Contingent capital and the black horse’s head
Lloyds seems to be taking a leaf out of Vito Corleone’s book: if you need someone to do something that they don’t want to, you have to make them an offer they can’t refuse. For the mafia boss in The Godfather, that meant decapitating a horse. For Lloyds, the UK bank whose logo is a black horse, it means threatening to cut off interest payments on your own debt.
Lloyds’ plan is to convert subordinated debt into 7.5 billion pounds of contingent capital. These new-fangled securities pay out fixed coupons, but can be converted into shares in times of need. The exchange is part of Lloyds’ efforts to avoid the government’s asset protection scheme. Lloyds is likely to pull off this deal, but the jury is still out on whether this kind of capital will be widely used by other banks.
Regulators like the idea of contingent capital because it is better able to absorb losses than subordinated debt. The new Lloyds bonds are classified as lower tier two capital, but the Financial Services Authority includes them as part of the bank’s core capital when conducting stress tests.
However, contingent capital is untested. It is not clear what price investors will demand to hold debt that carries a risk of turning into equity if things go wrong. The proposed exchange could also be problematic. Many fixed income investors aren’t allowed to buy equity-linked debt.
As a result, Lloyds is paying up to get investors on board. They get to switch out of their existing debt into the new contingent capital at par, and get a coupon that is up to 2.5 percent higher than the one they’re getting at the moment. For investors who bought the debt below par — some Lloyds bonds traded as low as 15 percent of face value last March — this means a healthy pay day.
The sweeter coupon alone probably wouldn’t clinch it. Many investors would rather stick with what they have rather than accept an untested instrument which may trade poorly and could be forcibly converted into shares at a later date.
Enter the European Commission, with which Lloyds has been negotiating over state aid. The Commission is compelling Lloyds to cut off coupon payments for up to two years on bonds where it has the right to defer interest. This should help investors with any lingering doubts to make up their minds.
A healthy appetite for the bonds will be a boon for Lloyds, but it doesn’t necessarily mean contingent capital will catch on. For one, it is very expensive: Lloyds is paying interest of up to 16 percent on its bonds. Not every bank will want to pay that.
The capital has other advantages: interest payments are likely to be tax-deductible, and is less dilutive to shareholders than issuing ordinary shares. Moreover, as regulators push banks to improve the quantity and quality of their capital, they will need to explore every possible source of funding.
Still, not every bank is in as dire a situation as Lloyds. Without mafia-style coercion, these kind of large-scale debt exchanges will be harder to pull off.