Bankers, regulators eye next generation of CoCos

By Reuters Staff
November 20, 2009

By Jane Merriman
LONDON, Nov 20 (Reuters) – Investment bankers are already pitching to clients a new form of hybrid bond that financial regulators see as a potential saviour of troubled banks, but it is uncertain if they will work or if investors will buy them.The bonds, which convert to equity if a bank’s capital runs low, have been created for Lloyds as part of a 21 billion pound ($34.63 billion) capital raising to free the UK bank from a government insurance scheme for bad loans.

The new Lloyds’ hybrids — known as enhanced capital notes — are a special case because the bank is offering them to investors in exchange for bonds where coupon payments will be deferred for two years.

These investors are expected to bite because they will get a higher coupon rather than no coupon.

One banker likened it to a forced exchange. As such, the real test for contingent convertibles (CoCos) will come if and when other banks decide to issue them.

“CoCos will have a role if they are priced efficiently by the market and this is where we have to still see more new deals coming to the market which are not part of an exchange,” said Thibaut Adam, head of capital markets structuring at BNP Paribas.

“We need to see new issues from stronger names and see how they price.” He said there were proposals in the United States to have systemically important banks issue these instruments.

Hybrid structurers said that the price needs to be attractive relative to the cost of raising true equity capital.

A number of financial regulators have given their support to CoCos, including the Bank of England.

“All the regulators are looking at them,” said Thomas Huertas, FSA banking sector director. “It’s a rapidly evolving area where a consensus is developing,” he said, speaking on the sidelines of a Citi European Credit Conference.

“We’ll look to see how the Lloyds’ ECNs (hybrids) go.” The results of Lloyds’ bond exchange are due on Monday.

Huertas said CoCos would be discussed by regulators at the Basel Committee on Banking Supervision in December.

CoCos’ selling point with regulators is that they convert into equity just when a bank needs more equity. And equity is the kind of bank capital regulators like because it can absorb losses while the bank is still a going concern.

In Lloyds’ case, the bonds would convert if the UK bank’s capital fell to 5 percent.

“Technically, the bank gets more capital in because the CoCos convert,” said Gary Jenkins, head of fixed income research at Evolution Securities.

“It’s got to be a positive and it’s better than what we had before, but it doesn’t necessarily mean it saves it.”

Jenkins said most troubled banks fail because of liquidity problems, which would not be solved, even by a capital injection from CoCos.
DIFFERENT UNIVERSE
Bond investors have so far given Cocos a cool reception.

Bank of America Merrill Lynch, for example, had to row back on a decision to include them in its bond indexes after investors objected.

Investors say CoCos do not really have the characteristics of traditional bonds, which should offer stable cashflows and relatively low-risks.

“There will be people who opportunistically use them,” said Lise Coleman, head of global credit fixed income at JP Morgan Asset Management. “It’s a way of getting a higher beta play into your portfolio. But it won’t be the traditional buyer base… it will be a different universe.”

The type of investors attracted to CoCos could pose questions for regulators.

“Would it be an issue for the FSA who provides this (capital) buffer?,” said Oliver Judd, financials analyst at Aviva Investors. “Is it a long-term stable investor base or a more short-term volatile investor base?”

CoCos could evolve to reassure mainstream investors.

One additional feature under consideration is that the bonds convert into a variable number of shares, bankers said. Another issue is whether regulators would have some discretion over when to activate the conversion, they said.

With regulatory momentum behind them, CoCos could gain some credibility, but bankers said they doubted if a brand new CoCo bond could come to market before Christmas.

“But would someone start to add a sort of contingent spin on Tier 1 issuance in 2010? Well, we are certainly pitching for that and people are listening,” said Adam.
($1=.6064 Pound) (Additional reporting by Claire Milhench; editing by Simon Jessop)
((jane.merriman@thomsonreuters.com; +44 207 542 3121; Reuters Messaging:jane.merriman.reuters.com@reuters.net))

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