Nervous banks hedged UniCredit exposure

Despite some banks worrying that they would end up as shareholders, the €7.5bn rights issue by UniCredit ended with exceptional support as 99.72% of the rights were exercised.

Banks had put on a brave face as the share price collapsed by 45% in four days, including the first day of subscription. But their worries were all the more acute as it turned out that several underwriters had spent significant chunks of their fees on hedges – and these were not performing.

Three banks admitted to IFR last week that they had used basic hedges, largely deep out-of-the-money puts on European indices, to mitigate some of their underwriting risk. Many others in the extensive syndicate distanced themselves from this practice, arguing that it would undermine their promise to back the issuer.

However, bankers made plain that when they committed to underwrite the rights issue in November 2011 this was a very high-risk transaction and European firms in particular felt pressured to back a fellow European institution caught up in the eurozone crisis. Banks were also nervous as the two previous rights issues by Italian banks – for BPM and UBI in the second half of 2011 – had both ended up with the underwriters holding shares.

Some reacted to the risk by using basic equity hedges.

Doomsday scenario

Underwriting agreements state that banks are not allowed to enter into hedging transactions on the underlying stock. But underwriters can hedge in any index where the underlying asset has a low weighting, normally less than 10%–12%, in a portfolio of stocks or an individual stock – though the latter is difficult as it would affect the other company’s share price.

“The market exposure is so high [from underwriting in the midst of a crisis] banks may buy a crash or deep out-of-the-money put in an index like Euro Stoxx just to hedge against a meltdown in the market,” said the head of syndicate at a US bank.

One bookrunner admitted spending a hefty €2m–€3m on basic hedges on the Euro Stoxx, typically out-of-the-money puts or options. A second said his firm had hedged just €20m of exposure using the DAX, after concluding that it could not use the Euro Stoxx because this included Italian banks. A source at a third firm said it had bought a “not particularly significant” amount of deep out-of-the-money puts.

“Gone are the days when you can say having a fully underwritten transaction is a mark of support”

The hedges were basic and performed poorly. As UniCredit shares dropped by 45.2% over four days, the Euro Stoxx 50 softened by 4.3%, the overall Euro Stoxx by 3.6% and the DAX by just 2.4%.

Bankers at two of the firms involved indicated that the hedging had been completed largely to satisfy internal risk committees and had been carried out against a doomsday scenario.

“It was very small, very rubbish and for the sake of it,” said one. “We used our 25bp volume underwrite fee and it was just in case the whole world ended.” He added, though, that €20m would have clearly made no difference to his bank in that doomsday scenario.

Discount works best

Other bankers pointed out that there was no way to effectively hedge rights issue exposure and that the risk/reward ought to be addressed through the fees, TERP discount and, if possible, sub-underwriting to shareholders.

“Hedging never works, as the correlation between the bank undergoing a rights issue and whichever sector or basket you choose diminishes once the rights issue begins, and so you lose all the fees you gained in getting on the deal,” said one head of European ECM.

“You should either be comfortable with the underwriting risk or not. That’s why the only hedge that really works is sub-underwriting,” said the head of syndicate.

A number of bookrunners agreed that the wide 43.3% discount to TERP was an effective hedge in itself, albeit one that was tested during the initial stock dive.

“With that discount to TERP, if you are still negative on UniCredit that’s a very negative view of the equity market,” said the regional head.

One banker pointed out that the hedge could also be a distraction if it turned into a “John Travolta” – a situation where the hedged index moves up while the underwritten stock falls, a reference to the iconic poster for Saturday Night Fever where Travolta’s dance move involves one finger pointing to the ceiling and the other to the floor.

While the hedges could be viewed as largely innocent and even amusing by rivals, given their simplicity and likelihood of failure, some bankers were outraged at learning of the practice.

“When banks speak to issuers they are whiter than white, and by and large nobody admits anything otherwise,” said one head of syndicate that underwrote UniCredit. “People make a lot of noise about acting in an issuer’s best interests, but it seems you would spend as much time worrying about hedging the risk as doing the deal. Gone are the days when you can say having a fully underwritten transaction is a mark of support.”