Commentaries

The EC bank smackdown

Dexia and ING’s recent decisions to call some of their subordinated debt has puzzled market observers, as they seem to fly in the face of the European Commission and its crusade on burden-sharing for banks that have received state aid.

The Commission wants junior creditors of bailed-out banks to share some of the pain along with the public sector, and wants to make sure public funds aren’t used to repay equity or junior debt if a bank can’t. Holders of some of RBS’ subordinated debt recently found this out to their horror when the bank chose not to call the bonds at the first opportunity. The Dexia and ING bondholders, by contrast, will have had a nice pay day. The Dexia upper tier 2 bond was trading below par in the mid 70s area, according to CreditSights.

It looks like the EC wasn’t too pleased with Dexia and ING’s generosity, as last night it issued a stiff press release reminding banks of its rules. That’s not good news for any bondholders who had been hoping that the Dexia and ING calls may have signalled a thawing in the EC’s stance.

Here’s the EC statement:

State aid: Commission recalls rules concerning Tier 1 and Tier 2 capital transactions for banks subject to a restructuring aid investigation

Following questions from market operators regarding the possibility  for banks which are the subject of pending European Commission investigations regarding the grant of restructuring aid to repay bonds before maturity, the Commission would like to recall that its Communication on restructuring aid to financial institutions of July 2009 (see IP/09/1180 and MEMO/09/350) sets out that “banks should not use state aid to remunerate own funds (equity and subordinated debt) when their activities do not generate sufficient profits”. In a restructuring context, measures which reduce the total amount of own funds (payments on hybrid instruments, avoidance of loss absorption, buy-backs, exercise of call options) are in principle not compatible with the objective of “burden sharing” (i.e. banks must pay a significant share of the costs of restructuring) and the “minimum necessary” requirement (i.e. the amount of state aid must not exceed the minimum necessary to allow the bank to restructure). For that reason, banks subject to a state aid investigation should consult the Commission before making announcements to the market concerning Tier 1 and Tier 2 capital transactions.

Transactions such as coupon payments, buy-backs and the exercise of call-options of Tier 1 and Tier 2 capital instruments reduce the total regulatory capital of a financial institution and put into question whether granted state resources were limited to the minimum necessary. Moreover, such measures may infringe the principle of burden sharing in so far as they protect the Tier 1 and Tier 2 capital holders from their exposure to the inherent risk of the investment.

Such transactions by financial institutions subject to restructuring obligations may therefore have implications for the compatibility of the aid received. On the other hand, the Commission may accept these transactions on the basis of a case by case assessment, after balancing the above mentioned principles of burden sharing and limiting aid to the minimum against the contribution of the transaction to the refinancing capability and return to viability of the institution. For that reason, banks subject to a state aid investigation should consult the Commission before making announcements to the market concerning Tier 1 and Tier 2 capital transactions.

Dash for trash in tier 1

Bondholders seem to be relatively undaunted by the European Commission and its various machinations to ensure bank investors share some of the pain for state bailouts.

Tier 1 debt, the lowest-ranking form of bank capital security, is enjoying a rally this week as investors scramble for higher-yielding securities. Among the chief gainers are bonds sold by Royal Bank of Scotland and Lloyds, both of which have taken state-aid, meaning their bonds are likely candidates for the “burden-sharing’’ the EC is keen to see, such as having to defer coupons or worse.

RBS’s 7.0916 percent notes have gained 10 percentage points to 51 cents since last week, according to Societe Generale, while equivalent bonds sold by Lloyds have gained 6 points to 55.

Why are they buying? In some cases, bondholders may be hoping for some kind of buyback. Belgian bank KBC, for example, is offering to buy back four subordinated securities at 70 percent of face value. Alternatively they may just be scrambling for yield.

Given the uncertainties that hang over some of these banks, let’s hope investors are ready for a bumpy ride.

A dark horse for financial innovation

Financial crises tend to spark innovation, and this one will be no different.  Today’s Times of London carries a story on a new security Lloyds Banking Group is devising to raise capital and reduce its participation in the British government’s asset protection scheme (GAPS).

The advantages for Lloyds of raising new capital are obvious: it would reduce the government’s stake in the bank taken as payment for GAPS, give it greater free rein and a more powerful negotiating stance with the European Commission over its restructuring plans.

The trouble is, the plan would require tens of billions of capital. A rights issue may help raise some of that, as would asset sales, but the other natural source of capital – the debt market – is still in turmoil.

Many investors are shunning hybrid securities after taking steep losses. While some banks have issued deals, the market is pretty much closed for any bank in which the government owns a large stake because of fears the European Commission will compel banks that have taken state-aid to defer coupons.

Lloyds may need to come up with something different.

It will be helped by the Financial Services Authority, which would like to see banks develop a capital instrument that absorbs losses in a more meaningful way than hybrid debt.

FSA director Thomas Huertas gave an example of a kind of new capital security in a speech in January, in which he outlined “contingent’’ or “top-up’’ capital — capital a bank can call on if it gets into dire straits before having to turn to the public sector for help.

Retail no answer for bank capital dearth

How does a bank raise capital when institutional investors are steering clear of hybrid debt? The dilemma may be particularly acute for Deutsche Bank, which is still in bad odour with some fund managers for not repaying some subordinated debt at the first opportunity this year as expected.

Deutsche has come up with an answer — bypass the institutional investors and flog some of your capital to the rich man in the street instead. The bank is marketing more than 300 million euros in fixed rate perpetual notes, yielding nearly 10 percent, primarily to retail investors.

If that yield sounds like a lot, it isn’t enough to tempt many asset managers who previously bought tier 1 debt securities. They are still nervous of the asset class because the European Commission is starting to demand banks spread the pain of bailouts with creditors by forcing them to defer coupons and not call debt.

Investors have also twigged that banks won’t always repay the bonds at the earliest opportunity just to please bondholders, as Deutsche illustrated this year. Some fund managers are now so sick of subordinated bank debt they want to have the bonds excluded from investment-grade bond indexes, as Reuters reported yesterday.

Retail investors may be less discerning. Perhaps they care less about the bank choosing to delay repayment and are less sensitive to the price volatility these instruments have displayed in recent months. The fear, however, is that they are simply being bamboozled by the yield, which may look juicy compared to paltry deposit rates but won’t mean much if the bank has to stop paying interest.

To be fair to Deutsche, it isn’t the first bank to issue retail tier 1 bonds so far this year and the rates are not scandalously low when compared to yields in the secondary market of about 9 percent or less.

It certainly won’t be the last bank to launch a retail offering. However, private investors alone will not solve the problem: 300 million euros is equivalent to less than 1 percent of Deutsche’s total Tier 1 capital.