The market for the hybrid debt of British banks was rather roiled last week
First there was news that Northern Rock would be deferring payment of its suboordinated debt coupons. Then then there was a mass-downgrade of the hybrid debt of banks including Lloyds and RBS, from ratings agency Fitch. In short, things are happening in the market — and they haven’t been all that good.
As a reminder, hybrid, or suboordinated debt, has characteristics of both equity and debt, and forms an important part of banks’ capital cushions.
On Tuesday, Northern Rock deferred coupon payments on some of its hybrid debt in an effort to conserve its capital base, which has fallen below minimum requirements since the bank was nationalised in 2008. The bond payments can legally be deferred without counting as a default — something which enables them to qualify as regulatory capital in the first place.
The thinking behind Fitch’s Thursday downgrade of RBS’ and Lloyds’ hybrid debt, meanwhile, is that there’s an increased risk of other such coupon deferrals after the European Commission introduced the concept of “burden-sharing” for bond – and shareholders. That’s a nice way of saying that bondholders will have to share some of the pain involved in bank bailouts — the lack of which formed a prime criticism of bank bailouts earlier this year.
Fitch’s fear then, is that governments are no longer implicitly supporting suboordinated bondholders. In fact, governments may encourage their state-owned banks to defer coupon payments if it means they the companies can conserve capital while lightening the government’s own associated bailout costs. HM Treasury currently has stakes in both Lloyds and RBS.
Here’s Monument Securities’ Marc Ostwald on the subject:
If one reads through Fitch’s rationale, this is primarily about the level of political interference in banks where a govt (most obviously the UK) has taken a stake, given aid. They are taking the EU clarification on the implicit EU ‘burden-sharing’ and “state aid” rules as materially raising the risk of forced restructurings (asset sales, branch closures, caps on remuneration or market share and margins/pricing, etc), which in the case of hybrid subordinated debt, which DO have deferral features, raises the risks of deferrals of interest payments. In effect it’s as simple as saying that bond holders will have to wear some or all of the pain of state bank bail-outs (as already seen in the case of Anglo Irish and KBC).
To be honest this has long been in the price of these type of bonds, the EU clarification just gave Fitch and the other ratings agencies the opportunity to confirm that this type of debt will be treated as the lowest of the low (i.e. highest in risk terms). So for an end investor, you would have to be comfortable that the “B rating on watch negative” is as low as this will go, and that govts and or the EU will not impose the aforementioned restrictions, which would likely trigger non-payment of coupons and/or default.
The subtext in all this — Fitch’s actions and the Northern Rock news — is that RBS and Lloyds may well end up following the Crock’s example and deferring coupons on their own hybrid debt.
As Ostwald notes, that shouldn’t necessarily be a huge (i.e. unexpected) deal for the bondholders anyway, but it could, in a rather ironic way, end up being quite painful (i.e. costly) for the UK government. Here’s some related commentary from Reuters columnist Neil Unmack:
A deferral need not be permanent, but it could make it harder for the UK government to offload its stakes in the two lenders [RBS and Lloyds]. An outstanding or missed coupon looks ugly and can prevent a bank from paying dividends. If RBS and Lloyds do have to defer, the government would likely have to come to terms with bondholders before it can sell down any of its stakes.
Related links:
Bank bail-outs weigh on some states – FT
Hybrid debt attack — for real, from Fitch – FT Alphaville
Hybrid debt attack! – FT Alphaville