a proactive initiative by the Society to underpin its financial strength and further enhance its standing as a marketcounterparty. Under the Capital Agreement, the Society has agreed with holders of certain classes of its subordinated debt and PIBS to add, in return for an uplift in coupon, a conversion feature such that those instruments would convert into profit participating deferred shares (“PPDS”), a core tier 1 capital instrument, should the Society’s core tier 1 capital ratio fall below 5%. The Capital Agreement applies to £46 million in total of the Society’s subordinated debt and PIBS.

As a result of the Capital Agreement therefore, in addition to the £179 million of core tier 1 capital held by the Society as at 31 December 2009, the Society will also have £46 million of contingent core tier 1 capital (such contingent core tier 1 capital being equivalent to 2.2% of the Society’s risk weighted assets). As at 31 December 2009, the Society had a core tier 1 capital ratio of 8.7% (up from 7.8% at the prior year end). The Capital Agreement will therefore further strengthen the Society’s capital position, providing 2.2% of contingent core tier 1 capital in addition to the existing 8.7% core tier 1 capital ratio as at 31 December 2009.

Additionally, the Society has introduced an innovative feature which means that the relevant instruments would cease to be convertible and the coupon uplift would fall away if the Society’s core tier 1 capital ratio exceeds 12%. This feature has helped minimise the level of coupon uplift necessary to secure the agreement of the investors who are a party to the Capital Agreement.

Assiduous Readers will remember that I consider conversion triggers based on Regulatory Capital Ratios to be completely insane. What if the rules change? How do you price it?

Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve System, gave a speech at the Council of Institutional Investors meeting, Washington DC, 13 April 2010.

A second proposal that has received considerable attention is to require large financial institutions to hold so-called contingent capital, which is basically debt that converts to common equity as a result of some predefined triggering event. There are actually two distinct concepts that may be characterized as “contingent” capital. The first is a requirement for a specified kind of capital instrument to be issued by the firm – one that would have debtlike characteristics in normal times but would convert to equity upon the triggering event. The other is a requirement that all instruments qualifying as Tier 2 regulatory capital convert to common equity under specified circumstances, such as a determination that the firm would otherwise be on the brink of insolvency.

Frankly, the distinction between the two concepts is not immediately apparent to me!

The market discipline effects of both variants could be considerable, since holders of certain kinds of capital instruments would know that their debt-like interests in the firm would be lost if the firm’s financial situation deteriorated. However, there are also significant questions about the feasibility of both. The specification of the trigger is critical. If supervisors can trigger the conversion, investors cannot be certain as to when the government will exercise the trigger. That uncertainty would make it difficult to price a convertible capital instrument and diminish investors’ willingness to hold it. Tying the trigger to the capital level of the firm runs headlong into the serious problem that capital has traditionally been a lagging indicator of the health of a firm. Using a market-based trigger could invite trading against the trigger, which, in extreme cases, could lead to a so-called death spiral for the firm’s stock.

I am in full agreement with his identification of a major problem with supervisory triggers. I will add that if supervisors trigger conversion when the bank is merely in trouble, the triggering of conversion will almost certainly also trigger a run on the bank, converting trouble into the kiss of death.

Capital levels … I will add that capital levels can be manipulated. Lehman’s Repo 105 transactions, last discussed on March 17, are merely a glaring example.

Market based trigger … I agree that trading against the trigger could very well occur. However, extreme cases leading to a death-spiral will be avoided under my proposal which leads to conversion at a set price if the common trades below that set price. No death-spiral there! However, it is true that a cascade could occur: conversion 1 throws a lot of common on the street, which gets sold, lowering the price, triggering conversion 2 … it is not immediately clear to me, however, that this should be a regulatory concern: at the end of the process, you have a bank in which every single penny of capital has been converted to common equity. Isn’t that a good thing? However, a valid argument can be made that it will be harder to sell new common if it’s only a buck or two above the first of a series of conversion prices. Ain’t NUTHIN perfect!

Despite the work that has been done on contingent proposals, it is not yet clear if there is a
viable form of contingent capital that would increase market discipline and provide additional equity capital in times of stress without raising the price of the convertible debt close to common equity levels. The appeal of the concept is such as to make further work very worthwhile but, for the moment at least, there is no proposal ready for implementation.

But what is the alternative? If the trigger is too remote, it won’t get priced properly and will only be triggered way too late in process. If it’s triggered too late, it won’t help much, as S&P has commented.

