Lloyds escape plan won’t come cheap
What’s the price of freedom? Ask Lloyds Banking Group, which is hoping to persuade bondholders to buy into a new kind of risky subordinated capital in a bid to avoid having to use the UK government’s asset protection scheme. This Houdini-esque escape trick will be expensive — if it can be pulled off at all.
Lloyds wants to raise 25 billion pounds of new core tier 1 capital to avoid using the APS and having to hand over a bigger stake to the government. As much as 7.5 billion pounds of that could come by converting some of its subordinated debt and preference shares into so-called contingent capital, securities that can be swapped into equity if its balance ratios deteriorate, according to reports.
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.
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.
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. Investors could be forced to sell as soon as they agree to exchange their bonds into contingent capital, pushing down the price. Others, such as hedge funds, will have bought the debt at a discount and may be more amenable to a trade if it gives them a quick profit. But it is far from clear that there will be a liquid market in the instruments.
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.