Employee earnings are set to decline sharply in the investment banking division of RBS.  Future bonuses to be paid in subordinated debt spread over the following 3 years.  Subordinated debt is currently about as popular as a bad smell in a lift.  Hence its even more of a pay cut to be allocated a bonus in sub debt at par when other subordinated bank debt is trading at a big discount to par in the marketplace.  Sub debt has the same downside as equity but no upside as its limited to par. 

Yesterday the Government agreed to pay RBS par for £19 bln of convertible preference shares, which are even further down the capital structure than sub debt.  Technically the RBS B shares are Convertible Non-Cumulative 7% Preference Shares, issued on a 108% conversion premium and automatically callable at 130%; coincidentally the 65 pence call trigger is the same price as the second rights issue of 2008.

RBS will be aiming to buy back the B shares from future retained earnings.  Having 38 bln new shares created is not in the best interests of minority RBS shareholders – so don’t expect RBS shares to trade above 65 pence until all the B shares have been bought back.  RBS would also benefit from buying back subordinated debt in the market if they could buy it back below 50%.  Below this level the profits from cancelling the debt would exceed the Core Tier 1 capital spent on the buyback.  This would therefore be neutral from a Core Tier 1 capital perspective and would also wipe out future coupon payments.  Buying back below 33% would even be neutral from a normal Tier 1 capital perspective.  There are will be even fewer buyers of perpetual subordinated bank debt once they realise that none of this debt will be called until RBS has spent £19 bln of future retained earnings on buying back B shares.

Back to those pressured employees.  We are at the start of a structural change in pay in the marketplace.  More of the company earnings will be retained by shareholders.  This marks the end of the 48% compensation payout ratio.  Will they all leave and go work somewhere else in today’s global marketplace?  A few individuals may leave, especially those whom are already independently wealthy, but for the rest I doubt it as there is nowhere else to go.

In the very long run investment banking will go back to private partnerships as these are the best way of risking capital – when its the partners’ money they pay attention to the risk.  Not quite the same as hedge funds as partnerships are not creaming off 2% of their investors’ money every year come rain or shine.  Boutiques offering corporate finance advice will be set up first as these require little start-up capital.  Risk-taking partnerships will start small and build up their capital by retaining earnings – this will take much longer but at least these partnerships will not bring an economy to its knees if they go bust.

Expecting deflation to take hold is essentially betting against the combined power of the MPC, BoE and Government and the efforts of their counterparts in the US and elsewhere to prevent deflation.  Ultimately they control the printing presses and given that we are not shackled to a Gold Standard (and neither Sterling nor the Dollar are in a fixed currency bloc) and the authorities are well aware of the deflation risk then it seems unwise to bet against them.

Low bond yields are not necessarily predicting deflation but could just be the result of expecting interest rates to remain at very low levels for several years (which does not appear an unreasonable expectation at the moment).

Ben Bernanke wrote the book “Essays on the Great Depression” about the 1930s and gave a speech in 2002 about the Japanese experience of the 1990s.  His speech was entitled “Deflation - Making Sure it Doesn’t Happen Here” (see prior blog post of 3 Nov 2008 entitled “Get Me a Printing Press”).  So Ben is well aware of the risks of deflation and as the US Dollar floats freely then we can bet he will have the printing presses rolling day & night if necessary to avoid deflation as the Fed spends the money it prints on buying US Treasuries, corporate debt & asset-backed bonds to keep credit flowing.

The US stockmarket rallied once again last Friday (6 Feb) as the monthly employment report showed another 600,000 jobs had been lost in January.  The FT’s Lex column showed total disrepect for the market by claiming this was a “la-la” reaction by the market as it ignored a terrible piece of economic data.  Lex appears to have forgotten the concept of a market being able to price in the bad news ahead of its publication.  The unemployment rate is now 7.6% whereas many economists are expecting unemployment to rise to 9% before this recession ends.  Given that the market has now rallied after the publication of each of the last two monthly employment reports it seems fair to assume that the market’s focus of attention is elsewhere – perhaps upon the Obama stimulus plan and what Q1 earnings are going to look like (we will find out the latter during the April reporting season).

The reality is that markets have been in a wide trading range since the November lows last year.  This is clearly a consolidation pattern and there are only two outcomes: Either the markets are building a broad base here before eventually breaking higher or those expecting the Dow to go to 5,000/6,000 are right and we are going to break lower and the bear market has not ended yet.  The sensible course of action is to raise some cash if markets rally to the top of their trading ranges before the G20 London summit at the start of April (billed as the world coming together to fix the credit markets), and the Q1 earnings season which will follow during April.  But with the world’s governments & central banks focused on preventing deflation, it is not likely to take hold.

A new wholesale bank is born.  The UK Treasury has provided more details about its Asset Purchase Facility (APF), a £50 billion fund, financed by Treasury Bills & managed by the Bank of England, which will buy corporate debt, commercial paper, syndicated loans & asset-backed securities.  The stated objective of the APF is to “increase the availability of corporate credit” by making purchases which “would be most likely to restore the flow of finance to corporate borrowers”.  The plan is to wind down this fund as “normal conditions return”, i.e. when corporate credit spreads have tightened back into historical ranges, mostly by allowing existing assets to mature (rather than pressuring the market with a £50 bln overhang of paper).

The BoE has been directed to publish a quarterly account of the APF’s transactions together with an assessment of developments in corporate debt markets.  These accounts are sure to be eagerly awaited by the market – given that the BoE has been directed to buy “high quality assets”, any company which gains the BoE seal of approval will surely see its credit spreads tighten.  But then again that is the purpose of the APF, to tighten spreads and improve liquidity in the corporate debt market.

Whilst the prime objective is not to make money, the APF most certainly will – pots of it.  With 5-year investment grade corporate debt currently yielding in excess of 6% and Treasury Bills yielding less than 1%, this is going to be a good business for the UK taxpayer to get into (and I can’t see any of the APF’s profits being paid out to BoE employees in bonuses either).  But if this is such a great idea – why didn’t anyone think of it before..?  Well, Citigroup did when they invented the Structured Investment Vehicle (SIV) in 1988.  Like all banks, SIVs borrowed short & lent long (in their case buying bonds financed by issuing commercial paper).

Citigroup’s idea lasted 20 years until August 2007 when worries about losses on SIV’s assets caused commercial paper investors to refuse to lend the SIVs any more money.  Game over.  Whilst all the existing SIVs were closed down or went bankrupt post-August 2007 (Sigma Finance, the last surviving SIV went into liquidation in October 2008), the APF mirrors the idea perfectly.  The APF won’t suffer funding problems because Treasury Bills will always find buyers and any losses the APF suffers will be covered by the Government.  A 5% spread on £50 bln implies profits of £2.5 bln annually (credit losses will be non-existent as any company enjoying access to APF funding is highly unlikely to go bankrupt), the APF will prove to be a source of revenue which the Chancellor is going to be reluctant to shut down.  The SIV is dead, long live the SIV.