PrefBlog

One thing that has irritated me for a long time has been the inclusion of Innovative Tier 1 Capital (IT1C) in the major bond indices. Those things aren’t even bonds! IT1C is simply preferred shares dressed up as bonds – this doesn’t degrade their utility as an investment vehicle and can make them quite attractive for non-taxable portfolios … but it doesn’t make them bonds.

However, Scotia stuck them in the index when the DEX indices were still the Scotia Capital indices, which I always presumed was just a way to make them easier to sell. There is never any shortage of pig-ignorant portfolio managers who neither know nor care about the specific risks of particular investments; the dirty part about this is that since institutional clients generally know even less and benchmark against “the index”, portfolio managers must make the choice: not buy them, and risk underperforming for 9 years out of ten; or buy them and pretend that, yes, they really are bonds.

I have previously pointed out that the lack of first-loss protection means that the Lloyds notes are not bonds. They may have merit as investments, certainly, but they are not bond investments.

Now Duncan Kerr of eFinancial News reports that UK government and regulatory authorities are teaming up to pull exactly the same trick with ludicrous index inclusions in a column titled Investor threat remains to Lloyds’ contingent capital plans:

Some of the UK’s biggest fixed-income investors are already frustrated about Lloyds’ lack of clarity over its plans, and some are even threatening to block the inclusion of the new capital securities on widely-used bond indices.

The UK Treasury and Financial Services Authority have been pushing hard for Lloyds’ new contingent capital bonds to be included on the main indices, which would make them more attractive to fixed-income investors.
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However, according to analysts some of the UK’s biggest bond investors are arguing that the new securities should not be classed as debt and therefore cannot be included on the main traded indices, which could severely dent investor demand.
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>“The Treasury and FSA have been pushing very hard for contingent capital to be in the indices, clearly because it is more attractive when it is part of a tradable index. And if it is more attractive, the more is sold to investors and the less the Treasury will have to buy of this new instrument,” the [anonymous] banks analyst said.

One factor exacerbating this crisis has been the lack of trust in the authorities: when the BoE lent money on good collateral to Northern Rock, they felt they should do so covertly, in contrast to prior practice … doubtless feeling that their word that the instution was solvent but illiquid would be doubted. How much of the current crisis would have been averted if a man with the gravitas of J.P.Morgan had simply asked his right man “Are they solvent?” and reliquified freely on an affirmative answer, as happened in the Panic of 1907? The reliquification and word of J.P.Morgan that it was indeed reliquification was good enough to stem the panic … but nowadays, that sort of statement from the authorities is regarded as just another lie. Well done with the record of integrity, guys!

And now we have the UK authorities trying to pretend that these notes are actual bonds and should be in the bond indices, right up there with 10-year Gilts. It’s a disgrace.

And so the seeds of the next disaster are sown: we’ve seen what happens when the myth that Money Market Funds are risk-free gets punctured, even by just a little bit … should the authorities be successful in weaving the myth that Contingent Capital = Bonds, we will learn the effect of an overnight drop in bond funds due to mandatory conversion to over-priced common.

I can only hope that the structure of the Lloyds Contingent Capital notes (now referred to as “CoCos” by the ultracool). It really does not require a lot of thought to arrive at the conclusion that these are bad investments at any rate of interest that may be of interest to the issuer; that they do not go very far towards meeting policy objectives; and that they are strongly procyclical.

Prior posts in the series about these notes are:

• Lloyds Issues Contingent Capital
• Contingent Capital and the RBC CLOCs
• Lloyds Bank to Issue Contingent Capital with a Tier 1 Ratio Trigger?

… while Contingent Capital has been discussed in the posts:

• Contingent Capital: Blinder Supports Squam Lake Model
• Contingent Capital: Squam Lake Working Group
• Contingent Capital: Reverse Convertible Debentures
• OSFI Joins Contingent Capital Bandwagon
• Tarullo Confronts ‘Too Big to Fail’
• Dudley of FRBNY Supports Contingent Capital
• HM Treasury Responds to Turner Report
• Treasury Announces Bank Capitalization Wish-List

Gee … I’ll have to think about adding a category!

There are two elements of a contingent capital deal that are of interest:

• The conversion trigger, and
• The conversion price

In the Lloyds deal, the conversion is triggered when the “published core tier 1 capital ratio falls below 5 per cent“. Commentators have been breathlessly announcing that in order to reach this level “loan losses in 2009 and 2010 would have to be about 50 billion pounds”.

