Winners take all

2010 was the year concerns about the health of European sovereigns eclipsed the banking crisis. For the first time since the credit crunch of 2007, financial institutions were no longer the sole target of public opprobrium, and concern about defaults centred on entire countries. Bailouts were no longer an enforced favour from taxpayers to their national banking systems but had become instead an international rescue mission mounted to prevent the EU bloc from foundering on its own economic contradictions. Yet while the financial crisis may have found a new epicentre, the aftershocks were felt everywhere, and nowhere more so than in financial institutions. Banks, especially those that had been in receipt of state aid, were viewed as highly correlated with their sovereigns as market participants and commentators waited for the next institutional failure that would turn investment bankers into de facto civil servants. High quality banks from the most troubled regions found themselves the victims of regional tiering by investors. Many institutions further down for credit curve found that they had no access to the market, even, in some cases, in government-guaranteed format. As the bid for quality assets increased in response to the general turbulence, covered bonds became the format of choice for many issuers able to access that market. For much of the year, the senior sector suffered prolonged periods of shutdown – including one of almost two months. These coincided with the worst episodes of the sovereign crisis as well-funded top-tier issuers refused to validate widening secondary levels with new issues. While they kept their powder dry, less well-regarded issuers dependent on the best banks’ willingness to reopen the sector found themselves locked out of the funding market. For every Rabobank (profiled in this supplement) able to fund through the cycle, there were many more that could not. On the capital side, the market has done its best to innovate in the face of a murky regulatory picture. The experience of the contingent capital sector is an example: two issues have emerged so far, each of them carrying both merits and disadvantages for fixed income investors. Those issues are both valuable for providing a context in which the discussion about that market’s future can proceed. But as this supplement went to press its future was in doubt following the latest communication from the Basel Committee, which explicitly excluded contingent capital instruments from the regulatory buffer in which many had hoped they would appear. There have been some successes on the regulatory side. The Committee’s proposal on burden-sharing in particular has been praised for its even-handed approach to ensuring that investors in capital instruments are not the unintended beneficiaries of future state assistance for banks. But the Committee’s habit of issuing piecemeal and incomplete updates on the new regime can hamper bank treasuries keen to comply as soon as possible with the new capital requirements. As one banker notes in these pages, there is no rule book as yet but the market sorely needs one.

At first glance, the progress made by a core group of financial institutions since the release of the European banks stress tests on July 23 was impressive. The following week saw BBVA become the first Spanish bank to issue unsecured senior debt since April, when it sold a €1.25bn five-year note. The price at which it sold the notes – mid-swaps plus 170bp – was also 30bp inside where an array of syndicate sources had thought it likely to print. “The market has improved hugely from the conditions seen during April and May, although we have a little way to go to reach the kind of backdrop we saw in Q1,” said Mark Geller, head of financial institutions syndicate at Barclays Capital in London. “The results of the stress tests and recent earnings numbers have improved confidence significantly and we have seen a strong rally in senior bank spreads.” There are various reasons why the mood has ameliorated so much from the spring. Top of the list, according to most London syndicate bankers, is the stress tests. Although this examination of the European banking system was far from flawless, it did bring some much-needed clarity to the situation. The generally good half-yearly results recorded by the banks are another factor, while growth rates in some European countries have been better than expected. The austerity measures introduced by the new UK government have won widespread plaudits from the capital markets. One of the success stories for European banks in the last few weeks of the summer was the Yankee market. UBS got the ball rolling with a US$2.5bn 10-year at the end of July, and then on a single day – August 10 – HSBC, ING and Royal Bank of Scotland raised a total of US$5.6bn. “A lot of the more frequent borrowers have done more than 50% of the funding required for 2010. The dollar market is looking good at the moment, as proved by the success of HSBC, RBS and ING,” said Edward Stevenson, head of UK and North European FIG origination at BNP Paribas in London. The Yankee market offers a series of signal virtues for the European bank borrower. It presents investor diversification, the chance to issue in size and at longer maturities than in euros and a hefty basis swap pick-up to euros. But to derive benefit from the US market required a