For four months, no bank followed Lloyds.
Now Rabobank brings the concept to the primary market for the first time. Credit buyers know the risk they are taking from the outset and were closely involved in establishing the price for taking it. As Rabobank does not have publicly traded equity, there is no dressing this risk up as an exchange in extremis into an equity option with potential upside.
"Rabobank has about 35 billion of equity. It would have to lose about 15 billion of it. Our mortgage loan book would have to be catastrophically hit"Michael Gower, Rabobank
But what might lead to such a dire outcome? "Rabobank has about 35 billion of equity. It would have to lose about 15 billion of it," says Michael Gower, head of long-term funding at Rabobank. "Our mortgage loan book would have to be catastrophically hit. Our CFO has called it hedging the unthinkable. What could make it happen? It would be something like the dykes breaking in the Netherlands and the whole country being flooded. The risks are very, very remote."
In such an event, investors could probably expect the bank to collapse into insolvency, in which case they would hold a senior claim on the proceeds of disposing of the banks unencumbered assets. A 25% recovery rate is in line with what tier 2 capital investors could expect.
For taking this risk, investors extracted a coupon of 6.875%, 351 basis points over mid-swaps. The spread was enough to attract an order book of 2.6 billion from 180 different investors, including credit fund managers, private banks and even some equity income funds. No doubt these investors all took comfort from Rabobanks reputation for conservative management of its balance sheet and capital. However the ratings agencies appeared incapable of assigning a rating to a deal for which the documentation contained discussion of the circumstances of a 75% write-off.
This acceptance by senior unsecured creditors of risk of capital loss from lending to banks is something that regulators have been pressing hard for in recent months.
Allocation by geography
Allocation by investor type
Source: Morgan Stanley
When Bank of England governor Mervyn King and deputy governor Paul Tucker gave evidence to the House of Commons Treasury committee earlier this year, they revealed an obsession among regulators to dispel the notion that bank bondholders will always be bailed out.
Tucker declared: "When one of these enterprises fails, do the creditors pick up the tab as well as the shareholders? That is the irreducible question. That is at the heart of the too-big-to-fail question."
King knows what he wants. When banks get into distress bondholders must share the pain. "We at the Bank put a lot of weight on the potential contribution that contingent capital can make in this area and I think the United States does too. I see real benefits of cooperation here in working with them to ensure that in future contingent capital is a major part of the liability structure of the banking system."
Because the Rabobank bonds are classed as senior debt, they offer no immediate regulatory capital advantage to the issuer. Rabobank has always prided itself on being a smart user of the debt capital markets while maintaining strong capital ratios and low leverage underpinning an asset portfolio of well-structured mortgage and other loans. "There is expectation that banks may have to have this in their capital structure in future and so we wanted to address that early and on our own terms," says Gower. "If theres a new instrument that can bolster a banks balance sheet, we want to ensure we have it in ours."
Not so smart
Rabobank has hardly been jostled by a pack of other bank issuers rushing to sell contingent capital though. Theres a reason for that. They dont think its a very smart idea.
"Weve talked to our investors about it a lot," says the CFO at a highly rated bank that avoided taxpayer bailouts. "Their response divides into two groups. Some of them say they would love us to issue contingent capital, as they dont think we will get into trouble. Theyd like to take a higher coupon on debt that they consider safe but very low yielding. Then theres another group that says if we did a contingent-capital deal they would see it as a signal of some big problem looming, and so they would sell out their exposures to us. Neither of those strikes me as remotely desirable outcomes."
This CFO questions whether there is sufficient capital available from investors to support a sizeable new-issue market in contingent capital. He also questions the whole approach of re-educating providers of funds to banks towards expectation of capital losses. He suggests this will undermine a still vulnerable financial system.
"There would be a wholesale flight of capital and funding away from any bank over which there are any doubts towards a few particularly stable and no doubt very large ones."
Regulators would perhaps vigorously approve these words. Thats exactly what they want. Riskier banks shouldnt have so much funding. The question remains: could those that continue to attract funding transform it into enough lending capacity to support economic recovery? And would they not become too big to fail?
"Instead of working out how to spread the pain of the next banking crisis, lets try not to have one," says the sceptical CFO.