Wachovia’s new $2.5 billion bank hybrid offering – Wits (Wachovia interest trust securities) – priced at the end of January, initially sparked controversy that the Federal Reserve had made a mistake in allowing the deal to qualify for tier 1 capital. But the Fed has stood by its decision to allow the structure into the tier 1 capital basket. This could prompt more innovation and more than $40 billion of new issuance.
Wits is a mandatory convertible into preferred shares after five years, on which interest payments are tax deductible. Since the mid-1990s until recently, the only tax-deductible hybrids acceptable to the Fed as tier 1 capital were trust preferred securities (Trups). Many market players believe that banks will replace some of their outstanding Trups issues as they become callable with more flexible Wits-type structures.
“Given that $35 billion of outstanding trust preferred securities will be callable within the next year, I don’t think $45 billion of issuance of hybrid capital from banks, incorporating traditional trust preferreds plus various new flavours of trust preferreds plus mandatory convertibles, is out of the question,” says Jennifer Piekut, executive director and global head of hybrids at Morgan Stanley.
Some think that figure could be higher. David Hendler, banks analyst at CreditSights, says that banks taking their tier 1 capital concentrations to the new upper limit of 25% allowed by the Fed for these deals (trust preferreds were only allowed up to 15%) could account for $46 billion of new mandatory convertible preferred issues alone.
The Fed’s new stance and the decision by the ratings agencies to give Wits significant, if not total, equity credit (75% at Moody’s, 100% at Standard & Poor’s) could revolutionize the bank hybrid market for issuers. Now, alongside copycat deals closely emulating the Wits structure, there could be more innovation as other banks launch their own proprietary deals. “There’s not going to be just one structure. Eventually issuers will pick and choose what suits them best based on their objectives and what their target investors want,” says Piekut.
It will also change the landscape for investors. “Because one type of bank capital has been the norm for US bank issuers for 10 years, US investors are pretty new to analysing a variety of different bank hybrid structures, whereas European investors have been doing this for seven to eight years owing simply to the web of differing legal frameworks in each European country,” says Piekut.
The scarcity value of Wits – and the fact that the deal was reckoned to have evinced a momentary lapse in the Fed’s judgment over tax treatment – prompted some market players to think that the issue was priced far too cheaply and did not account for the extension risk of the securities not being called after conversion. Wits priced at 142 basis points over five-year treasuries and had traded 13bp tighter as Euromoney went to press. Hendler says the 5.85% coupon almost matches Wachovia’s weighted average cost of capital, even though this is higher-cost, equity-like capital.
Hendler thinks demand from hedge funds lay behind this. “It seems total return/hedge funds may now be dictating at the margin the thinner pricing terms in bank hybrid bond land as they look at it as a short-term trade to 2011, rather than the final maturity of 2042,” he wrote in a recent note. Now that a flood of similar issues is predicted, deals could be priced wider but Piekut says it is too early to predict demand for this product based on one price point. “US investors are getting a new taste of this. Over time, they will decide where they feel these securities should be priced.”
Piekut believes the new market focus on bank capital will not be limited to innovative new tax-deductible structures that qualify for tier 1 capital. “Banks are beginning to assess the amount of straight preferred equity they issue outside the 25% tier 1 basket, for example. I think we will see new straight preferred issuance before too long.