considerable shift in sentiment from American investors. In the spring, US buyers were reluctant to touch anything made in Europe. By August real money accounts were falling over themselves to get their hands on European bank paper. London bankers were quick to attribute the Yankee success to the stress tests. Many bankers in New York saw it differently. “The ECB had a much more meaningful impact on the market’s willingness to fund the banks than the stress tests. The market had been worried about the banks and sovereigns defaulting. When the ECB - in combination with the EU - stepped up, it eliminated the risk of anyone defaulting,” said Justin D’Ercole, head of Americas investment grade syndicate at Barclays Capital in New York. Fast money accounts which had been gambling on at least one or two European bankruptcies also had to think again. “The hedge funds had bet on liquidity events. They did it with Lehman and they got it right. They did so with Morgan Stanley, Goldman Sachs, Citi, but the Fed bailed them out. Then they tried to bet on liquidity events in Europe but the ECB stopped them,” said a US syndicate banker.The haves and the have nots All this explains why some banks are now able to borrow in senior format. But there are still many banks that cannot do so – or can only do so at prices that would be economically unsound. As a result of the sovereign debt crisis, a distinct ‘tiering’ process has occurred within the European banking universe. “There is still a proportion of banks that are facing the same issues that they did three months ago – that is to say that their access to the wholesale funding market on an unsecured basis remains challenging. There are haves and have nots,” sai

After many months of anticipation, last Sunday the Basel Committee finally revealed the new capital ratios. Common equity, or core Tier 1, will be increased from 2% to 4.5% while the Tier 1 ratio will be raised from 4% to 6%. The market will have two years from January 2013 to accomplish this – an achievable task for most banks. A 2.5% capital conservation buffer composed entirely of common equity, rather than a proportion of contingent capital as some had hoped, will be introduced between 2016 and 2019. While this is not a mandatory requirement, banks not complying will suffer a curtailment of their rights to pay bonuses and dividends. The market reaction was broadly positive. More than one banker described the widely anticipated phase-in period as generous, although there were many notes of caution. “It’s not the worst case, but it isn’t all roses,” said Prasad Gollakota, head of capital solutions, EMEA, at UBS. “All they’ve done is spread them out over time, but the banks still need to meet requirements that will transform the sector; they will introduce a leverage ratio, liquidity measures and capital buffers. People now need to be managing towards those targets over time – capital planning is going to be really important over the next three to five years.” Gollakota is also concerned about the fate of instruments that are not grandfathered or lose such status. “How will they be treated? If they fall out of Tier 1 you can’t necessarily assume they’re compliant as Tier 2 because that in future has to have gone concern loss-absorption features, which past Tier 1 deals do not necessarily include. Also where do the trigger levels need to be set for additional going concern Tier 1? It’s unclear if the Basel Committee is going to leave that to the national regulators or tell them that the triggers have to be a certain level above the minimum.” Basel’s treatment of non-qualifying assets is a possible area of contention. These will be phased out over 10 years from 2013, losing 10% of their recognition as regulatory capital each year, or all of it in the case of step-up transactions once the first call date is reached. Grandfathering will only apply to deals issued before September 12.Contraditions All this contradicts the EU’s capital requirements directive, the current incarnation of which envisages an approach that looks at institutions’ total reserves rather than on a deal-by-deal basis. The current CRD approach is that institutions will be 100% compliant if by 2020 non-qualifying Tier 1 assets are at 20% or below of total reserves, falling to 10% in 2030 and zero by 2040. The EU has said it will clarify the terms of the CRD’s fourth version some time in the first quarter of next year, but as banks look to the EU and national governments for guidance as to the application of new regulations, there is currently an apparent contradiction. Another key point is the amount of hybrid Tier 1 issuance permissible under the new regime. “There was no further specific guidance on the predominance test itself, IE X% of Tier needs to be common equity and X% can be additional going concern capital,” said Gerald Podobnik, co-head of capital solutions Europe at Deutsche Bank. “We know the common equity minimum ratio will be 4.5% and the Tier 1 minimum ratio 6% and there is of course a 25% gap in between but this does not answer the question as to how much additional hybrid paper you will be able to include, so I would expect greater clarity on this in future publications.” UBS’s Gollakota is happier to infer a 25% bucket for hybrids from the rules as currently understood, but warns that for the market to reopen, issuers will have to take the plunge without any hand-holding from regulators. “There will need to be a meeting of minds – there will have to be one or two banks that take the lead and put something to the regulators, get a reaction from them and come to the market. The pack might follow – it might not be a case where issuance waits fo