I won’t take issue with this statement but it should be fairly obvious that this is not the only way in which conversion can be triggered. Other pathways are:

• A deliberate increase in Risk-Weighted Assets, and
• Changes in the regulatory regime

From an investment perspective, changes in the regulatory regime must be considered a random variable. At time of conversion, under the terms of the issue, it is the published Tier 1 Ratio that is used – not the Tier 1 Ratio computed in accordance with procedures in place at time of issue. Thus, investors are being asked to buy into a regulatory regime that may have completely changed in effect prior to maturity of their investment. How is anybody supposed to price that? The risk of regulatory change will add significantly to the coupon required by a rational investor, increasing the expense to the issuer and – potentially – leading to political pressure on the regulators to take or refrain from action for the convenience of one side or the other.

Investment isn’t some kind of new age cooperative game. An investor must consider the issuers to be his enemies, eager to take action to compromise his interests. This is particularly true for bond investors, who have no role in the selection of management.

From a public policy perspective, the trigger-point of 5% Tier 1 Ratio is unsatisfactory. What if regulatory changes make 6% the mandatory level? The issuer could then be in a position where it was wound down due to insufficient capital – or forced to issue equity at fire-sale prices – without the conversion being triggered.

Triggers based on regulatory ratios mix market value considerations with book value considerations. While not necessarily a deal-killer all by itself, such mixtures require close inspection.

The other problem with the Lloyds issue is the conversion price – put management, the FSA and the EU together in the same room and you know that something ridiculous will emerge! The conversion price is, basically, equal to the price at time of issue.

What this means is that conversion may be triggered at some point in the future due to unfortunate results, but that the price is based on today’s price. In other words, holders of these notes have no first-loss protection on losses experienced between issue date and conversion date. And without first-loss protection … they’re not even bonds. They are merely equities with a limited upside. Sounds like a really, really good deal, eh?

It is the interaction between the two vital elements of the issue terms that introduces the greatest danger. Let us assume that – some time after issue, but well before maturity – we enter normal banking times in which management is free, subject to normal regulatory requirements, to make its own decisions regarding risk and leverage.

Management works for the shareholders, so what is the optimal course of action to take on their behalf? I suggest that it is optimal to lever up the company with as much risk as possible to a level slightly above the conversion trigger. If things work out well … then pre-existing shareholders get to claim all the rewards, paying the contingent capital noteholders their coupon. If things work out badly … well, pre-existing shareholders lose money, sure, but they get to share these losses with the contingent capital holders.

The risk/reward outlook for the existing shareholders has become skewed – precisely the thing that the regulators are telling us they’re oh-so-worried about! This asymmetric risk/return is a source of systemic instability.

As has been previously argued, I support a model for contingent capital in which:

• The conversion trigger is a decline of the common stock to a value below X, where X is less than the issue date price
• The conversion price is X

Such a model

• provides noteholders with first-loss protection
• is unambiguous (uncertainty in times of crisis can be rather disturbing!)
• allows the market to work out prices using extant option pricing models, without incorporating regulatory uncertainty, and
• simply formalizes “normal coercive” exchange offers such as that of Citigroup

I suggest that a good place to start thinking about the value of X is:

• half the issue-date price for issues to be considered Tier 1 (e.g., preferred shares and Innovative Tier 1 Capital)
• one-quarter the issue-date price for issues to be considered Tier 2 (e.g., subordinated debt).

Update, 2015-4-12: Lloyds ECNs at centre of legal dispute:

Lloyds Banking Group has won permission from the City regulator for a controversial plan to redeem some of its high-yield convertible bonds, although it has suspended the redemption until the courts clarify the law.

The bank’s “enhanced capital notes” were issued in the teeth of the financial crisis, switching investors, many of them pensioners, from preference shares and permanent interest-bearing shares in a bid to improve its capital base.

The notes would convert to equity if Lloyds’ core tier one capital ratio fell below 5pc, although this threshold turned out to be too low to count under the European Banking Authority’s rules on convertible capital.

While the Prudential Regulation Authority has agreed that, from the point of view of Lloyds’ financial strength, the bonds can be redeemed at par, the matter will now go to court for a “declaratory judgement” on whether a redemption would breach bondholders’ contractual rights.

Redeeming the bonds would strip investors of generous interest payments. The bonds have until recently traded above their par value as they offered annual payments as high as 16.125pc, making them particularly attractive as interest rates on other savings products have dwindled.

However, Lloyds said in December that it would seek permission to redeem the bonds at par value, following the Bank of England’s stress tests that did not take the bonds into account when measuring the bank’s capital strength.
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Lloyds intends to call in 23 tranches of bonds, worth a total of almost £860m, that were issued in 2009 and 2010.