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Banks Recapitalization : Implications for hybrid debt holders

Who will be recapitalized and how much? How recapitalization work? And most importantly, for investors, how does it impact bank hybrid debt? These are the issues addressed by Philip Hall, Volatility and Credit Quantitative Manager and President of Axiom Alternative Investments ...

Article also available in : English EN | français FR

I. Introduction

The press is widely echoed the willingness of European states to better capitalize their banks. Just months after stress tests found to be satisfactory and a few months before the establishment of a new comprehensive prudential regulation, the initiative can make you smile as it demonstrates the inability of European leaders to assess the current crisis and constraints faced by banks. No matter, the reality is there: the political will is such that banks will be recapitalized certainly in the coming months. Some questions naturally arise: what will be the impact of the recapitalization on the current crisis? Who will be recapitalized and what amount? How recapitalization work? Banks will they be nationalized? And most importantly, for our investors, what the impact on bank hybrid debt? These are questions that we address here.

II. Why recapitalize banks and how does it impact the crisis ?

Let’s face it; recapitalize banks today is useless. Why?
- This is useless because the banks have never been funded.
- This is useless because the prudential requirements imposed on banks have been accentuated in recent months (Basel III, then Stress Tests I and Stress Tests II) and each time the crisis has intensified than decrease.
- This is useless because all the banks that have "failed" or that had to be saved in emergency displayed very high solvency ratios: Northern Rock, HRE, Dexia, RBS, etc..
- More importantly, it serves no purpose because the banks do not suffer from a lack of capital, but a lack of trust and collateral. The subprime crisis has shown once again that banks fragility lies in the possible loss of confidence, not capital losses. The rate of loss on the famous toxic assets, these ABS slices of subprime rated AAA, has finally been only 0.17%. This ridiculously low figure had no significant impact on bank capital. These are forced sales, the Mark to Market, the investors fear who refused to continue lending at low rates and attrition of the collateral available to refinance while investors refused these AAA assets as collateral , which generated huge losses from the crisis. The indirect effects were far more important than direct effects. The problem is not in the amount of capital required to cover these losses, it comes from the style of contagion.

The rate of loss on the famous toxic assets, these ABS slices of subprime rated AAA, has finally been only 0.17%. This ridiculously low figure had no significant impact on bank capital. These are forced sales, the Mark to Market etc ..., which generated huge losses from the crisis.
Philip Hall

Similarly, in the current sovereigns debt crisis , banks go through a crisis of confidence related to the risk of explosion of the Euro area, the consequences would be incalculable with tension on refinancing market related to this crisis of confidence and the massive reduction of collateral available including repo markets: increased haircuts, fewer AAA assets. In this context, a recapitalization is useless because none level of capital will protect banks against the risk of explosion of the Euro area or Italy default . If the assets and liabilities are suddenly denominated in different currencies, the losses are potentially unlimited and banks will not stand for "bank runs" that follow a sudden change of currency. Finally, it is useless because the crisis originated in the "manufacturing defect" in the Euro area and the introduction of Greek PSI scared investors by confirming some of their fears: the sovereign assets of euro area are not without risk. Assert a commitment to recapitalize the banks in order to inflict greater losses on sovereign assets only adds fuel to the fire and returned to fill a hole by digging another hole - deeper (a fairly common technique in the European finance ministries). Apart from the EFSF, all devices designed by European leaders to manage the sovereigns debt crisis (ban on CDS and short sales, greater control over the rating agencies, bank recapitalization) only deal with different thermometers available without acting on the fever origin. Unfortunately, one issue remained aloof from all discussions, the only really worthwhile: once the CDS banned, short selling removed, rating agencies muzzled and banks recapitalized, what could tempt an investor to buy Italian government bonds?

The problem is not in the amount of capital required to cover these losses, it comes from the modes of contagion
Philip Hall

Recapitalize banks would therefore have no interest without a complete and finally effective control of the sovereigns debt crisis (a device that we have already discussed in other documents). Moreover, in this case it would not do anything either, since the banks would then be overcapitalized, once the risk we wanted to cover disappeared. However, the political decision has obviously been taken and recapitalizations will certainly occur. They will not solve the sovereigns crisis, but will necessarily have an impact on banks hybrid debt.

III. Who and how much ?

How high will the banks be recapitalized? The estimation is highly complex because it is primarily the result of purely political decisions without solid economic base. The press echoed many options, analysts have proposed different methodologies and were able to read numbers as far away as 50Mds 400Mds € or €. To this is added the confusion related to capital requirements resulting from the implementation of Basel III, which are known from the QIS conducted by the Basel Committee, but which in theory will be fully felt in 2018. Clever is the man who knows now how much capital banks will have to raise and especially... Let’s explore some ideas that seem the strongest.

