PrefBlog

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.
…
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.

This entry was posted on Tuesday, November 3rd, 2009 at 2:03 am 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.