It was all change for the Lower Tier 2 market on August 19, when the Basel Committee released its new consultation document entitled “Proposal to ensure the loss absorbency of regulatory capital at the point of non-viability”. Under the terms of the proposal all regulatory capital instruments will be required to contain a mechanism in their documentation ensuring that they will take a loss at the point of non-viability. This, says the Committee, should take the form of a write-off or conversion to equity once a bank cannot support itself in the wholesale market. The proposal hinges on the definition of the concept of a “gone concern”. The Tier 2 debt capital instruments in question have always been designed to become loss-absorbent when a bank enters insolvency and liquidation. The Committee argues this should apply at the point of a bail-out as well, to ensure capital instrument holders do not become the unintended beneficiaries of a public sector bail-out. The proposal precludes the use of a temporary write-down mechanism, as such a residual claim would be senior to the common equity injected by the state. As far as the Committee is concerned, “the increased downside risk will provide an incentive for the investors in capital instruments to monitor the risks taken by the issuing bank. If a bank takes more risk, and the risk of loss to investors increases, buyers of existing instruments in the secondary market, or new instruments in the primary market, will demand a higher coupon. This sequence of events should help impose additional market discipline on banks”.Weighing the options One option considered but discarded by the Committee was to stoprecognisingTier 2 as regulatory capital for systemically important banks. This was regarded as too complex and damaging. Naming systemically important institutions would carry moral hazard implications. Subordinated debt is also viewed as both an important indicator of a bank’s health and, in the case of banks not taking excessive risks, a cheaper capital source than common equity. Despite this, some market participants are likely to be disappointed. “There was probably some residual hope that Lower Tier 2 would only be drawn upon in the case of a wind-down and spared any burden-sharing in a rescue scenario, but that was somewhat optimistic in my view,” said Georg Grodzki, head of credit research at Legal & General. Lower Tier 2 issued to comply with the new regulations will probably come at a cost. “It is likely to become more expensive if issued in the new form,” said Steve Sahara, head of DCM solutions/hybrid capital at CA-CIB. “Tier 2 issued with either a permanent write-down or equity conversion is significantly more equity-like than old-form LT2 so could be more expensive for banks to issue.” While there is talk that transactions from perceived strategically important banks might be subject to more stringent treatment, thus acting as a playing field leveller, this remains conjecture at present. As the proposals appear to stand, “national champion first-tier banks may find it easier to access LT2 funding in the proposed form, with other smaller second and third-tier banks finding it more challenging – either the new-form LT2 could be too expensive or not feasible to issue if the investor base is too restricted”, said Sahara. While the reasoning behind the proposals is well understood, there remain concerns that the measures could be overly draconian. Commerzbank analysts summed up the view in a research note published on September 3 and attention-grabbingly subtitled ‘Bond issuance to become extinct?’. “Regulators are currently trying to resolve the so-called bondholder moral hazard, where bondholders rely on the systemically important banks being bailed out by their governments to avoid making losses while taxpayers suffer. While the regulators’ rationale is clear, they might be well on the way to taking it a bit too far,” they wrote. And the audience for the new-style paper

With just two contingent capital deals successfully completed so far, the asset class is still in its infancy. Its supporters argue that it could represent the future of the hybrid market. But with continued uncertainty over the regulatory treatment of the structure, it is still too early to tell. Lloyds was first out of the traps with a contingent capital deal last November, a €7.5bn Lower Tier 2 transaction that is convertible into equity if a core Tier 1 threshold of 5% is breached. That trade, the result of an exchange offer for existing Tier 1 and Upper Tier 2 securities, was followed in March by a transaction from Rabobank targeting new money, a 10-year deal of €1.25bn, featuring a write-down of principal to 25% of par if the bank’s equity capital ratio falls below 7%. Since then, the market has languished, with opinion divided as to which of the two will be the model for future deals. The Basel Committee has since published a proposal on ’gone concern’ contingent capital (discussed in a separate feature in this report). Some argue that the Rabobank trade was specific to the issuer and could not be replicated by