And so it began — the Lloyds statement detailing the bank’s plans to raise contingent capital is out.
This is a concept still confusing the market even as it’s gaining increasing prominence with regulators. In simple terms, contingent capital is a kind of convertible bond that becomes equity when a certain trigger is hit. In the Lloyds case, it will be if its core Tier 1 capital ratio falls below 5 per cent.
Contingent capital’s traditionally been used by those in the insurance industry as a way of provisioning for big one-time losses. One of the few banks (the only bank we could find, in fact) to have sort of used it historically was Royal Bank of Canada — with a deal with insurer Swiss Re in 2001.
The deal, called CLOCS (committed long-term capital solution), was aptly summed up in a CFO article:
Royal Bank of Canada had a different motivation than Michelin: It wanted access to capital to replenish its Tier 1 ratios in the event of exceptional losses. Prior to engaging in the transaction, the bank held funds for such scenarios in its general reserve, which is paid out of net income to absorb both low- and high-level credit losses. “But when you look at the probability of drawing from the reserve, the first draw (the low-level credit losses) has a much higher probability of use than later draws–even though the cost of holding the reserve is the same for each,” explains Suzanne Labarge, Royal Bank’s chief risk officer and a vice chairman. She adds that since keeping capital on the balance sheet for the later draws isn’t very efficient, and the probability of tapping it is much more remote, the bank began to think in terms of insurance.
What makes the transaction groundbreaking is that it uses Royal Bank’s equity to absorb the low-probability, high-loss events, which are handed over to Swiss Re in return for the insurer’s capital. Here’s how it works: If the policy is triggered (it is linked to an undisclosed drop in Royal Bank’s general reserves), Swiss Re will provide C$200 million cash in exchange for C$200 million in Royal Bank preferred shares. The noncumulative, perpetual shares are priced at their market rate on October 27, 2000.
If the policy is triggered and Swiss Re receives the C$200 million in preferred shares, it would represent about 1 percent of the bank’s total equity. While the shares do not carry voting rights, they do pay dividends, and Swiss Re retains the right to sell them, although that would be unlikely. “They’d attract a pretty poor price right after such a serious credit-loss situation,” explains David McKay, Royal Bank’s vice president of portfolio management.
The bank declined to reveal the cost of the premium. “What I will say is that it’s a very small fraction of what it would have cost us to put aside capital in a reserve, or take it through our income,” says McKay. As in the Michelin transaction, the premium is charged against annual earnings, providing a nondilutive equity cushion in the event of losses.
The deal bodes well for the double-A-minus-rated bank, says Mark Puccia, a managing director at Standard & Poor’s Rating Services, in New York. “They obtain capital protection as opposed to earnings protection, which we view favorably,” he says. “This is not earnings protection–if there are write-offs, those still go through the bottom line. The difference is that the earnings losses will be offset by the newly issued equity to Swiss Re.”
We’re trying to find out if RBC ever actually made use of its contingent capital policy, and are waiting to hear a response from the bank itself. In the meantime though, we’d note that that the article contains a hint about one of the potential problems with contingent capital — as others have noted, it does not come cheap.
Here is Reuters columnist Neil Unmack on the subject:
One way to look at contingent capital is to view it as an out-of-the-money put option that investors are selling to the bank. Investors could put a price on it by examining the cost of buying a similar option – effectively hedging their risk.
The cost of this hedge varies according to the price at which the contingent capital converts into shares. Buying a put at 37 pence, less than half Lloyds current share price of 84 pence, would involve paying at least five percent a year. But a put at a price of 55 pence would cost nearly 11 percent a year.
For investors, however, hedging their exposure to Lloyds for longer than a year is difficult. Doing it for seven billion pounds of securities for as long as five years may be impossible. It is also unclear what effect the contingent capital will have on the way investors value the bank’s ordinary shares – an important consideration, given that it is simultaneously lining up a mammoth rights issue.
Even then, the parallel is imperfect. That is because the put option is only be exercised when Lloyds’ capital ratios deteriorate significantly. Viewed from this perspective, contingent capital is more like subordinated debt in an ordinary company, that can be converted into shares through a restructuring if the company runs into trouble. The only difference is that the terms of the restructuring are spelled out in advance.
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.
In fact, the European Commission has indeed struck again – making it clear to Lloyds that the bank will not be able to pay discretionary coupons or dividends on its hybrid securities, or subordinated bonds. That is part of the EC’s “burden-sharing” concept for bondholders — forcing them to share some of the pain of state bank bailouts.
Here’s a bit more detail on the EC point from the Wall Street Journal’s Simon Nixon:
Core Tier 1 securities currently yield around 9%. Adding in the extra yield investors would require to compensate for the conversion risk would make contingent capital prohibitively expensive.
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. So why is Lloyds so confident?
The answer lies in the European Union’s rules prohibiting banks that have received state aid from calling or paying coupons on core Tier 1 securities where they have an option to defer. Lloyds won’t say what deal it has struck with the regulator over the terms of its proposal. But it is gambling that, for its core Tier 1 investors, swapping into a Tier 2 instrument offering a similar yield, but with the risk of conversion to equity, will prove attractive.
And lo and behold — it came to pass. RBC Capital Markets sums up the idea nicely (they should know, right?):
Lloyds announced plans regarding its exit from the UK government’s Asset Protection Scheme that will see fully underwritten proposals generate at least £21bn of core capital. This includes a £13.5bn rights issue, to which the UK Treasury will subscribe to its 43% entitlement, and exchange offers that are expected to generate at least £7.5bn of Contingent Core Tier 1 and/or Core Tier 1 capital, with the latter capped at £1.5bn. The exchange offer relates to 52 existing securities, comprising £2.52bn of UT2, £7.68bn of innovative Tier 1 and preference shares with an aggregate liquidation preference of £4.09bn. The new securities comprise enhanced capital notes (ECNs) and new shares, with the ECNs qualifying as new LT2 capital that will automatically convert to ordinary shares if the bank’s Core Tier 1 ratio falls below 5%. The ECNs have non-discretionary payment provisions with a fixed maturity date and will not be affected by coupon and dividend-blocker restrictions. The European Commission will however require Lloyds not to make discretionary payments on coupons or dividends and will block the exercise of optional early redemption features for a 2-year period commencing 31 Jan 2010 on existing securities.Related links:
In case of capital emergency – FT Alphaville
Contingent capital: cure or cost for banks? – The Guardian