In this context, a recapitalization is useless because none level of capital banks will protect against the risk of explosion of the Euro area or Italy default.
Philip Hall

- The new capital should be in the form of core Tier 1, as defined by Basel III / CRD IV and the need for capital should be calculated using the Core Tier 1 ratio. It does not seem to be about complementary hybrid capital. However, remember that Basel III gives differential treatment to the capital hold by states and, paradoxically, hybrid capital could be included in the Core Tier 1 if held by the state. We discuss this point below.
- The calculations of capital requirements should be conducted under the auspices of the EBA, in the stress tests format, and not in the classic solvency ratio. A core tier 1 ratio of 9% after stress test goes beyond a prudential ratio with a Core Tier of 9% and well above the Basel III ratio of 7%. This raises a real problem of superposition of two prudential rules, while we have just deeply redesigning measurement of regulatory banks capital.
- Weighted assets should be calculated in "Basel 2.5", ie with some significant overload compared to Basel 2. However, the prudential filters in the Core Tier 1 Basel III should not be applied (AFS reserves, deferred taxes, etc.).
- Finally, and the heart of the problem, some sort of discount should be applied to sovereign debt: fixed discount, market price, subtract the negative AFS reserves, the final methodology remains to develop. An approach to the market price seems to hold the rope as it avoids the painful political issue about displaying arbitrary haircuts for some large countries, but it raises the question of the inclusion of potential gains to offset potential losses This would encourage some banks (British, in particular.) but would reduce the impact of the measure.

Several analysts have estimated the missing. The differences between the approaches are mainly three factors: the threshold of Core Tier 1, the use of a negative macroeconomic scenario or not, and the level of discounts on sovereign debts. We believe that organized leaks to the press are realistic and that the threshold will be set at 9% with a mark to market on the PIIGS but no macroeconomic stress scenario. Morgan Stanley has estimated this scenario, which seems the most credible, limiting itself to certain banks, including the Greek banks, Portuguese and Spanish, no doubt that the total figure would be closer to € 100Billion.

The conclusion from this work is that for large European banks, the amount of capital to raise is substantial (up to € 5Mds Deutsche Bank) but quite manageable in view of their market capitalization (20% for Deutsche Bank) and their access to capital markets. Naturally, the situation will be much more complex to manage in Greece, Ireland and Spain (for the Cajas) and injections of public capital will be needed in those countries. We now examine the probable terms of recapitalization.

IV. How ?

Governments have clearly stated their desire for banks to use market initially. Apart from the ordinary shares, there is no common market instrument eligible for Basel III Core Tier 1. Recapitalizations, will therefore be as simple capital raising, particularly for institutions that do not have the ability to achieve the target ratio for Core Tier 1 with their profits by 2011 and 2012. But do not neglect the sector profit potential. This is especially true for French banks. Morgan Stanley’s study cited above shows Core Tier 1 deficits below their 2011 profits. Some banks have therefore the ability to achieve the target ratio of 9% without coming to the market.

In addition, according to equity analysts, the largest banks listed in the Core Area (with the possible exception of Dexia, which is of course a special case) would be able to raise these funds in equity markets and will do if the alternative is a nationalization. Injections of public funds will be needed in the PIIGS, Greek banks, Portuguese banks, Cajas in Spain and, perhaps, some Italian banks, or banks already nationalized as some German public banks. In countries under EFSF program, then it is likely that the money injected would come from the EFSF.

The alternative to private recapitalization is that some countries accept or choose public recapitalization to prevent their banks from operations considered too dilutive. We believe that in this case, the instruments used are probably hybrids rather than common stocks, neither the banks nor the states would indeed benefit from governments equity stakes in banks , while we are looking to break the vicious circle between bank risk and sovereign risk. Regulatory flexibility would then allow the states to provide the Core Tier 1 without buying shares: hybrid securities (as in 2008) or CoCo whose conversion to ordinary shares would be triggered if the bank does not reach the threshold of 9% before 2014 , for example. This would give banks time to generate sufficient profits (retained earnings) to reach the threshold of 9%.

Some banks may be partially or fully nationalized: this risk is present in Greece, Portugal for some banks, the Cajas in Spain or in Italy (Banca Popolare and Banco Popolare Milano [1]). Apart from these cases, there is no real risk of nationalization.

Finally, the overall impact of recapitalization will be positive on hybrid debt, as they are mostly made out of all state aid
Philip Hall

V. How does it impact hybrid debt ?

At the macro level, the most obvious impact of these massive recapitalizations will be a strengthening of the capital, a reduction of credit risk and dilution effect to existing shareholders: as the Basel III reform, these recapitalizations will be generally positive for bank loans, including subordinated, and negative for shareholders.