banks that did not benefit from Rabo’s enviable credit rating. But one banker involved in structuring both deals rejects that view. “It could be replicated by other issuers,” said Prasad Gollakota, head of EMEA capital solutions at UBS. “There were people before and during Lloyds saying the deal might fail, and when it was a success they said it would only work for an issuer going through a distressed situation and that no one would buy a new issue, then we saw Rabo and people said that structure is restricted to them because they’re triple A. But the truth is that markets evolve this way. You get exceptional cases and stronger credits first – it doesn’t mean they won’t work for others.” Both issues have advantages and disadvantages. Lloyds’s equity capital note is not ideal for a fixed-income investor to hold, because most investment mandates are not compatible with equity-linked and equity-convertible instruments. That said, the prospect of a recovery play is an enticement Rabo’s senior capital note structure lacks. The SCN’s major drawback is that it effectively subordinates the holder to the level of equity or even junior to equity, because the equity holder participates in any upside while the SCN investor is effectively cashed out. The SCN’s major advantage is that it is relatively easy for a prospective investor to calculate expected losses and returns, even if the contingent loss event is severe. Gollakota believes the Rabo SCN could be replicated by future issuers, pointing out that the deal’s unrated status was a stumbling block for investors. This, he believes will be remedied in time. “The features themselves, while some investors would have preferred to there to be a write back up or some sort of conversion into equity, were acceptable given Rabo’s equity capital buffer. The direction of all regulatory capital entails the inclusion of ongoing loss-absorption mechanisms, so the agencies will have to come to the party. It’s a matter of time.” The rating agencies’ problem with the format as it stands is the discretion associated with the trigger – they don’t feel comfortable assessing an instrument’s credit-worthiness on the basis of an issuer’s own assessment of its risk-weighted assets.Justification to issue While Rabo brought its deal to eliminate tail risk, most issuers will bring contingent capital deals with a view to obtaining regulatory benefit. But exactly what treatment deals in this format will receive is not yet clear. Although the Basel Committee had previously suggested they would find a home in the capital conservation buffer, the latest word from Basel is that this buffer has to be composed of common equity, leaving unresolved the question of where contingent capital will sit. As this supplement went to press, this and other topics relevant to systemically important banks, such as bail-

The European Central Bank launched its covered bond purchase progamme in June 2009. Its purchase of covered bonds helped to stabilise prices and boosted issuance to a record €105bn in the first half of the year. The programme, which also helped the covered bond market weather the sovereign debt storm, came to an end in June, raising concerns about the market’s sustainability. Despite the removal of the safety net, the market has rebounded sharply. Covered bond issuance enjoyed a late summer surge, thanks to a combination of factors, while the results of the bank stress tests eased investors’ worst fears over the solvency of the Eurozone banking sector. Meanwhile, the introduction of austerity programmes by European governments mitigated concerns over sovereign risk, enticing issuers to exploit low borrowing costs to offer investors some spread pick-up over sovereign debt. However, the glut of issuance also shows that a flight to quality remains. Investors clearly remain wary of covered bonds from peripheral issuers, while the sovereign crisis is only one bad news story away from spooking markets. “The big change is that pricing in covered bonds has move from bank credit to sovereign risk,” said Heiko Langer, a senior credit analyst for covered bonds at BNP Paribas. “It is not so much who the issuer is but where they are from.” This approach is dictated by the risk approach of investors, who pull or extend credit on a country-by-country basis. Langer added: “There has been little difference between the covered, the senior and the sovereign with all asset classes stigmatised at the same level, so the added protection afforded by covered bonds is less relevant.” While the banking stress tests were criticised for their leniency and did little to restore faith in the Eurozone’s weakest banks, they did nothing to harm stronger banks and stabilised flagging consumer sentiment.No rest for the covered “The big difference from a year ago was that we had quite a lot of issuance in the first half of this year because of the ECB purchase programme and there was a sense that issuers were front-loading,” said Langer. This does not appear to be the case. The seasonal pick-up in covered bond issuance began with €8.2bn of deals announced in the last week of August, led by ING which issued €2bn of five-year notes and DNB Nor raising €1.5bn of seven year debt. The pace continued into September, with the Royal Bank of Scotland launching a €1.5bn five-year UK covered bond at mid-swaps plus 127bp with a coupon of 3.000% on September 1. On