Standard & Poor’s has commented:

We understand that the Basel committee intends that Tier 1 capital should enable each bank to remain a going concern, with Tier 2 capital re-categorized as a “gone concern” reserve to protect depositors in the event of insolvency. We expect to assess the credit implications of the extension risk that may be created by the proposed introduction of a lock-in clause in respect of Tier 2 capital in the future.

The introduction of much stricter criteria for the inclusion of hybrid instruments into Tier 1 capital generally accords with our recent criteria refinement, under which our capital metrics would give only minimal equity content to certain types of hybrids that we do not view as providing sufficient flexibility to defer or suspend coupons. The loss absorption capacity provided by principal write-down or conversion features is not a condition for equity content under our criteria. (See “Assumptions: Clarification Of The Equity Content Categories Used For Bank And Insurance Hybrid Instruments With Restricted Ability To Defer Payments,” published Feb. 9, 2010.)

The proposals state that “innovative” capital instruments with an incentive to redeem through features like step-up clauses (currently limited to 15% of the Tier 1 capital base) will be phased out. We currently assign different levels of equity credit to some hybrids with step-up features (or equivalent features) depending on their individual features. As stated in our criteria, step-ups (and similar provisions) question the permanence of issues that incorporate them, and so undermine the equity content of a hybrid capital security. Such hybrids are in our view therefore a weaker form of capital than other hybrids included in our measures of capital, such as similar instruments without step-ups.

Contingent capital may address some of the demonstrated deficiencies of traditional hybrid structures. One of the difficulties in practice in our view, however, is how to assess whether contingent capital securities would convert into capital (through conversion or a form of write-down) early enough to help a bank experiencing capital pressures. Some triggers may be lagging indicators of the bank’s health.

As stated in our published criteria, we may take the view to deny equity credit to hybrid instruments even if regulators allow for grandfathering, based on our view of the fundamental characteristics of the instruments. We interpret the grandfathering proposals as being a method for regulators to enable banks to transition to a more conservative regulatory environment without requiring large capital-raising in the short- to medium-term. In our view, grandfathering can create inconsistencies and a lack of comparability in capital ratios that could remain for an extended period. Grandfathering could also result in hybrid instruments that have been demonstrated to be ineffective as a form of capital still being included in regulatory capital measures.
…
The proposal to discontinue regulatory adjustments for unrealized gains and losses on securities or properties we believe would likely exacerbate pro-cyclicality, which is already perceived as an issue under the Basel II regime.

Their emphasis on the need for contingent capital to have an effect early in a bank’s deterioration is sharply at variance with Flaherty’s position.

Julie Dickson recently wrote an opinion piece for the Financial Times that was startling in its lack of rigour, absence of detail and non-existent support in OSFI’s published papers. This bumbling approach to a serious issue has now been adopted by Canada’s finance minister, her boss:

While some countries may choose to pursue an ex ante systemic risk levy or a tax, I do not believe that this would be an appropriate tool for all countries. Such a levy would remove capital from an institution to an external fund or to general government revenues, which could result in weakening an institution’s ability to absorb losses. A global levy could also result in excessive risk taking as a result of a perceived government guarantee against an institution’s failure. In my view, contingent capital is aligned with the principles above and should be considered. As noted in the attached Financial Times editorial by Julie Dickson, the Canadian Federal Superintendent of Financial Institutions, contingent capital would create a notional systemic risk fund embedded in the capital structures of financial institutions. Embedded contingent capital would force the costs of excessive risk taking to be removed from taxpayers and placed on to the right people – shareholders and subordinated debt holders – thus improving market discipline and significantly reducing moral hazard in the banking sector. Moreover, for the same reduction in credit intermediation, contingent capital has the advantage over a levy or charge of leaving capital available in the institution to facilitate a more stable provision of credit during economic downturns.

DBRS has announced a policy on contingent capital.

DBRS has today clarified its approach to rating a subset of hybrids and other debt capital instruments whose features include principal write-downs or conversions to lower positioned instruments, if certain trigger events occur. See DBRS Methodology, “Rating Bank Subordinated Debt and Hybrid Capital Instruments with Contingent Risks” April 2010.

“Principal write-downs” were used in the recent Rabobank issue. “Conversions to lower positioned instruments” (which, presumably, includes the possible conversion of Innovative Tier 1 Capital to preferred shares, which has been around for ages), is the mainstream proposal and was used in the ground-breaking Lloyds deal (which was poorly structured due to the high conversion price).

