Commentaries

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.

No-one escapes the European Commission

Fitch just delivered some pretty hefty downgrades on subordinated debt sold by Lloyds Banking Group’s insurance arms Clerical Medical and Scottish Widows. 

The rating cuts follow similar downgrades on debt issued by the group’s banking units last week. Once again, the cause for the downgrades is the European Commission’s renewed zeal for banks that have received state aid to share the pain with their investors, notably by deferring coupons on subordinated debt.   The seven and eight notch cuts take the bonds from high investment-grade to low-junk (B+). Not pleasant.

It’s starting to look more than likely that Lloyds and RBS will have to defer subordinated bond coupons. The question is for how long?

Don’t underestimate the European Commission

Will RBS and Lloyds have to follow Northern Rock and defer coupons on their hybrid debt? There’s a nagging fear that any bank that has needed large amounts of state-aid may have to make subordinated bondholders take some of the pain.

Fitch Ratings has just added to the debate with a slew of downgrades of RBS, Lloyds, and six other banks’ subordinated debt, citing an “increased risk of deferral.” The chief threat here is the European Commission, which is getting very keen on the concept of “burden-sharing”, a euphemism for crucifying bondholders.

“The capacity for the Commission to materially influence both the capital remuneration policy and the future shape of state-aided banks should not be under-estimated,” warns Fitch.

The rights escape for Lloyds

Talk about hitting the ground running. Even though he doesn’t formally take charge until next month Win Bischoff, chairman-designate of Lloyds, is reported to be pressing for the bank to raise up to 15 billion pounds through a rights issue and to scale back its participation in the government’s Asset Protection Scheme (APS).

His intentions are to be applauded. But regaining some independence will not come cheap for Lloyds shareholders, and substantial government support will still be needed.

The world has changed since the APS was launched on March 8. It prevented the collapse of the UK banking system, while stopping short of full nationalisation.

At the time, Lloyds agreed to submit assets worth 260 billion pounds — a quarter of its entire loan book — into the scheme. After absorbing the first 25 billion pounds of write-downs on the loans, the government would absorb 90 percent of any further losses.

The fee was 15.6 billion pounds, in the form of ‘B’ shares convertible into ordinary shares at 115 pence. Lloyds shares were around 42 pence at the time, so the terms were extremely generous to the bank.

The crisis passed, and Lloyds shares have more than doubled. Five months on, the bank has a better handle on the losses in its loan book, particularly the disastrous HBOS portfolio which accounted for 80 percent of its 13.4 billion of write-downs in the first half.

Having taken what peers consider to be a conservative view of provisions (i.e. a lot), Eric Daniels, Lloyds chief executive, went so far as to predict last week that bad debt charges had peaked.

from Neil Unmack:

UK mortgage debt: remain calm! All is well!

That's the message given by Moody's today on the resilience of UK mortgage-backed securities to the current downturn. The survey is based on so-called master trusts, a kind of securitization vehicle first applied to U.K. mortgages about a decade ago which quickly became the most efficient way for a large bank to securitize home loans. The master trusts grew so big that they now finance about a fifth of all UK home loans (although a large chunk of this must have been from deals issued by banks after the credit crisis to use as collateral for borrowing with the central banks).

Master trust bonds haven't been immune to the credit crisis. Forced selling by SIVs and funds caused yields on AAA master trust securities to gap out sharply from their low of around a tenth of a percentage point over Libor. Spreads have rallied in recent months, but they are still around 2 percentage points over Libor, largely because many asset managers simply won't touch illiquid asset-backed debt, even if the returns are much higher than equivalent corporate bonds. 

Anyway, Moody's latest report on the sector may give some grounds for cheer. The firm conducted a stress test of the master trusts to see how the deals would perform in a 1990s-style housing downturn. The result; no bonds, not even the sub-investment grade securities, would suffer a loss, Moody's says. Moreover, no bonds would even be downgraded under the stress, which applied the same level of reposessions as seen in the last downturn.

There is one caveat here. Moody's analysis assumes that loss severities -- losses after repossessing and selling a house and taking into account accrued interest -- will remain at similar levels to those seen so far this year. That may yet prove optimistic if prices start to fall again.

No early bank exit for Britain

John Kingman has finally stated the obvious. After nine months of near-silence, the civil servant responsible for managing the UK government’s bank shareholdings has piped up to say Britain must be patient in recovering the 35 billion pounds it has so far injected into Royal Bank of Scotland and Lloyds Banking Group.

But Kingman has not gone far enough in stating his objectives. If British taxpayers are to fully recover the sums they have pledged to rescue their banks, they should hold onto their shares for a very long time.

UK Financial Investments, the body Kingman runs, has played down any hopes for an early exit from its bank shareholdings. This is sensible. With an election due in the next twelve months, Gordon Brown’s government is desperate to show an early return on the funds it has injected into the industry. But selling out now would be a mistake. The paper loss on Britain’s investments in RBS and Lloyds alone is currently around 11 billion pounds.

Meanwhile, UKFI is being far from clear about its own goals. Kingman even refuses to say whether he is aiming to fully recover the sums injected into RBS and Lloyds. True, setting an explicit target would tie UKFI’s hands by allowing investors to anticipate its actions. In the absence of a clarification, however, the suspicion will be that the government will in future raid its bank shareholdings to raise some much-needed cash.

One way out of this dilemma is to issue exchangeable bonds convertible into RBS and Lloyds shares at premium to the current market price. However, the government would be forced to buy back the bonds in the future if the shares failed to rise.

Moreover, taxpayers’ exposure to RBS and Lloyds goes far beyond the equity they currently hold. The government is about to insure those banks against future losses on some 450 billion pounds of toxic assets. In return for this insurance, UKFI will receive 51 billion and 37.1 billion non-voting shares in RBS and Lloyds, respectively.

But this does not compensate for the cost: mounting losses mean Lloyds could start claiming on its insurance policy before the end of 2009. The final bill will not be available for years.

Humbug watch: Lord Levene on “fair pay”

Lord Levene, chairman of Lloyds of London, the insurance market that offers a berth for those who fluff their job interviews at the City investment banks, offered the following sage remarks about pay to the British Bankers’ Association dinner on Monday 29th June:

At Lloyd’s we held a conference a few months back in New York discussing the origins of world wide risk and, in particular, the current problems of the banking industry.  Speaking at the conference was one of the most successful and best known investment bankers in New York.  One remark he made sticks very much in my memory.  He said that when he got his first job on leaving business school at a New York investment bank, he was paid $30,000 per year.  At that time, the CEO of the bank was paid $300,000 a year.  He thought that that was a sensible multiple.  Perhaps we might reflect on the highest paid individuals in some of our institutions and ask whether they are paid more than 10 times the amount of a new joiner.  I would leave that thought with you.

Fine words. One can imagine the looks on the faces of the City grandees in attendance as they digested this thought with their Sylphides à la Crème d’Écrevisses. But do they butter many parsnips, as the saying goes. Let’s see how Levene measures up by this rough and ready standard. According to the Lloyds website, a graduates’ starting salary is £26,000 a year. Levene’s remuneration in 2008: £806,000. Levene/graduate multiple: 31 times.

Humbug rating: five humbugs.