Subordinated bondholders in the UKs Co-operative Bank have upped the ante in their fight against the banks recapitalization plans.
The situation at the bank, which remains profitable, albeit weakly, is the result of the Prudential Regulation Authoritys (PRA) demand that the bank increase its core equity tier 1 ratio from 7% to 9%.
This has opened up a £1.5 billion hole at the lender, which bondholders are now being asked to help fill.
The demand has prompted a furious reaction from bondholders. It has been described as arbitrary and putative in a July 9 letter to Andrew Bailey, CEO of the PRA, from Mark Taber, who is representing retail investors in the bank.
Taber successfully fought off similar plans at the Bristol & West Building Society. In 2011, holders of £75 million in permanent interest bearing shares (Pibs) issued by the former Bristol & West Building Society were originally offered 20p in the pound as part of owner Bank of Irelands (BoI) capital exchange offer.
Taber fought a successful campaign and the Pibs were dropped from the exchange. One of the hedge funds active in the BoI situation, Aurelius Capital Management, also has a position in Co-op subordinated debt and is understood to have hired law firm Bingham McCutcheon to represent its interests.
Retail investors are now hoping Taber can repeat this at the Co-op. The PRA is ostensibly mandating the 9% CET1 ratio to demonstrate the strength of UK banking regulation. For a non-Sifi lender such as the Co-op, the legal minimum capital requirement is 4.5% and individual capital guidance is 7%.
The suspicion is, therefore, that the capital increase is being mandated in anticipation of further losses to come. The bank has so far lost £350 million in commercial real estate lending, which it has largely blamed on its acquisition of Britannia Building Society in 2009.
The Co-op plans to plug its capital hole in several ways: an exchange offer to subordinated debt holders, the issue of new group level senior debt, together with the sale of assets such as its life insurance operations, and skipping coupon payments on deferrable debt.
However, the bank has £2.25 billion debt outstanding, which was restructured in July last year to incorporate prepayment on the sale of any major group asset. The bank has roughly £330 million upper tier 2 debt which incorporates permanent interest bearing shares held by around 7,000 retail investors and £60 million tier 1 debt outstanding. These bondholders will be subject to an equity exchange offer with a substantial haircut perhaps more than 50%.
Controversially, the proposal states that the Co-op Group, which owns 100% of the banks shares, will see its holding diminished but will not face losses. This imposes losses on bondholders before shareholders and subverts the basic creditor hierarchy.
Since we dont yet know the details of the exchange offer, and given the potential for future upside in the equity conversion, it isnt clear that retail buyers will take a loss in the long run, says Oliver Burrows, senior banks analyst at Rabobank in London.
The Co-op has suggested paying for independent financial advice for retail investors to advise them on how they participate in the offer.
Many of them might not sit around waiting for that advice. The likelihood and perhaps the strategy with the greatest likelihood of success is for them to pursue a claim for mis-selling.
They argue the FSA should have been aware of the nature of Britannias lending activities when it approved the merger in 2009 and that the need to raise capital and address loan book issues at the Co-op had been known for some time. This, they claim, created a false market in the banks preference shares and perpetual subordinated bonds.
The Co-op has built its reputation as an ethical brand and therefore will be particularly sensitive to the bad press that would surround bailing in retail buyers. If the bank took a similar approach to that taken by the Irish banks which stipulated that any bonds not tendered in the proposed exchange would be subject to a clean-up call at a punitive 0.05 per 1,000 nominal the political backlash would be severe.
There are £1.3 billion bonds outstanding in addition to the three perpetual issues outstanding, there are seven lower tier 2 issues totalling £937 million.
Holders of the perpetual bonds could take some heart from recent developments at SNS Reaal Bank. On July 11, holders of 57 million participation certificates issued by the Dutch bank in June 2003 at a nominal interest of 5.16%, which were initially bailed in as part of its nationalization in February, received a proposal for compensation from the bank.
An investigation conducted by SNS Bank has shown that customers were insufficiently aware of the characteristics and risks of the product at the time they purchased the certificates, the bank concluded in a statement.
The compensation amounts to the nominal value of the certificates plus the interest on government bonds for the period they had the participation certificates in their possession.
This is a good outcome for SNS Reaal bondholders. Could the Co-op bondholders hope for the same? Details of any proposed exchange offer coercive or otherwise are due in October.
The massive difference between the Co-op and the other situations, such as Bankia and SNS Reaal, is that the solvency and viability of the latter two were such that they required state support, says Burrows. So far this is not the case at the Co-op.
However, Burrows reckons the Dutch bank acts as a warning sign of where things could be going.
The parallels between SNS Reaal and the Co-op are too striking: both are modest-sized domestically focused retail banks, with real estate asset quality problems, and difficulty in retaining sufficient earnings to meet these, he says.
It is tempting to view the Co-op today as in a similar situation as SNS was in 2009. The difference now is that the European Commission has ruled that from August 1 all future state bailouts of European banks must follow the SNS example, and wipe-out all subordinated debt and shareholders before a penny of taxpayer support can be injected.
Ironically, [Dutch finance minister and Eurogroup president Jeroen] Dijsselbloem did establish a template for bail-in after all.
The Co-op will certainly will find it hard to plug its £1.5 billion hole without hitting retail buyers. If they have to effectively carve out retail from the recapitalization, it is quite a large number, says Burrows.
However, the risk of a high-profile mis-selling claim is real. And Burrows warns that the situation has substantial implications for senior bondholders too.
If they take out the subordinated debt now, an important loss-absorbing buffer is removed, and the senior bondholders will become the frontline of defence, he warns.