Participants in UK financial institutions debt capital markets have been fascinated by the manoeuvrings at HBOS over the past few weeks.
The first bit of intrigue surrounds the status of Claire Bright, head of asset and liability management of HBOS Treasury Services. Officials at the UK bank stated that Bright was “on leave” and would make no further comment on her current standing. But given that her duties have been divided up among her former colleagues, according to non-HBOS sources, it seems unlikely that she will be returning soon.
The tittle-tattle is rather surprising because the dynamic, likeable and highly regarded Bright has been at HBOS for only a little over a year. In that time she has overseen an overhaul of the funding activities of the bank, the biggest independent financial institution player in the capital markets. Bright’s role was a new one, created after the departure of Tony Main, who ran funding and liquidity until May 2004. In effect Cliff Pattenden, who took over from Lindsey Mackay as head of treasury at HBOS in late 2003, has now lost two funding chiefs in less than two years.
At first the rumours surrounding Bright were linked to completely baseless suggestions that HBOS’s latest dollar tier 1 transaction ($1.5 billion tier 1 pref) had failed to obtain the approval of UK regulator the Financial Services Authority. HBOS officials explain that the deals were approved as core tier 1.
The borrower and its lead managers – Lehman Brothers, Morgan Stanley and JPMorgan – were completely transparent with the regulatory authorities on the structure, which was ingeniously designed to qualify as a liability despite being a preference share.
The original purpose of bank hybrids was to create a security that received equity treatment from regulators but were debt and therefore qualified as tax-deductible. Many years ago the Bank for International Settlements limited this type of “innovative” tier 1 to just 15% of total equity – the rest must be preference shares or common equity. Most banks have now filled their innovative buckets and are simply issuing tier 1 in the form of prefs, which count as core tier 1 capital.
HBOS wanted these securities to count as liabilities not for tax purposes but for IFRS accounting reasons. If these securities count as equity it causes volatility in the profit-and-loss account as it is not possible to obtain hedge accounting for swaps under the new accounting regime.
So the borrower approached the FSA with a feature called payment in kind (PIK). Under certain circumstances, HBOS can issue additional prefs to investors if it does not pay a dividend. This PIK attribute bestowed liability status on the preference share. It also made the bonds cumulative for investors, although not cash cumulative.
There was another notable feature, namely that HBOS has the right to substitute economically equivalent securities for the pref if the authorities begin to allow tax-deductible core tier 1.
So far so good. But the door was firmly shut on other UK issuers that wanted to replicate its structure by the FSA. Quite soon after the HBOS deal priced the FSA said to advancing investment banks that it would not allow any similar deals. This remarkable situation can only be explained by the fact that although its Ipru (Interim Prudential Sourcebook) allows PIK structures, upcoming regulations in the General Prudential Sourcebook (Genpru) do not.
But perhaps it is even more straightforward. The FSA appears to have broken its own rules, which do not allow core tier 1
instruments that qualify as liabilities. This rule is ostensibly there to ensure that the FSA is not reliant on legal opinions on the likely treatment of an instrument in the determination of insolvency. There is no doubt, though, that the UK tax authorities would be very anxious about an expansion of tax-deductible tier 1.
This game of cat and mouse between underwriters on one side and regulators on the other on tier 1 has gone on for years. The FSA has got itself into trouble before with the RCI and TONS structures devised by Barclays Capital several years ago when it inadvertently expanded the scope for innovative hybrid issuance, thus raising the ire of other European regulators.
It appears that this time the FSA has bolted the stable doors before too many other horses escape.