Investment banking “practical jokes”
Every upcycle, clever investment bankers devise exotic securities that they sell to gullible portfolio managers, who come to regret their purchase decision almost immediately. They continue to rue their bull-market impulsiveness for the many months it takes them to find (if they can) some even more gullible person to sell them to.
One of my favorite issues of this type was a wildly oversubscribed issue made by Hong Kong property company New World Development in 1993, at the height of an emerging markets mania. It was a zero-coupon bond, convertible into shares of a China subsidiary of New World that did not yet exist, except as a name on a certificate of incorporation.
The hybrid bond
This time around, a leading candidate for purchase blunder of the cycle is the hybrid bond, a type of security issued notably by financial institutions.
What made these securities hybrid? They had terms of 40-60 years, or sometimes were perpetual, that is, principal was never returned–just like stocks. Also, the interest payment could be reduced or eliminated without causing a default.
What made them bonds? A good question. That’s what they were called on the front page of the prospectuses. This naming made them eligible to be purchased by bond fund managers. The inducement to purchase was a relatively high yield. The instruments ranked below all other bonds, just above equities, in the pecking order in case of bankruptcy.
If bonds were food, I think the Food and Drug Administration would have been alerted to hybrids, just like it was when Aunt Jemima was selling “blueberry waffles” that had no blueberries in them. In fact, some tax authorities or industry regulators do classify the hybrids as equity. But a couple of years ago, this was regarded as another beauty of the hybrids, because having regulators count them as equity bolstered the issuers’ capital ratios.
Fast-forward to the present
Lloyds Banking Group of the UK has a bunch of these hybrids on its balance sheet. It wants to swap them for a new type of securities, which it is calling contingent convertible bonds.
The idea is that under normal circumstances the securities will be bonds, paying interest and having a bond’s liquidation preference over equity. But if Lloyds gets into trouble (again), the securities would convert automatically into equity, losing their bankruptcy advantage and presumably their income payment as well. The trigger for conversion would be Lloyds’ tier 1 capital ratio falling below 5%.
Yes, this is kind of like having medical insurance that terminates if you get sick. No, it’s not a joke. On second thought, though, this could be a little more investment banking humor. Sometimes, it’s hard to tell.
I can’t imagine contingent convertibles finding any takers in an original issue, other than at the tippy-top of the business cycle. But Lloyds and the EU are playing hardball with the conversion offer. Unswapped hybrids are set to cease making interest payments after the swap period ends.
The offer situation isn’t as bad as it looks at first blush, however–it’s worse. Not taking it may be very difficult to do. Depending on their current carrying value in portfolios, post-exchange, post-interest-elimination hybrids may have to be considered as further impaired and written down. Also, it seems to me that any remaining hybrids have got to be much less liquid than they are now. So they may be impossible to dispose of, thereby having to remain on the lists of holdings sent to clients for some time to come.
Moral to the story?
I’m not sure there is one. If we consider hybrids and contingent converts as two parts to one story, the combo probably rockets to the top of my list of bull market follies. My only other thought is that this is Liar’s Poker all over again.
An update from Nov. 22nd
Here’s the link.