Lloyds rights issue: Lloyds creates new regulatory capital asset class

Lloyds Banking Group is finally catching some breaks. Its £22.5 billion ($37.6 billion) underwritten capital-raising – the largest ever in Europe – saves it from falling even further into UK government ownership and has seen off the risk of the European Commission’s competition authority imposing a complete break-up, as it did on ING. Execution analyst Joseph Dickerson says the EC’s plan for ING “looks to us like a pre-pack bankruptcy expected to be funded by common shareholders via a rights issue”. So Lloyds and its investors are mightily relieved not to share such a fate and its bonds and equities rallied as the £13.5 billion rights issue priced and the £9 billion bond exchange closed at the end of November.

Lloyds had been in negotiations with the EC long before the combined rights issue and exchange offer was devised with the help of UK regulators. Only as it approached launch did the competition authority approve a plan to divest 600 branches, comprising Cheltenham & Gloucester, Lloyds TSB Scotland and some others together equivalent to 4.6% of current account market share and 19% of the group’s mortgage book. Lloyds airily dismissed these state-aid remedies as immaterial. How did it get such a good deal? 

"I think the fact that Lloyds was using the public capital markets was critical to the Commission," says Matthew Greenburgh, head of international financial institutions advisory at Bank of America Merrill Lynch, which was joint adviser, joint global co-ordinator and joint bookrunner on the deal alongside UBS. "And both the commission and the UK government were very conscious of the timetable attached to delivering a market-based solution."

Lloyds might feel it deserves some leniency after letting itself be rushed into ingesting the poison contained in the HBOS balance sheet. But it is extraordinary to claim that this is essentially a capital-raising from private investors happy to bet more money on the prospects for its earnings recovery.

“This was force majeure,” says an ECM banker, “where your choice is invest more or lose what you’ve got.” The rights issue was a done deal only from the moment the UK government stepped up to underwrite its entitlement, investing another £5.7 billion of hard-pressed taxpayers’ money to maintain its ownership of the bank at 43%. It was only then that other investors sensed an easy ride on an offering anchored by its core shareholder and likely to be priced to go. By pricing date, the deal was, according to one banker, “heavily sub-underwritten”.

This is a bank, meanwhile, that rating agency Fitch warns “still relies heavily on funding from the Bank of England or issued under the guarantee of the UK government”. Lloyds Banking Group may have got one £4 billion RMBS deal away in recent months and a 10-year £1.5 billion bond without the government’s guarantee, but analysts at Credit Suisse also remain concerned by the group’s liability structure and think the market is underestimating this. “Its core funding ratio is sub-standard in our view and it is overly reliant on SLS and CGS bonds, the majority of which mature in 2011 and 2012.”

"The slowdown in the run-rate in the third quarter provides  additional comfort that the Group's overall impairment charge has peaked, and that there will be a significant reduction in impairments in the second half of  2009." - Eric Daniels, Lloyds chief executive

The hands of government and regulatory bodies are still all over the bank. Chief executive Eric Daniels and his advisers on the deal were shuttling between them as it neared launch. At least they knew they would receive regulatory approval for the contingent capital notes that are the new wrinkle in its capital structure: the Financial Services Authority suggested them to Lloyds in the first place. And in return for all this support, it has renewed commitments to lend into the sluggish UK economic recovery.

Lloyds’ owners must hope the deal shows the bank finally turning the corner. Rupert Hume-Kendall, head of international equity capital markets at Bank of America Merrill Lynch, says: “This financing and avoiding APS charges fundamentally transforms Lloyds investment case.” But the real bet for investors now stumping up more cash to subscribe to their rights in Lloyds is not so much on Eric Daniels and the bank itself as on the UK economy. Other UK banks say they are now close to the peak of charge-offs that might come this quarter or next and that the path to a brighter future lies in view. Daniels even claims Lloyds is ahead of the curve on this, saying that the overall impairment charge has already peaked and that the bank will report “a significant reduction in impairments in the second half of 2009”.

But if the UK suffers a double-dip recession when the Bank of England turns off the tap of quantitative easing and funding for government support measures dries up, equity investors might face more pain. Holders of Lloyds’ new ECNs might rue the day they clamoured for conversion into bonds devised by Hector Sants to turn into high-risk equity just at the worst moment and at a time when Lloyds would not be able to access the equity capital markets.

It remains to be seen whether the Lloyds deal will encourage other banks to issue contingent convertibles, which automatically top up a bank’s balance sheet in times of distress.

Debt investors lured by payment of coupon

Lloyds Banking Group ushered in this new asset class last month with its £7.5 billion exchange of existing hybrid securities into contingent convertible bonds, popularly dubbed CoCo bonds. The regulator-backed creation of a new form of bank capital is designed to boost Lloyd’s core capital ratio to 8.9% from 6.3%, because the CoCos convert into common equity precisely in the event that Lloyd’s tier 1 ratio falls below 5%, a key metric in the FSA’s stress test for UK banks.

Investors in Lloyd’s existing £16.5 billion of hybrid securities snatched at the chance to switch from bonds that had had their coupon payments switched off at the instruction of regulators into debt that now pays a coupon between 1.5 and 2 percentage points higher than the old bonds. On the eve of the exchange, just a quarter of that outstanding debt was still paying a coupon and many bonds had fallen to a price of 70% to 80% of face value. No wonder then that 75% of eligible debt was submitted to the exchange, says UBS, one of the book runners.

The transaction had two unique features: the first being that the bonds were exchanged par-for-par, where typically investors usually take a loss upfront when exchanging into new bonds. This made it easier for investors to take the risk of larger losses on the more junior new instruments at a later date. The second key feature was the technique through which the conversion took place. A so-called waterfall structure was used to create a priority list of bonds that would convert into the CoCo bonds, meaning investors knew with some certainty whether the old bonds they owned were actually going to be exchanged.

“By dint of the waterfall investors could see which bonds were likely to convert, allowing them to analyse their holdings, and assign a value to the new security,” says Rob Ellison, deputy head of FIG debt capital markets, UBS. “The old bonds at the top of the waterfall started trading as if they were the new bonds. This allowed for rational trading.’’

Implied yield on top 20 new ECN notes

As the exercise progressed and investors fully analysed the terms of the new notes, the implied yield on the new Enhanced Capital Notes, as Lloyds dubbed the new bonds, fell to approximately 11 percent. Currently a Lloyds Tier 1 security typically trades with a yield to maturity of between 9 percent and 10 percent.

Revived trading of existing bonds enabled those investors that were ineligible to own the new securities to sell out before conversion, UBS said.

In all the bank exchanged existing junior debt for £7.5 billion of enhanced capital notes, and issued another £1.48 billion of new shares, cash or further ECNs, after receiving £12.5 billion of orders from investors. It will also raise $986 million of hybrid debt from US investors.

Equity investors have until December 11 to take up their entitlement to new shares priced at a hefty discount of 59.5% to the price on November 23 and a 39% discount to the theoretical ex-rights price.