the same day, French CM-CIC Covered Bonds (CMCICB) used a €1.00bn French common law covered bond. The deal, which carries a coupon of 3.125%, was priced at mid-swaps plus 73bp. The revival of the market was underscored by the return of Spanish banks, which have been shut out of the wholesale financing markets since May. In the first four days of September, Spanish banks issued US$4bn of paper, of which US$2.5bn was in covered bonds. Spanish commercial bank Banco Sabadell issued a two-year €1.000bn Cedulas Hipotecarias at mid-swaps plus 210bp, while La Caixa issued €1bn of three-year covered bonds. In the non-benchmark space, Spanish commercial bank Banco Popular (POPSM) issued a €700m three-year Cedulas Hipotecarias at mid-swaps plus 215bp, while Italian Banca Carige issued a €500m deal at mid-swaps plus 105bp on September 1. On September 5, Santander exploited the improving sentiment by tapping the market for €1bn of three-year unsecured bonds at 145 bps over the benchmark swap rate, with strong international demand. The rebound in issuance came after a strong first-half, albeit one undermined by a closure of the covered bond markets in May following contagion fears after the Greek sovereign debt crisis. “In peripheral countries such as Spain, spreads on government and covered bonds widened in May,” said Torsten Elling, head of covered bond syndicate at Barclays Capital. “Covered bonds traded close - or flat

In what has almost become a tradition for Rabo in recent years, the bank began the year with a blowout 10-year deal of €3.5bn. It was the first of a diverse range of transactions across currencies, maturities and formats. The bank’s approach to the market is predictable in that it funds through the cycle, has a very liquid curve and prides itself on working with investors. “Deal performance is massively important to us and we provide liquidity in our own paper like no-one else,” said Michael Gower, Rabo’s head of long-term funding. “We’re in front of people all the time so people feel they have direct contact and access.” The bank’s investor-friendly approach means it is willing to offer assets to the market outside the comfort zone of most issuers, as evidenced by the 15-year euro and 50-year sterling transactions it brought in July. “There are times when investors want specific assets and we try and help them out on that,” said Gower. “Does Rabo require 50-year fixed-rate sterling funding? No. But there is huge demand in the UK for super-long assets and we feel duty-bound to provide that given the relationship we have with these accounts.” The bid for high quality paper in the face of the sovereign crisis has benefited the Triple A rated issuer throughout the year. Traditional buyers of agency paper have returned, after withdrawing from Rabo in 2007, despite its rating, because of the general squeamishness about banks. While those conservative investors have returned, Rabo has not lost the support of the credit investors who became involved after spreads blew out. A highlight for Rabo this year – and for the market in general – was its contribution to the nascent contingent capital market, the Senior Contingent Notes transaction it launched in March. The 10-year deal of €1.25bn features a regulatory capital trigger which will be deployed in the unlikely event of Rabo’s equity capital ratio falling below 7%, whereupon the principal will be written down to 25% of par. The heavily over-subscribed deal almost inevitably attracted comparisons to the Lloyds deal the previous November. However, the Lloyds trade, a liability management exercise involving existing investors and a conversion to equity, was not a precedent in any way, said Gower. The deal was not brought with any regulatory benefit in mind. The aim was not to generate capital immediately, which is why it came in senior format. “It’s a product hedging such remote tail risk that it’s almost impossible to conceive of it happening, although the trigger we set would have quite a high probability of being set off by some banks,” said Gower. For that reason, some in the market have said that the deal could not be replicated by other issuers lacking Rabo’s reputation. But for most credit investors the promise of an immediate payment of 25% of principal – admittedly a bruising write-down - is a more acceptable outcome than conversion into equity. Consequently many bankers favour the SCN as a model for future issuance. There was some confusion about the deal. One investor expressed a preference for Tier 1 because of the potential upside, even though a breach of the trigger would probably spell liquidation for the bank. “People who bought the trade understood that the probability of the trigger being breached was so close to zero that it would probably lead to bankruptcy, so they were taking on the same risk as senior paper,” said Gower. “Theoretically they got free money.” The SCN was an exciting interlude but Rabo’s ability to bring innovative deals is tempered by a consistent approach to the global markets it serves. It has a consistent record in borrowing through the cycle which, according to Gower, has proved a comfort to investors in difficult times. He mentioned one investor at the height of the crisis holding large amounts of Rabo paper who could scarcely find a bid for government bonds but found Rabo willing to take on its own paper. “Could you argue that we could pri