At the level of individual bank, the impact of a possible recapitalization will depend on the structure chosen to recapitalize banks and the terms of each hybrid debt.

a. Private structures

In the context of purely private recapitalization, the impact on hybrid debt comes from two main factors:
- The increase in capital reduces the credit risk, increase profitability (but not profitability per share) and therefore promotes the payment of coupons and the exercise of calls.
- The importance of Core Tier 1 criterion in relation to the rest of the regulatory capital strengthens the interest for banks to redeem their hybrid debts in the market and constitute Core Tier 1 with the profit generated. This is what Caixa Geral and BPCE have been doing. Other banks would soon adhere to a similar approach.

b. Public structures

In the case of public structures, the analysis is more complex. The analysis of several European examples in recent years shows that we must distinguish several cases:
- Whether or not a state aid
- Complete or partial nationalization - or no nationalization
- Existence of a bad bank

When it came to rescue or assist troubled institutions, European states have adopted very different strategies, depending on their own sensitivity, but also depending on the situation of the banks concerned. Moreover, the same rescue plan may have very different impacts on several instruments of the same group, as shown by the examples of Northern Rock or, more recently, Dexia. We cannot say point blank that the "nationalization" will have a particular impact on hybrid debt, we must go into the details. The existence criterion for a state aid and / or its terms, are important because the European Commission, in many cases, but not all, imposed constraints on the payment of discretionary coupons on banks hybrid debt having receiving a state aid (in the legal sense).

Any injection of public funds in a private company may not be a state aid. When made at a normal price or in normal market conditions, the injection does not constitute a state aid. This is for example the case when the State subscribed to the company capital under the same conditions than other private actors. Otherwise, the injection is an aid that can be declared compatible if it is the subject of counterparties that avoid creating competition distortions. Counterparties may be more or less restrictive depending on the case. This may be about a single premium paying a public guarantee, a limitation on the dividends payment or coupons linked to hybrid securities, or an obligation to transfer some industries.

For investors in hybrid debt, the risk associated with the injection of public funds come from several factors:

- coupons interruption risk : this risk occurs mainly when a decision of the European Commission bans discretionary coupons for a certain period. It is also reflected when the state takes control of the bank and decides not to pay discretionary coupons. This second case is less likely because the state is generally keen to quickly disengage from the bank (ABN Amro case or HRE for example) and then continue the payment of dividends / coupons.
- "absorption" losses risk: this risk materializes when the state decides to limit its injections to the bank capital by imposing losses on subordinated creditors in a coercive manner, just like what happened in Ireland. For reasons we have discussed extensively in other research papers, this risk seems very low and only concerns the few banks that have no more viable strategy in the long term and are just "walking corpses". Moreover, these approaches give rise to significant litigation and will not be favored by the states.
- The risk of "siphoning" or majority’s abuse: this risk materializes when the government is in conflict of interest or because it is located at both ends of the capital structure (senior debt /guarantees and capital) or because it is both the buyer of assets and the majority shareholder of the assets seller. It is tempting to calibrate the cost of disposal or guarantees to leave in the bank just the bare minimum. This risk is still relatively small for three reasons: states generally seek to leave the viable banks in order to sell them, banking regulations dictates to leave core capital and thus bans the "dismemberment" of banks and it is naturally impossible to calibrate the price at the sufficient level to protect senior debt without protecting subordinated debt, which is a very thin part of the balance sheet. In addition, the current talks at European level apply only to capital injections and no guaranties or defeasance structure, which a priori rules out this risk.

In addition, public recapitalization may also provide important protection for investors in hybrid debt:
- Ensuring the maintenance of regulatory ratios or improving gross profitability, in some cases, it can strengthen the coupons payment. (This naturally depends on the terms of the prospectus.)
- When recapitalizations are performed using hybrid instruments (and no shares) investors and the state become pari passu, which strengthens the investor position who is therefore "on the strong hand side ". Thus, in recent years, public capital injections have been able to protect the coupon payments or avoid triggering mechanisms of absorption losses because the state would also have been affected.
- When they are done outside of any state aid, the public capital injections are not usually accompanied by constraints on hybrid debt and they only reinforce the bank financial position and thus the value of hybrid securities. Even for "nationalized" banks , recapitalized using public funds or benefiting from state aid, it is not possible to generalize the impact on hybrid debt. A detailed analysis on a case by case basis, bank by bank, is required to measure the impact and benefit from it - what we will obviously not do here.

Philip Hall , October 2011

Article also available in : English EN | français FR

Footnotes

[1] However, the nationalization of these institutions would be politically very difficult: the need for capital is mainly due to exposure to Italian sovereign debt and nationalize a bank on the grounds that the country that buys is unable to pay its debts is an exercise for the less complicated ...

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