Bond investors’ bets on bank nationalizations are hindering already reduced lending by the world’s biggest financial institutions.
The market for securities with characteristics of both debt and equity that Citigroup Inc., Bank of America Corp. and other financial companies used to bolster their capital is in freefall on concern governments will stop banks that took public cash from paying interest. The hybrids, which typically count as regulatory capital to cushion against losses, fell 11 percent last month in the U.S., more than they did in all of 2008, according to Merrill Lynch & Co. index data. Citigroup and Bank of America bonds lost as much as 34 percent of their value.
“The danger is the government’s going to take over everything and not pay anything,” said Gregory Habeeb, who manages $7.5 billion in fixed-income securities at Calvert Asset Management Co. in Bethesda, Maryland. “It could happen.”
The U.S.’s $700 billion Troubled Asset Relief Program, 350 billion pounds ($499 billion) of U.K. debt guarantees and asset purchases and financial-industry bailouts around the world are weighing on banks’ capital securities, making it more difficult for them to resume lending. Investors are selling their holdings of hybrid securities, including Tier 1 bonds, banks’ lowest- ranked debt.
Treasury spokeswoman Jenni Engebretsen referred to comments that Secretary Timothy Geithner made on Jan. 28. “We have a financial system that is run by private shareholders, managed by private institutions, and we’d like to do our best to preserve that system,” he told reporters before a meeting with officials charged with providing TARP oversight.
“Government’s objectives for its support for the banking sector are financial stability, protecting taxpayers and protecting customers,” said a U.K. Treasury spokesman, who declined to comment further and wouldn’t be identified, citing department policy.
Only $694 million of preferred securities were sold in the U.S. since September, when the government closed the market by seizing Fannie Mae and Freddie Mac. That compares with about $44 billion in the first three quarters of last year, according to data compiled by Bloomberg.
Insurance companies, hedge funds and other investors bought more than $73 billion of hybrids in 2008, taking advantage of yields that were generous for issuers they considered too big to fail, according to Bloomberg and Societe Generale SA data. The bonds were offered at yields of as much as two percentage points more than senior unsecured debt.
Less than a year ago, analysts at Merrill Lynch and Lehman Brothers Holdings Inc. predicted that banks and other financial institutions would sell more than $125 billion of the debt to replenish capital after writedowns and losses that now exceed $1 trillion, according to Bloomberg data.
“If they still have difficulty accessing this market it’s not a good sign for the credit markets in general,” said John Lonski, chief economist at Moody’s Capital Markets Group in New York. “It’s difficult to conceive of capital markets having returned to normal without the ability of banks to issue.”
Hybrid notes, whose interest can in some cases be deferred without penalty at the borrower’s discretion, have plunged around the world since the U.S. took control of Fannie and Freddie, the largest mortgage-finance companies.
Bank of America
Citigroup’s $1.4 billion of 6.95 percent preferred shares lost 34 percent in January, the worst performing securities in the Merrill Lynch preferred and hybrid index.
Charlotte, North Carolina-based Bank of America’s $4 billion of 8.125 percent perpetual hybrid bonds have tumbled to 48 cents on the dollar from 73 cents at year-end, according to Bloomberg data. The securities were issued in April at 100 cents on the dollar. Bank of America received $138 billion in emergency government funds on Jan. 16 after posting its first loss since 1991 in the fourth quarter.
London-based Lloyds Banking Group Plc’s 6.35 percent notes callable in 2013 are quoted at 42 cents on the euro, less than Hannover, Germany-based travel company TUI AG’s hybrid 8.625 percent bonds, which are at 50 cents, according to Bloomberg data. TUI’s debt is graded CCC+ by Standard & Poor’s, 11 steps lower than Lloyds’s bonds.
Hybrid notes still haven’t fallen as much as bank shares this year, with the MSCI World Financials Index of stocks declining 20 percent, according to data compiled by Bloomberg.
‘Insolvent’ Banking System
U.S. financial losses may reach $3.6 trillion, suggesting the banking system is “effectively insolvent,” New York University Professor Nouriel Roubini, who in January 2007 predicted the economy was headed for a “hard landing,” told a conference in Dubai on Jan. 20. President Barack Obama will have to use as much as $1 trillion of public funds to bolster the capitalization of the industry, he estimates.
