FOCUS: Big Obstacles Remain To Contingent Capital Issuance

By Michael Wilson Of DOW JONES NEWSWIRES LONDON -(Dow Jones)- Lloyds Banking Group's plan to swap some of its subordinated bonds for so-called contingent capital bonds marks a step forward in the drive to improve the quality of bank capital. The key element of the securities, which have received endorsements from policy heavyweights such as Mervyn King and Ben Bernanke, is that they convert into equity in times of stress, thereby boosting bank capital and helping to reduce the need for support from the government. But the very fact that they do convert into equity raises questions about how banks will find a market for the bonds outside of exchanges such as Lloyd's, in which investors have little choice but to accept the securities. "The benefits in principle are clear," said Andrew Haldane, executive director for financial stability at the Bank of England. "The difficulties in practice include whether there is likely to be sufficient investor demand for such hybrid instruments." Jose-Antonio Gagliardi, head of equity-linked origination at Societe Generale corporate and investment bank, said there is little initial upside for equity investors buying contingent capital bonds, as they pay a fixed rate of interest if the bonds do not convert. Fixed income investors could also be uncomfortable with the idea of a large capital loss, he said, as this is not something they are accustomed to dealing with. "It is difficult to say what will happen as issuer and investor interests are currently very different," Gagliardi said. "I think finding a solution to this problem could mean both issuers and investors have to give something up." Gerald Podobnik, Deutsche Bank's co-head of capital solutions in Europe, says the key for investors is how narrowly they define their investment mandates - or the rules that limit the kind of securities they can buy and the risks they can take. "No doubt there will be some discussions about trigger levels and whether they are likely to be hit, and this will likely affect investors investment decisions," he said. In Lloyds case, the securities convert into equity if the bank's tier 1 capital ratio falls below 5%, a level which the bank's bondholders seem happy to entertain. "Also it depends how widely used these instruments become," said Podobnik. Indeed, if contingent capital notes take off to the extent that they dominate the subordinated debt market, investors may be forced to reconsider their mandates. One development that could determine whether investors can hold the bonds is whether the ratings agencies view the bonds as credit or equity. Moodys Investors Service is currently undertaking a review of the amount of equity credit it gives to institutions which issue bonds which comprise both debt and equity characteristics. The agency said it will review the way it classifies hybrid securities in terms of the relative amount of debt and equity they contribute to calculations of a banks regulatory capital ratio. "I wouldn't expect to see much issuance of new hybrids (contingent capital structures) until the rating agencies and regulators decide on what forms of hybrid capital will receive greater equity treatment," said T. Rowe Price's Samy Muaddi. Moodys says its refined methodology is on track for release by the end of November. All other issues aside, the key question for contingent capital instruments is whether the bonds can become established outside the confines of an exchange. While there is clearly political pressure for the instruments to succeed, one Lloyds bondholder, who declined to be named for the purposes of this article, said this week that the Lloyds deal may not serve as a good test-case. In fact bondholders have little choice but to swap into contingent capital securities as Lloyds is suspending coupons on their existing bonds. This key incentive would clearly be missing in the case of a new issue. And while contingent capital might provide banks with a capital boost when they need it most, this added protection comes at a cost. As T. Rowe Price' Muaddi, puts it; more risk demands a greater reward. "Initially, I would expect a higher risk premium (yield) to compensate for the new structure and more equity-like content," he said. "This again reinforces the higher cost of capital for banks going forward." This is certainly true of Lloyds, which is offering investors compensation in the form of a coupon that pays 1.5% to 2% above that paid by the existing securities. -By Michael Wilson, Dow Jones Newswires; 44 20 7842 9349, michael.wilson@dowjones.com