Co-op Bank bail-in inevitable as bidders show their hand
All submitted bids to buy the troubled lender incorporate a liability management exercise for its subordinated debt, but bondholders are unlikely to go down without a fight.
Finding a buyer for the UK’s troubled Co-operative Bank was always going to be tough. But when its mutual owner, the Co-operative Group, declared its 20% stake in the lender to be worthless just two days before the deadline for interested bidders, it became clear just how tough this process was going to be.
“We are being very prudent in the way that we value the bank,” said Steve Murrells, chief executive of the Co-operative Group on April 6. The deadline for bids was Tuesday April 4. “We made the decision [to value it at zero] because there is a sale process going on. It is the right thing to do because during a sale it is quite a volatile market. This is purely an accounting treatment. We are very hopeful that the bank will find a buyer.”
Valuing 20% of it at zero isn’t likely to help. But on Friday April 7 the bank announced that it had received a number of non-binding proposals from strategic and financial parties, and had selected several of them to enter the next stage of the process. Unsurprisingly, each of the preliminary offers selected includes some form of liability management exercise.
"In parallel, the bank continues to have discussions with existing and other potential new investors on options to build capital,” the bank added. “There can be no certainty that any offer will be made for the bank or as to the level of any proposal or offer that may be made nor that the bank will pursue, or successfully implement, an equity raise and/or a liability management exercise of its outstanding public debt."
This statement is not exactly brimming with confidence. The bank has been between a rock and a hard place since it revealed in February that it was unlikely to meet its Individual Capital Guidance (ICG) set by the Prudential Regulatory Authority (PRA) and that its core equity tier-1 (CET1) ratio would fall and remain below 10% in the medium term. It needs to meet its ICG of 14.5% by 2020, which will entail a capital raise of around £750 million.
“The PRA's ask for additional CET1 capital of £750 million was higher than anyone was expecting,” reveals Mark Taber, a bondholder activist who led a successful campaign for retail investors in the 2013 Co-op Bank restructuring. “The PRA was expected to look for around £400 million and some tier-2 debt. The amount of money they are looking for is far more than the value of the bank.”
The fact that the level was set so high is a worrying indication of the extent of the problems that the PRA believes the bank is facing.
Co-op Bank made a £477 million loss last year, which erased nearly one third of its common equity. It lost £610 million in 2015 and has not made a profit since 2011. It therefore faces three options: a disposal, a debt for equity swap or regulatory intervention.
By any measure, the sale of the bank in its entirety looks like a big ask. The takeover of Britannia Building Society in 2009 burdened Co-op Bank with extensive bad real estate lending and its problems were further compounded by its subsequent failed bid for 600 Lloyds branches.
The PRA’s demand that the bank increase its CET1 ratio from 7% to 9% blew a £1.5 billion hole in its finances and prompted a controversial 2013 restructuring that saw tier-1 and tier-2 bondholders subject to a debt for equity exchange, a process that hit 7,000 retail investors holding upper tier-2 debt. They were eventually offered new subordinated instruments in the Co-op Group and the lower tier-2 bondholders took control of the bank.
The bank’s financial problems led to turmoil among senior management. Former CEO Barry Tootell resigned in May 2013 and was subsequently banned for life by the PRA from holding a senior job in the financial services industry. Former chairman Paul Flowers resigned in June 2013, and was later that year embroiled in a drugs scandal that led to him being dubbed in the media as “The Crystal Methodist”.
There have been other departures too. Niall Booker, who had replaced Tootell as CEO in 2013 after 30 years at HSBC, stepped down at the end of last year. He has been replaced by deputy Liam Coleman. Some 2,700 jobs have been cut since 2013 and 59 branches were closed last year, with another 10 due to go this year.
Despite the Co-op Group’s decision to publicly deem the bank worthless, there is value there. “Co-op is not typical of a failing bank,” observes Simon Adamson, analyst at CreditSights. “The reason for its losses – and therefore its capital weakness – is not loan impairments or trading losses, but rather a combination of restructuring costs, including heavy expenses to modernise its IT systems after years of under-investment, high financial conduct charges and the impact of a fair value unwind.”
At June 2016 it had £28 billion of assets and 4 million customers. Customer loans stand at £19.6 billion and deposits at £22 billion. Some £16.6 billion of the loans are high quality mortgages and there is a £2.7 billion portfolio of higher risk lending.
Prior to April 6 Co-op Group had valued its 20% stake at £132 million, which would make the bank worth between £600 million and £700 million.