Government capital injections are failing to restore investor confidence in subordinated bank securities, which support the capital on banks’ balance sheets so they can lend.
The average price for issues in Merrill Lynch’s preferred stock and hybrid securities index decreased 8 cents on the dollar to 64 cents last month. New York-based Merrill agreed to be purchased by Bank of America as Lehman Brothers filed for bankruptcy.
“Subordinated bank debt is really, really suffering,” said Phil Roantree, a portfolio manager who helps oversee $14 billion at New Star Asset Management in London. “Something is seriously wrong. Regulators need to restore confidence.”
S&P slashed the ratings on $5.49 billion of collateralized debt obligations that hold hybrid bonds last month because of the risk banks will defer payments. The New York-based ratings firm also cut rankings on hybrids issued by Commerzbank AG, Dexia SA, Dresdner Bank AG, Eurohypo AG and Northern Rock Plc to below investment grade after they received government bailouts.
Moody’s Investors Service is reviewing its hybrid rating methodology and is talking with regulators and market participants about how to incorporate nationalization concern into its assessments, said Barbara Havlicek, senior vice president and chairwoman of the rating company’s new-instruments committee.
Aflac Inc., the largest seller of supplemental insurance, lost about half of its market value this year as S&P cut its rating one level to A-, citing investments in subordinated bank debt, including hybrids. The Columbus, Georgia-based insurer yesterday reported $262 million of losses from its investments.
Allstate Corp., the biggest publicly traded U.S. home and auto insurer, was downgraded by Moody’s last week to A3 from A2 because of “significant investment losses.” The Northbrook, Illinois-based insurer owns more than $1 billion of hybrids, Judith Greffin, the head of Allstate Investments LLC, said on a conference call last week.
“How can anybody have any confidence in that market?” said Marilyn Cohen, president of Envision Capital Management Inc. in Los Angeles, which oversees $175 million in fixed-income assets. “Especially now that we have had a de facto nationalization of some of the banks. All the government has to do is say ‘You can’t do it anymore.’ It’s been perilous.”
Hybrid bonds pay a relatively high yield for investors still willing to bet against nationalization, said Calvert’s Habeeb, describing the notes as “very cheap.”
“They’re not all going to stop paying, and maybe none of them do,” Habeeb said. “I’m not saying” nationalization that wipes out the securities “can’t happen, but now you’re getting compensated for the risk,” he said. Habeeb declined to say whether he’s been buying the debt.
When former U.S. Treasury Secretary Henry Paulson took control on Sept. 7 of Washington-based Fannie and McLean, Virginia-based Freddie, he scrapped dividends on their preferred stock and put $200 billion of new securities owned by the government ahead in the capital structure of the companies.
Deutsche Bank AG, Germany’s biggest bank, roiled the hybrid bond market when it declined in December to exercise an option to redeem 1 billion euros ($1.3 billion) of 3.875 percent securities due 2014.
The U.K. government’s attempt to bail out Royal Bank of Scotland Group Plc last month by switching its holdings in the bank to ordinary shares from preference shares backfired when S&P on Jan. 19 cut the lender’s hybrid debt by three steps, to BB, below investment grade.
“The bank capital market is totally closed to them now, they can’t raise money,” said Roantree. “While the government owned RBS’s preference shares, bond investors assumed they would always get a coupon because their securities ranked equally with the government. They removed that certainty.”
The Edinburgh-based bank’s 1.3 billion euros of 7.092 percent undated subordinated Tier 1 notes slumped 21.9 cents to 9 cents on the euro on Jan. 20.
Envision’s Cohen said she “unfortunately” bought preferreds issued by banks, many of which she’s sold since September. She still owns securities sold by JPMorgan Chase & Co. which she said should be “fine,” and some issued by Bank of America, which are “questionable,” she said.
“Those hybrids and preferreds are going to be the dinosaurs of the market,” Cohen said. “They’re not coming back for a long time. Everybody got bruised and battered.”