The DBRS Methodology: Rating Bank Subordinated Debt and Hybrid Capital Instruments with Contingent Risks notes:

This view that most hybrids are closer to debt than equity was evident in the global fi nancial crisis. Despite all their ‘bells and whistles’, most of these bank capital instruments could not be converted into equity to help struggling banks absorb losses and bolster their capital while they were still operating. The main benefi t for bank equity capital came when banks made exchange offers for hybrids, either at less than par or for equity instruments. The limited contribution to equity capital is consistent with DBRS’s perspective on the function of these instruments for banks. In analyzing the contribution of bank capital instruments to a bank’s capitalization, DBRS does not generally give any signifi cant equity credit for hybrid instruments, although we recognize their full value in meeting regulatory requirements.

They classify triggering events as:

In assessing the additional risk of these contingent features, an important factor is the ease of tripping the triggers that cause the adverse event to occur. The easier the triggers are to trip, the greater the additional risk for the hybrid holder. DBRS organizes the ease of tripping triggers into four broad categories:
• Level 4 “Very Hard”, e.g., Bank is insolvent or has been seized
• Level 3 “Hard”, e.g., Bank has exhausted most of its capital, but is not technically insolvent
• Level 2 “Easier”, e.g., Bank no longer meeting minimum regulatory requirements
• Level 1 “Easiest”, e.g., Capital ratio falls below a level set above minimum requirements
For those instruments where the trigger event requires the bank to be insolvent or seized by the authorities, DBRS views the risk as similar to debt instruments.

Julie Dickson’s op-ed advocated – eseentially – a Level 4 trigger – but, of course, she is trying to get something for nothing: equity capital priced like debt. The solution I advocate, a conversion into stock if the stock trades below a certain level, is a Level 1 solution; more expensive for the banks, but on the other hand, actually has a hope of accomplishing something. YOU CAN’T GET SOMETHING FOR NOTHING FOREVER! Hasn’t the last few years convinced anybody of that?

The fi rst step is evaluating the elevated risk posed by the specifi c features of each instrument. For some instruments, the combinations are relatively straightforward. An instrument with triggers that are hard to trip and resulting positions that are above preferreds is viewed as having elevated risk. For instruments with triggers that are easier to trip and resulting positions that are comparable to preferreds, the risk is viewed as being very elevated. Under DBRS’s approach certain instruments with contingent features can pose exceptional risk, if their triggers are the easiest to trip and the resulting position for holders is closer to common equity. One factor in rating these instruments below preferred shares could be that tripping the triggers could occur without preference shares being impacted or leave them in a preferential position relative to the converted instruments. Outside these straightforward combinations, there are a number of combinations that involve judgment in making the assessment of risk (See Exhibit 1). or those instruments where the write-downs or conversions to lower positioned instruments can be reversed, if the bank survives, the risk to investors remains largely the same as it would be in the absence of the feature. That is, investors face losses only if the bank is declared insolvent.

There seems to be acceptance of the idea that it will be possible for subordinated debt to leapfrog prefs and become equity; and I don’t understand this idea at all. Once you allow leapfrogging, investing becomes a lottery. Let all elements of capital have a mandatory conversion into equity at some point, says I; and make it clear that leapfrogging is not likely.

In my proposal, where prefs would trigger/convert at 50% of the common price at time of issue and sub-debt would trigger/convert at 25%, leapfrogging is sort of possible. You could issue a pref, wait a few years (decades?) until the common price doubles, then issue sub-debt. But that’s fine, that’s allowed. All the regulators should be worried about is the risk at the time of sale to the public.

DBRS also published a not-very-interesting Methodology
Rating Bank Subordinated Debt and Hybrid Instruments with Discretionary Payments. They used it when downgrading Dexia’s sub-debt today, amongst other actions.

The Financial Post reports:

Ms. Dickson, head of the Office of the Superintendent of Financial Institutions, spelled out her case in the Financial Times yesterday. Her comments, along with those yesterday from Royal Bank of Canada chief executive Gordon Nixon, represent the latest attempts by officials to head off new global financial regulations that could be damaging to Canada.

In a Times opinion piece, Ms. Dickson noted proposals to impose a global bank tax or surcharges on “systemically important” banks have not been universally accepted, with Canada leading the way in opposition to a bank tax.

Instead, she suggested a new scheme in which bank debt would be converted into equity in the event lenders run into trouble. This “embedded contingent capital” would apply to all subordinated securities and would be at least equivalent in value to the common equity.

“This would create a notional systemic risk fund within the bank itself — a form of self-insurance prefunded by private investors to protect the solvency of the bank,” she wrote in the Times.

