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.

Four Seasons debt odyssey – still one more year to go

Four Seasons Healthcare, the UK care home operator, has finally completed its 1.5 billion pound debt restructuring, after a year of creditor wrangling. The group has ended up in the lap of lenders including RBS, which owns about about 40 percent of the company.

Now it has to set about refinancing 600 million pounds of asset-backed debt due next September, which makes up the bulk of its remaining 780 million pound debt pile. If the company can pull it off it will be extra good news for RBS, which managed to negotiate a deal giving it an extra slug of equity (just over two percent) in exchange for advisory services, based on performance.

Four Seasons isn’t the private healthcare group to end up in RBS’ loving hands. The bank also indirectly owns the Priory Group – which it inherited from ABN Amro. The Dutch bank’s structured financiers bought the group in 2006 and refinanced later in the asset backed debt market.

Four Seasons original owner, Three Delta, run by former Natwest banker Paul Taylor, was less lucky. The company defaulted after failing to refinance a two-year loan taken out at the time of its acquisition at the top of the market in late 2006.

RBS issue must be on commercial terms

Britain’s state-controlled banks appear to be playing a game of tit-for-tat. Lloyds Banking Group last week admitted it was looking for ways to reduce its exposure to the government’s insurance scheme for toxic assets. Now it turns out that Royal Bank of Scotland is also sounding out investors about tweaking its own involvement in the scheme.

That is where the similarities end, however. RBS is being much less ambitious than Lloyds. It still wants the government to insure all of the assets it agreed to put into the scheme in the winter. It just wants to pay some of the premium in cash rather than its own equity. This may look a superficially attractive way to de-risk the tax-payer’s huge exposure to bank equity, but the government should think hard before accepting.

Unlike Lloyds, RBS is not proposing to scale back its use of the government’s asset protection scheme (APS). Instead, the Scottish bank is considering raising at least 3 billion pounds, about a tenth of its market value, from shareholders to help fund the 6.5 billion pounds it has agreed to pay (but not yet coughed up) in order to participate in the scheme.

When the APS was negotiated in February, RBS offered to pay this fee by issuing the government with `B’ shares that convert into ordinary stock at 50 pence. At the time, when RBS shares were changing hands at around 20 pence, that looked like a pretty good deal for the bank. But the recovery in RBS’s share price now means it can contemplate raising cash privately at a similar price.

The key question is how RBS’s fundraising is structured. The bank’s shareholders have given it the green light to issue up to two-thirds of its share capital, but any issue that involves selling more than 5 percent of its share capital must be offered to all shareholders, including the state.

In practice this means that the government, which already owns 75 percent of RBS, will have to decide whether or not to take up its rights. If it chose not to, the dilution from the rights issue and the reduced issue of `B’ shares would keep the government’s shareholding below 80 percent.

On the face of it, any move that replaced state funding with private capital should be welcomed. But it is also important that taxpayers do not lose out. UK Financial Investments, custodian of the government’s stake, should insist that it will only stand aside if a rights issue is priced at a modest discount to RBS’s share price, which on Monday already slipped almost 5 percent to 53.65 pence.

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.

The European Commission strikes back

Reeling from the humiliation of failing to stop Belgian bank KBC paying interest on some of its subordinated bonds, the European Commission has won a new victory in its bid to see bondholders share the pain of bank bailouts.

Acting as a sort-of policeman for Brussels, the UK’s Financial Services Authority has prevented the Royal Bank of Scotland from repaying four subordinated bonds at their first opportunity, causing prices to plunge by up to 15 percent. The Upper Tier 2 euro-denominated bonds fell to between 70 and 75 cents, depending on who you ask.

Behind all this lies the long arm of the European Commission, which recently launched a crusade to see banks’ subordinated bondholders share the pain of public-sector bailouts.

Brussels is very uncomfortable about the idea that banks that have accepted state funding should then use some of that money to pay discretionary dividends on, or redeem at par, bonds they have issued that are trading at a discount to face.

While it works out what to do with the banks, it doesn’t want to see them pay dividends or call bonds. In the case of the RBS, the FSA seems to be acting as its enforcer.

Coming up with a simple approach is far from easy. It’s a tricky negotiation process between the banks and the EC, made harder by the sometimes fiendishly complex nature of the debt in question, in which bondholders’ rights vary enormously depending on the instrument.

