Deutsche Bank broke an unspoken rule of the capital market at the end of last year when it failed to call a 1 billion 3.875% 2004/2014 lower tier 2 issue at the first opportunity.
"We decided not to exercise the early redemption option because the replacement costs would be more expensive than the existing coupon of Euribor plus 88 basis points," says Ron Weichert, a Deutsche Bank spokesman.
The vast majority of hybrid debt both tier 1 and tier 2 capital sold to institutional investors has a call date some five years or more earlier than the scheduled maturity. But in a wide-credit-spread environment the economic incentive to call normally an increase in the coupon of an additional 50bp plus the prevailing level of Euribor is not particularly strong.
"We think that taking into account the various important constituencies, this makes a lot of sense," says Weichert. Given the scrutiny of, and injections of public capital into, financial institutions it could be increasingly difficult for bank chief executives to reject immediate shareholder concern on the basis that it is imperative to protect investors.
Just a few days before the Deutsche decision, Calyon reopened the sterling lower tier 2 market with a £250 million ($386 million) deal and paid Euribor plus 330bp for the privilege.
From a short-term economic perspective it is quite clear that Deutsche Bank made the right decision. The question that market participants ask is whether or not its access to capital senior and subordinated in the long term is damaged. It is worth noting that this was a fixed-rate bond sold to normal credit investors only floating-rate lower tier 2 bonds were predominantly bought by SIVs, a constituency clearly not worth keeping onside given their demise.
"In 2004 we issued a note with a 10-year maturity that runs until January 2014 and there is a coupon that is fixed at 3.875% for the first five years and a floating-rate note for the next five years and its a transparent mechanism," says Weichert.
Unsurprisingly, prices on short-dated (from the call date) Deutsche capital bonds fell 10 to 12 points and were trading in the mid 80s as the market priced in the strong possibility of maturity extension. According to SG, there are 44 billion of hybrids that reach their first call or maturity date in 2009 of which 25 billion is lower tier 2, 10 billion is tier 1.
"Investors are pretty furious," says a trader. "Considering that Bank of Ireland and HBOS called theirs last week, its somewhat surprising. They might have opened up Pandoras box."
But the box has been open for some time its just that no one was willing to peer inside.
"We are disappointed and concerned at this action taken by Deutsche Bank, a leading global capital markets operator with no capital or liquidity issues. This is a severe setback for the stabilization of banking markets and is likely to increase funding costs for banks generally," the ABI said. "We would urge other major banks to continue to support markets in the medium term by honouring calls on bonds as per normal market practice."
Although both Bank of Ireland and HBOS called capital issues during December, this is not the first time that this has happened to investors.
The last time was in the perpetual capital market back in the 1980s. Given where subordinated spreads are, and the European regulatory impetus towards true equity capital, it seems unlikely that hybrid issuance will be substantial in the coming months.
This must call into question the whole viability of the lower tier 2. As a loss-absorbing instrument its of limited worth, leading some observers to suggest that it is merely an expensive form of debt.