Wednesday, November 7, 2012

Why would anyone buy Barclays' proposed contingent capital security?

The International Financing Review published an article looking at Barclays' proposed contingent capital security.

Contingent capital securities are being driven by the regulators.  The regulators would like a mechanism in place to automatically recapitalize the banks in the event that they incur major losses.

To meet this regulatory goal, Barclays is proposing a security that is written down if the bank incurs losses that cause its Tier I capital to fall below 7%.

So now Barclays is looking for investors who are willing to have their investment wiped-out if Barclays' experiences greater than a 2% decline in its Tier I capital.

Before any investor should be willing to take on this risk, they should independently assess the risk of Barclays.  Unfortunately, because Barclays disclosure leaves it resembling a 'black box', assessing its risk is impossible to do.  This leaves the pool of potential buyers greatly diminished.

In fact, the pool consists solely of hedge funds and other investors who are comfortable blindly betting.

To make contingent capital securities attractive to investors like pension funds and insurance companies requires the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  With this information, market participants can independently assess the risk of a bank like Barclays and its contingent convertible securities.

With this risk assessment, investors can then make an investment decision as to how much exposure they would like.
The planned Barclays contingent capital (CoCo) bond is getting wide attention in the market, which is waiting to see not only how much the capital will cost but also how this latest experiment in improving bank balance sheets will be treated by regulators. 
The bank is poised to file with the SEC on Tuesday in what will be the first true test for CoCos out of the UK, amid an uncertain regulatory environment for the still-developing product. 
“This will be an interesting trade,” said a hybrid capital banker....

In recent months, the Bank of England’s Financial Policy Committee and the UK Financial Services Authority have both come out in favour of contingent capital....

The Barclays CoCo features a full write-down rather than a conversion into equity that some regulators consider to be potentially destabilising for a bank. 
The instrument will trigger if the bank’s Common Equity Tier 1 (post CRD IV) ratio falls below 7%. If the bank hits that trigger, then the instrument would be completely written-off, thus creating instant capital for the bank. 
The 7% trigger is well below the SIFI (systemically important financial institution) buffer, which requires banks that are considered too big to fail to carry 9% common equity capital and below which Barclays will be required to restrict discretionary payments such as dividends and discretionary compensation. It is therefore expected that the 7% trigger would be shielded by at least a 2% capital layer....
Talk about a high risk security!  Barclays is asking investors to blindly bet that it is not likely to experience a loss of greater than 2% of is Common Equity Tier I ratio.

Losses from manipulating Libor are likely to be substantially greater than this.
Barclays will begin a two-week global roadshow Tuesday for the new CoCo via its in-house investment bank, CitiCredit SuisseDeutsche Bank and Morgan Stanley, in what is only the second-ever CoCo issue in the UK. 
Because the first, from Lloyds in 2009, was part of that bank’s distressed recapitalisation, the Barclays issue will be the first true measure of how investors respond to the product. 
In particular, the deal will test how far investors are prepared to go in search of yield, especially as it has a high trigger – the UBS issue has a 5% trigger, for example - and carries a severe potential loss. 
Credit Suisse’s CoCo had a “high-trigger” of 7%, but was convertible into equity, thereby giving converted bondholders a stake in the bank should it recover. 
Rabobank also sold a Senior Contingent Note issue with a relatively high trigger of around 7%, but investors get 25% of par upon the conversion trigger being hit.
I understand that there are buyers who are willing to blindly bet.  So Barclays is likely to be able to sell some of its contingent capital security.

As for investors, in the absence of ultra transparency, there will not be any.

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