Royal Commission Bad for Equity, Good for Debt

Christopher Joye

Coolabah Capital

In the AFR today I argue that the Royal Commission will give us even more conservative and risk-averse "narrow" or "utility" banks with fewer non-core businesses (bye bye planners, wealth, insurance, funds management and proprietary traders). As with the Austrac saga, the end game is stronger banks with lower risks of failure. It's good for depositors and bank creditors, but bad for shareholders focused only on raw returns on equity. I go on to highlight an important new study on why hybrids that get written-off in a bail-in as opposed to being converted into equity are great for shareholders but not so fancy for creditors (click on that link to read for free or AFR subs can use the direct link here).  Excerpt below:

"Over the years Australia's hybrid market has attracted considerable attention with former ASIC chairman Greg Medcraft, recently claiming they are "ridiculous" products for retail investors. Yet this $42 billion sector is less than 6 per cent of the global market, which has exploded since the 2008 crisis as regulators sought to replace bail-outs with bail-ins via "contingent capital" securities (CoCos). And a new study by the Bank for International Settlements (BIS), which is the peak global regulation body, reveals we can learn a lot from the experience overseas...During the global financial crisis (GFC) the ASX suffered a 48 per cent peak-to-trough slump, which the major banks' share prices matched. The ASX hybrid sector only declined 27 per cent. Hybrids, which rank ahead of shareholder equity in the capital structure, performed their role by protecting investors with much smaller losses than those endured by the market. The lower risk of most, but notably not all, hybrids is borne out in their volatility. Since 2003 Aussie shares plus dividends have displayed annual return volatility of 13.4 per cent. The hybrid market volatility has been 60 per cent less at 5.4 per cent. Most retail portfolios are highly polarised between bank equities (which account for one-third of the ASX) and cash. They are therefore overexposed at both the top and bottom of a bank's capital structure, with limited access to the rich range of securities that sit in between (including secured covered bonds, senior unsecured bonds, and subordinated bonds). So there is definitely a role for hybrids in retail portfolios. If what Medcraft meant is that these assets are too complex for retail punters to understand, price and trade, I agree. The truth is that hybrids are too complex for many institutions to value, let alone mum and dad. The new BIS paper on the global hybrid market highlights these complexities. I have complained for years about hybrids that do not convert into equity in times of stress but rather get automatically written off. My hypothesis was that these securities subordinate hybrids to shareholders and, by doing so, violate the sacred capital structure priorities that are sacrosanct in post-GFC regulation. Two domestic securities stand out. The ASX-listed Genworth issued a Tier 2 (T2) subordinated bond that has a "non-viability" clause that  APRA can exercise if Genworth gets into strife. This bond is meant to rank ahead of Genworth's hybrids and shareholders. Most T2 bonds get converted into shares in an APRA-declared non-viability event, which dilutes down shareholders to their detriment. The Genworth T2 instead gets written off instantaneously. The far-reaching dysfunction associated with this should be obvious. At a time of stress, Genworth shareholders have an incentive to reduce their debts. So they will be potentially motivated to encourage APRA to declare non-viability to wipe-out the T2 debt in what is a direct transfer of wealth from debt to equity. Genworth adopted this structure precisely because its US parent, which owns 51 per cent of the business, did not want to be diluted in a non-viability event. ME Bank recently issued a no-less-dysfunctional additional tier 1 (AT1) capital hybrid. ME is a private company owned by a couple of dozen super funds. It has a T2 bond that in an APRA non-viability event is converted into equity, diluting down its super fund owners. The equity you get is, however, non-voting: those industry funds don't want outside interference. ME's new AT1 hybrid went one step further. It has both a non-viability clause and an automatic "capital trigger". APRA controls the non-viability decision. The capital trigger is set at an equity ratio of 5.125 per cent. Crucially, if ME's equity ratio falls below 5.125 per cent or APRA declares non-viability, the hybrid gets written off (ie, zeroed), not converted into equity, like ME's T2 bond or normal ASX-listed hybrids. It appears ME's shareholders don't want to be diluted by the hybrid in any adverse scenarios. I refused to invest in both the Genworth and ME securities because of these capital structure violations. When BIS looked at the US$512 billion of hybrids on issue globally, it found some interesting results in this context.  It was discovered that large and better-capitalised banks were more likely to issue hybrids than weaker ones. This might seem counter-intuitive but BIS argues that "issuance decisions are made with shareholder interests in mind; and shareholders may pass on a CoCo [hybrid] issue if it does not enhance shareholder value". "As our theoretical model predicts, a CoCo issued by a bank with an impaired balance sheet mostly benefits the bank's senior unsecured debt holders [rather than equity owners because of the dilution they face]," the authors wrote. "Consistent with this interpretation, we also found that statistical significance is greater for CoCos that specify a principal write-down when the trigger is breached rather than a conversion of debt into equity. Principal write-down CoCos are, in effect, junior to equity in distress states and, therefore, particularly attractive to shareholders." This is the same criticism I made of Genworth and ME Bank. The BIS study documented that hybrid issuance normally reduces a bank's cost of debt "indicating that, according to market participants, a CoCo issue unambiguously strengthens the issuer's balance sheet". But when  it looked at hybrids that get written off on the trigger event rather than converted into equity,  it found that "the impact on [bond] spreads of CoCos that convert into equity is much stronger than the respective impact of principal write-down CoCos". "A CoCo that converts into equity disciplines risk-taking by shareholders because conversion may dilute existing equity holders' claims," BIS says. "In contrast, risk-taking is rewarded at the conversion margin when CoCos absorb losses via a principal write-down. This explains why the net reduction in credit risk following the issue of a principal write-down CoCos is lower."" Read the full article at AFR here.

Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs over $8 billion with a team of 40 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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