This week KBC managed to side-step the Commission, saying it would pay interest on some bonds after lawyers were able to convince Brussels that they were mandatory, not deferrable.

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.

Are Lloyds shares cheap? Not as cheap as this funny money

Shares in Lloyds Banking Group are worth 150 pence apiece, according to the analysts from Royal Bank of Scotland, who think the shares offer “a compelling restructuring opportunity” around today’s 95 pence.

Lloyds, say the brokers, is going to recover sufficiently to pay a nominal dividend next year, and something quite substantial in 2011, thanks to margin expansion, cost control and normalising bad debts.

Well, maybe. Over in the distressed debt market, they are a lot less sure. Mind you, they are not very sure of anything, and anomalies abound. Brokers Collins Stewart, who have specialised in the backwaters of preference shares and PIBs, have one this very day. They are offering the snappily-titled HBOS Capital Funding 9.54 percent fixed-to-floating perpetual preferred securities at 65 pence.

The buyer gets a 14.68 percent return until 2018, when he either gets 100 pence, or the coupon is reset at Libor plus 6.75 percent, a rate deliberately designed to be punitive for the borrower, which is of course, HBOS’ parent, Lloyds.

That, at any rate, is the theory. Existing holders of these obscure instruments have little idea how to value them. As Collins Stewart point out,  similarly-ranked paper from Lloyds itself yields 11.28 percent. There’s the additional risk of Lloyds following Northern Rock’s example and electing not to pay the interest, since it’s clear that the bank is still short of capital.

The point, though, is that Lloyds cannot pay a dividend if interest on these higher-ranking securities is not up to date. If the RBS analysts are right, then the mouthful of HBOS stock above is cheap; it looks better value than the shares, at any rate.

Why is RBS’s boss selling its shares?

Controversy and running RBS go hand in hand. Stephen Hester replaced Fred Goodwin as chief executive of RBS and is now in hot water himself over his incentive pay deal. The chief executive of the state-controlled bank could be paid 9.6 million pounds over three years if the share price (currently 44p) reaches 70p. However, he seems to have so little faith in the shares reaching that level that he has offloaded 1,264,565 shares since last November at prices between 28.5p and 48p, yielding just over 464,000 pounds.

When  unveiling first half results last week Hester asserted that “We have a strong plan in place that I believe can get us to where we need to be by 2013,” which presumably includes recovery in a share price still languishing more than 90 percent off its peak.

The official guff goes that Hester was granted shares, in tranches, when he joined RBS in lieu of those he would have received at British Land. Under British tax law, the awards are treated as income and so Hester sold some of the shares granted “to meet an immediate income tax and national insurance liability.”

In doing so, Hester can claim to be following best financial practice in matching a liability with the corresponding asset. Finance theory also says that investors should not put all their eggs in one basket.

Moreover, senior managers are highly circumscribed in when – or why – they can sell. There is virtually no “good” time and even fewer good reasons to sell. Therefore, if Hester thinks he might need to trim his holdings at any time, the best time to do so is when he has what looks like a legitimate reason.

And yet, and yet.

There are good reasons why Hester will be barred from selling the shares he is granted within his 9.6 million pay deal for five years. When investors’ money is at stake, they want to know that management has “skin in the game”; that he suffers when the share price falls and benefits when it rises.

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.

You are not a loan, RBS ads remind customers

Is the Royal Bank of Scotland softening up the public and politicians ahead of its results on Aug 7th with a series of newspaper advertisements telling us how many loans it is dishing out?

The 70-percent state-owned bank is expected to post a pre-tax profit of 1.2 billion pounds for the first half of the year, according to a Reuters poll of analyst forecasts. 

RBS is going to need to show British taxpayers that their investment is doing more than just helping the bank back into the black — particularly following criticisms that along with other banks it has not passed on the money the government has made available to it.

The RBS ads, carried in The Guardian newspaper, personalise the bank’s lending by naming some of the businesses it is supporting.

Along with a full-page letter to RBS shareholders from CEO Stephen Hester, the ads say that businesses have benefited from over 100,000 loans from RBS this year and that the bank is providing more than 5,000 loans to UK businesses every week.

While RBS says it is making 9 billion pounds of net new mortgage lending available to its retail customers over the next 12 months and has committed to making 16 billion pounds of new net lending available to UK businesses over the same period, nowhere does it say how much of this it has lent so far.

Let’s hope the bank has worked out the figures by the time of its results, after all they are bound to be asked.