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Reality arrives at The Rock

August 18, 2009

The surprising thing about Northern Rock’s decision to defer coupons on 1.6 billion pounds of its subordinated debt is the timing — arguably, it’s a miracle investors were getting paid anything at all.

The bank on Tuesday said it would stop paying coupons on various subordinated bank bonds, securities that count as regulatory capital.

The 12.625 percent subordinated notes fell to about 15-25 pence, down from as high as 50 before the announcement. Other tier 1 bonds that have been trading at around 20 percent of face for most of the year and fell below 10 today after being quoted around 15 last week.

While they all have differing terms and conditions, these bonds share the feature they can be deferred without counting as a default. That enables them to qualify as regulatory capital, the buffer banks must hold to absorb losses and protect depositors.

This feature meant Northern Rock might have deferred at any time since it was taken over by the UK government nearly two years ago. Bradford & Bingley, which the government broke up and placed into run-off, chose to defer coupons earlier this year.

The odds on Northern Rock following suit rose in July when the bank announced its capital position had fallen below regulatory minimum limits. The government now wants to restructure it by hiving off its dud assets into a bad bank. That will need state aid approval from the European Commission, which has become increasingly keen to see bondholders take their fair share of pain in bailed-out banks.

Market prices suggest there is some value left in the debt, perhaps if the debt is turned into equity or bought back at a discount.

While Northern Rock’s case looks clear, the jury is still out on which other banks the UK government has bailed out will have to defer as well. The Commission has already asked KBC, Commerzbank and a handful of other European lenders to defer.

The Commission is keen to “burden share” (a euphemism for spreading the pain) in cases where banks have received enough state aid to have to submit what it calls a restructuring plan.

That could include RBS and Lloyds, in which the government also owns stakes. Both have received big dollops of state aid, and are in discussions with the Commission.

Research company CreditSights listed both banks as potential deferrers in a recent report, alongside Dexia, ING and others.

A deferral need not be permanent, but it could make it harder for the UK government to offload its stakes in the two lenders. 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.

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