New RBC / NA / CWB reset prefs

I have been asked, in an eMail with the captioned title:

Not sure this is going to the right place. Can’t find anyone else to send these comments to.

I owned a number of bank “rate reset” prefs. In the past year, many have been redeemed, and a few have been reset for another 5 years.

There are 3 new issues that recently came out (RY / NA / CWB) with changes to factor in the new Basel capital requirements. My understanding is that basically, if real bad things happen to the bank, the shares can be converted to commons without the holders consent.

In my mind, this is a major negative change to an investor’s position compared to the previous reset prefs. But the pricing of these new issues (either the rate or reset premium) does not seem to give any value to the additional risk. In addition, there does not seem to be any discussion or commentary of the additional exposure anywhere. Is it possible that the people selling these new issues might have a bit of a conflict position (the brokerage houses are all owned by the banks).

Do you have any thoughts on this? If you agree, how does one convince the market that the pricing needs to be adjusted?

I would appreciate any comments you might have – maybe I’m missing something in my thinking. Thank you.

The new issues referred to are:

The desire for change is fueled by political resentment that European banks were bailed out while Tier 1 Capital note-holders were not wiped out and in some cases were unscathed (see my article Prepping for Crises; particularly the footnoted draft version. Or you could just google “burden sharing”).

As I have stressed in the past the big problem is that the Superintendent of Financial Institutions has a huge amount of discretion:

Principle # 3: The contractual terms of all Additional Tier 1 and Tier 2 capital instruments must, at a minimum Footnote 41, include the following trigger events:

  • a.
    the Superintendent of Financial Institutions (the “Superintendent”) publicly announces that the institution has been advised, in writing, that the Superintendent is of the opinion that the institution has ceased, or is about to cease, to be viable and that, after the conversion of all contingent instruments and taking into account any other factors or circumstances that are considered relevant or appropriate, it is reasonably likely that the viability of the institution will be restored or maintained; or

  • b. a federal or provincial government in Canada publicly announces that the institution has accepted or agreed to accept a capital injection, or equivalent support, from the federal government or any provincial government or political subdivision or agent or agency thereof without which the institution would have been determined by the Superintendent to be non-viable Footnote 42.

The term “equivalent support” in the above second trigger constitutes support for a non-viable institution that enhances the institution’s risk-based capital ratios or is funding that is provided on terms other than normal terms and conditions. For greater certainty, and without limitation, equivalent support does not include:

  • i. Emergency Liquidity Assistance provided by the Bank of Canada at or above the Bank Rate;
  • ii. open bank liquidity assistance provided by CDIC at or above its cost of funds; and
  • iii. support, including conditional, limited guarantees, provided by CDIC to facilitate a transaction, including an acquisition or amalgamation.

In addition, shares of an acquiring institution paid as non-cash consideration to CDIC in connection with a purchase of a bridge institution would not constitute equivalent support triggering the NVCC instruments of the acquirer as the acquirer would be a viable financial institution.

The first trigger is the tricky one, although there are also problems with number 2.

This uncertainty has led DBRS to rate these issues a notch lower than other bank issues (in line with S&P’s earlier decision), but there doesn’t appear to be any market recognition of this analysis.

This is precisely what the regulator wants – they have long been in favour of a low trigger for contingent conversion, in opposition to much of the rest of the world. As discussed on October 27, 2011 (the internal link is broken as part of OSFI’s policy to discourage public discussion of their pronouncements), OSFI dismissed high-triggers; while there were lots of rationalizations in their NVCC roadshow, the real reason was articulated by Ms. Dickson in a speech:

The conversion trigger would be activated relatively late in the deterioration of a bank’s health, when the supervisor has determined that the bank is no longer viable as currently structured. This 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 minimizing the impact on the costs of consumer and business loans.

So to hell with high-trigger CoCos and their potential to avert a crisis! In normal times, it will be cheaper for the banks to issue low-trigger CoCos and thereby be able to pay their directors more, particularly the ones who are ex-regulators.

So that’s the background. With respect to the reader’s question:

If you agree, how does one convince the market that the pricing needs to be adjusted?

Well, you can’t, really. I get a lot more requests to recommend bank issues, good solid Canajun banks, none of this insurance or utility garbage, on the grounds of “safety”, than I get requests to comment on risk factors particularly applicable to bank issues.

All you can do is make your own assessment of risk and your own assessment of reward, feed all your analysis into the sausage-making machine, hope you’ve made fewer analytical errors than other market participants and that the world doesn’t change to such a degree that analysis was useless anyway. Which isn’t, perhaps, the most detailed advice I have ever given, but it’s the best I can do.

4 Responses to “New RBC / NA / CWB reset prefs”

  1. GAndreone says:

    Another very bothersome issue is the conversion price. For the RY.PR.Z issue it has a minimum price of $5 or the weighted average price for a period before the announcement. Minutes after the announcement the stock will have fallen in price dramatically so the price it will be converted at is much higher then the true market value. For me this is not a good investment but obviously it is for the the market, otherwise the offering would not have sold out!

  2. jiHymas says:

    Yes. Dickson’s original proposal was:

    A range of conversion methods is being analyzed. For example, each contingent security could convert into any number of common shares determined by dividing the par value of the contingent security by the average mid-day market value of common shares during the last several (to be defined) trading days. All methods seem to generally convert par-to-market value of shares, and need to achieve the outcome that the more senior the capital security, the more consideration provided.

    I didn’t like that and don’t like that because of the ‘death spiral’ effect and continue to believe that the conversion price should be set at the date of issue of the instrument and that the trigger should be a move of the common (on a VWAP basis, over a period of at least several days) through that price.

    Another thing that exacerbates your concerns is ‘Principle 8’ of the NVCC requirements:

    Principle # 8: The terms of the NVCC instrument should include provisions to address NVCC investors that are prohibited, pursuant to the legislation governing the institution, from acquiring common shares in the institution upon a trigger event. Such mechanisms should allow such capital providers to comply with legal prohibitions while continuing to receive the economic results of common share ownership and should allow such persons to transfer their entitlements to a person that is permitted to own shares in the institution and allow such transferee to thereafter receive direct share ownership.

    This has been addressed in the extant issues by having the issuer accept delivery of the new common when it is issued, selling it instantly, and giving the cash proceeds to the holders.

    This is grotesque on two counts:

    • It will be a forced sale of a potentially very large block of stock at a time when, almost by definition, the market will be tumultuous already, and
    • I consider the fact that the regulations are making it easy for investment managers to circumvent legal restrictions on common stock holdings to be very close to investment fraud, though probably not in a legal sense. If an institution is not permitted to own common (or even if the contractual investment mandate is not to own common) then the investment manager should not buy stuff that’s convertible into common without consent. Full stop.

    However, from the bureaucrats’ point of view, the objective is simply to achieve all the effects of bankruptcy without the annoyance of having to go to court and deal with other people’s contractual rights. Seen in this light, all the rules make sense.

  3. indmuny says:

    Being way overweight in discounted insurance deemed-retractibles here’s hoping the regulators consider the ease at which the banks have marketed these new convertibles and apply the same Tier I capital rules to the insurers. It seems to be a no-brainer for them – they get the added security of convertibility at minimal cost to the issuer.

  4. jiHymas says:

    indmuny, that’s a very good point.

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