“What would be new is that investors in bank bonds would now have a real incentive to monitor and restrain risky bank behaviour, to avoid heavy losses from conversion to equity.”

The debt-to-equity conversion would be triggered when the regulator is of the opinion that a financial institution is in so much trouble that no other private-sector investor would want to acquire the asset.

It is very odd that Canadians are reading about Canadian bank regulation in a foreign newspaper. I can well imaging that the Financial Times is more commonly found on the breakfast tables of global decision makers than the Financial Post or the Globe and Mail … but I would have expected a major statement of opinion to be laid out in a speech published on OSFI’s website, which could then be accompanied by opinion pieces in foreign publications.

OSFI’s communication strategy, however, has been notoriously contemptuous of Canadians and markets in general for a long time. The same Financial Post article claims:

Some bank CEOs have grown impatient with Ms. Dickson and Jim Flaherty, the Minister of Finance, who have asked lenders to refrain from raising dividends and undertaking acquisitions — unless they are financed by share offerings that keep their capital ratios high — until there is greater certainty about new financial rules.

It would be really nice if there was a published advisory somewhere, so that the market could see exactly what is being said – but selective disclosure is not a problem if the regulators do it, right?

One way or another, I suggest that a regulatory trigger for contingent capital would be a grave mistake. Such a determination by any regulator will be the kiss of death for any institution in serious, but survivable, trouble; therefore, it is almost certain not to be used until it’s too late. Triggers based on the contemporary price of the common relative to the price of the common at the time of issue of the subordinated debt are much preferable, as I have argued in the past.

Ira Stoll of Future of Capitalism quotes the specifics of the piece (unfortunately, I haven’t read the original. Damned if I’m going to pay foreigners to find out what a Canadian bureaucrat is saying) as:

The second question is what triggers the conversion of the contingent capital. She writes, “An identifiable conversion trigger event could be when the regulator is ready to seize control of the institution because problems are so deep that no private buyer would be willing to acquire shares in the bank.”

in which case it is not really contingent capital at all; it’s more “gone concern” capital, without a meaningful difference from the currently extant and sadly wanting subordinated debt. The whole point of “contingent capital” is that it should be able to absorb losses on a going concern basis.

Update: On a related note, I have sent the following inquiry to OSFI:

I note in a Financial Post report(
http://www.nationalpost.com/opinion/columnists/story.html?id=6bb93a4f-b0c0-4d2a-bcd7-be7e6750e212
) the claim that “Despite the low yields, Nagel says the regulatory authorities have given their approval for rate resets to continue to count as Tier 1 capital. But he said the authorities have not been as kind for continued issues of so-called innovative Tier 1 securities.”

Is this an accurate statement of the facts? Has OSFI given guidance on new issue eligibility for Tier 1 Capital, formally or informally, to certain capital market participants that has not been released via an advisory published on your website? If so, what was the nature of this informal guidance?

We will see what, if anything, comes of that.

Update: I have just gained (free!) access to Ms. Dickson’s piece, Protecting banks is best done by market discipline, a disingenuous title if ever there was one. There’s not much detail; but beyond what has already been said:

The conversion trigger would be activated relatively late in the deterioration of a bank’s health, when the value of common equity is minimal. This (together with an appropriate conversion method) should result in the contingent instrument being priced as debt. Being priced as debt is critical as it makes it far more affordable for banks, and therefore has the benefit of minimising the effect on the cost of consumer and business loans.

She does not specify a conversion price, but implies that it will be reasonably close to market:

As an example, consider a bank that issues $40bn of subordinated debt with these embedded conversion features. If the bank took excessive risks to the point where its viability was in doubt and its regulator was ready to take control, the $40bn of subordinated debt would convert to common equity, in a manner that heavily diluted the existing shareholders. While other, temporary measures might also have to be taken to help stabilise the bank in the short run, such capital conversion would significantly replenish the bank’s equity base.

On conversion, the market would be given the message that the bank had been solidly re-capitalised with common equity, and not that it was still in trouble and its common equity had been bolstered only modestly.

I am very dubious about the claimed message to the market, given the conversion trigger. Frankly, this idea doesn’t look like much more than a regulatorially imposed, somewhat prepackaged bankruptcy – which is something the regulators can do already.

At the height of the crisis, how would you have felt about putting new capital into a company – as either debt or equity – that had just undergone such a process?

Update: I will also point out that the more remote the contingent trigger, the less likely it is to be valued properly.

Update, 2010-4-22: Dickson’s essay has been published on the OSFI website.