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.

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.
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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.
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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.

Neil Unmack of Reuters wrote a good post about Contingent Capital, Lloyds’ escape plan won’t come cheap:

Regulators are keen on contingent capital because they believe it provides banks with a better buffer against losses than subordinated debt. But banks have yet to answer the call. Royal Bank of Canada has issued some contingent capital, but that was nine years ago. As a result, it’s still not clear whether a public market of any real size can exist, and what the correct cost of the securities should be.
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Because contingent capital is untested and carries more explicit risks than existing subordinated bonds, Lloyds is likely to have to offer a higher interest rate than hybrid debt, which would imply a coupon of at least 10 percent and probably more. There’s also the threat the European Commission may force Lloyds to stop paying coupons on its existing subordinated debt, which would encourage investors to switch to the new instruments.

However, some holders of Lloyds’ subordinated debt won’t be able to hold the new securities because they don’t fit the risk profile of a pure fixed income fund.
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As a result, investors should be wary. If Lloyds prospers, investors’ upside is limited; but if loan losses soar they will rank first in line for losses. The new securities could end up having all the disadvantages of equity, without much of the benefit. Bond investors should demand a high coupon. Whether the deal is viable for Lloyds’ shareholders will come down to how desperate they are to escape the UK government’s clutches.

The RBC issue was with Swiss Re under their CLOCS (Committed Long Term Capital Solutions) programme: the capital was preferred shares with a dividend rate set at the time of the agreement; the trigger was “exceptional”, but not crippling, losses on RBC’s loan portfolio. Swiss Re touted the transaction as:

Reduces on-balance sheet capital without increasing overall risk profile of company (helps e.g. solvency ratio, capital adequacy )

It has been noted that transactions of this sort involve a certain amount of counterparty risk – what if RBC triggered the transaction, but Swiss Re could not or would not cover the purchase price of the prefs?

Simon Nixon of the WSJ comments in Lloyds Banking on Contingent Capital for Escape:

That points to going further down the capital structure to create contingent capital, such as using Tier 2 debt, which might typically yield around 6%. Including the price of the option, the cost to issuers might be closer to that of core Tier 1 securities.

The snag is that many Tier 2 investors are prohibited from owning equity, and few fixed-income investors — used to measuring performance in 10ths of a percentage point — are willing to expose their portfolios to equity volatility.

To square this circle, issuers will need to set the trigger sufficiently low that there is little prospect it will ever be hit. Yet the banks must also satisfy regulators it will convert into loss-bearing capital when needed.

Several European banks have investigated contingent capital and concluded there is no market.

Update, 2009-11-3: RBC’s CLOCS were discussed in a June 2001 article in CFO magazine by Russ Banham, Just-in-case capital. (hat tip: Tracy Alloway, FT Alphaville.