The problem is that the bank is still burning capital. Its CET1 ratio is now 12.6% and is projected to fall below 10% in the medium term. Its cost income ratio is 103% and after five years of losses there seems scant prospect of returning to profit any time soon, particularly in this interest rate environment.
There is also a huge question mark over pension liabilities. Co-op Bank has two pension schemes – Pace and Britannia. Pace is a joint scheme with the Co-op Group and there is dispute between the two over the extent of the bank’s liability. It currently contributes £5 million a year to the deficit, which is around £300 million but could rise. The bank has pledged £165 million of Warwick Finance RMBS notes towards the estimated actuarial shortfall in the Britannia Scheme, which is being currently being valued.
Bank of America Merrill Lynch and UBS are managing the sale process and various names are in the frame. Likely to have bid are Virgin Money as well as Clydesdale and Yorkshire Banking Group (CYBG). Private equity bids could have come from OneSavings Bank, owned by JC Flowers, and distressed debt specialists such as Cerberus, Fortress, Anacap or Apollo.
The problem is that most, if not all, bidders (except distressed specialists) are only likely to want the good stuff: the mortgages and deposits. Challenger banks such as Santander, Metro and Secure Trust have stated as much.
“We’re not interested in the Co-op Bank as a whole, it’s just too fraught with risk and it’s very difficult to see how we could construct a compelling business case to buy it,” said Paul Lynam, chief executive of Secure Trust Bank, at the end of March.
Option two, a debt for equity swap, is effectively also part of option one as the bank has made clear that all sale proposals involve some form of LME. “This could be equitisation of bonds prior to a bidder acquiring the shares,” warns Taber. “I hope subordinated bondholders are getting themselves organized to make sure that the credit hierarchy is respected and that existing equity is written off before they get converted.”
The bank has two tier-2 bonds outstanding: £250 million 8.5% bonds due 2025 and £206 million 11% bonds due 2023. It also has £400 million 5.125% senior bonds outstanding that are due in September this year and rated Caa2. In mid-March the seniors were trading at 89.8% and the tier-2 at around 50%. The bank has failed to rule out the senior bonds being included in a debt for equity swap.
A buyback of subordinated debt at 50p on the pound would increase CET1 capital by 300bp, according to CreditSights.
The confirmation by the bank that any sale would involve a LME seems to confirm a zero valuation for the equity. An important factor in the negotiations over any LME is that there is significant crossover between the shareholders and the subordinated bondholders, as many of the latter received equity as part of the 2013 restructuring.
The equity is held by, among others, hedge funds including Silver Point Capital, Golden Tree Asset Management, York Capital Management and Perry Capital. The last of these, which has a 10% stake, announced last September that it would close its flagship fund after heavy losses. Asset manager Invesco’s UK arm is understood to have a 60% stake in the senior bond and a position in the tier-2 as well. The firm declined to comment when Euromoney sought confirmation of the extent of its exposure.
“The question is whether the bank could get enough stakeholders to agree to a consensual solution to get them to £750 million,” Taber tells Euromoney. “Some subordinated bondholders might say that if they are taking a significant haircut then they are better off in resolution.”
The hedge fund group is now understood to be forming a bondholder committee. A complete wipe-out of the subordinated debt would yield £450 million but shareholders would still have to be persuaded to invest a further £300 million in order to meet the PRA’s demands. A bail-in of the senior debt is seen as unlikely at this stage.
Any real money fund holding the senior would not have a mandate to hold equity so swapping them would trigger an immediate fire-sale in the bonds. The seniors are nevertheless trading at distressed levels over concerns that not only could they be involved in any LME but that the PRA could push the bank into resolution before their September maturity date.
Resolution is the nuclear option. “A full sale of the bank is unlikely and an LME is feasible but not certain to succeed,” says Adamson at CreditSights. “While we do not think the PRA will put Co-op Bank into resolution in the near term, it would come under pressure to step in if the sale or LME process failed.”
If it did, it would be the first test of PRA resolution powers since 2008. However, for a bank to be pushed into resolution by the PRA it must be failing or likely to fail and be unable to take any action to prevent this happening. This is not currently the case, and as long as management is prepared attempt a sale and/or LME, resolution seems an unlikely prospect.
“If the bank can raise £450 million from subordinated bondholders, would the PRA really push it into resolution?” asks Taber. “It is a pretty tough call for the Bank of England to force a bank into resolution with this amount of capital.
“Co-op Bank does not meet its ICG requirement but it still has capital.”
If resolution was sought, however, the most likely scenario would be the sale of the core deposits and mortgage lending business and the orderly wind-down of the remainder. That could entail the wiping out of both senior and subordinated debt and would almost inevitably provoke legal action from the holders of both.
Let battle commence.