The Great Pay Experiment – Part II
Whilst politicians are busy bashing bankers over remuneration (perhaps in an attempt to deflect attention from investigations into MP’s expense fiddling), banks are getting back to the basics of sensible banking. RBS & LLOY are doing the right thing by buying back perpetual subordinated debt at 50% and below (see The Great Pay Experiment - 27 Feb 2009). Paying either in cash or new 5-year and 15-year bonds allows profits to be booked on the debt which has been bought back and represents sensible liability management as this subordinated debt would eventually have wound up being repaid at par when they were finally called/redeemed. Profits also count as vital Core Tier 1 capital. The banks are at the start of the long, slow road to recovery. Back to Banking 101. Leave derivative & sub-prime speculation to private partnerships and concentrate on lending out your deposit base at a nice fat spread. Use the profits to redeem the Government’s B shares to avoid futher dilution for long-suffering equity shareholders and restart dividends at a low level from which they can grow progressively once the last of the B shares are finally bought back & cancelled.
There is a significant amount of profit in these debt swaps by RBS. £16.1 bln of debt bought back at 50% of face value generates potentially £8 bln of pre-tax profits (LLOY announced a 65% early acceptance of its subordinated debt buyback by debt holders). Contrast this with the £10.3 bln of pre-tax profits which RBS reported for 2007 before the credit crunch really started to bite. Even assuming RBS uses up all its operating profit in 2009 to write off bad debts and raise its impairment charges, RBS would still report a healthy profit because of these debt swaps.
So why are subordinated debt holders selling out at 50% or less? In the good old days the banks used to issue perpetual subordinated debt with coupons much higher than perpetual gilts. This debt was callable (at par) by the banks after 10 years and the rules of the game used to be that banks always called the bonds on the first call date and the institutional holders of this paper were paid out at par. However since the onset of the credit crunch banks have better use for their money than repaying bondholders early when they don’t have to. Bondholders have realised that the problem with perpetual paper is that it is only worth what you can sell it for in the secondary market. Cue a collapse in the market price of this paper (the same thing happened to perpetual floating rate note paper back in the 1980s). The regulators have applied a further twist of the knife by hinting that in future they will not allow this type of perpetual subordinated debt to be counted as part of a bank’s capital. Game over for perpetual subordinated bank debt. The institutions know their best option is to sell this paper at the best price they can get for it, cut their losses and re-invest the proceeds elsewhere (there are plenty of cheap securities to choose from in current market conditions).
Post Script (24 April 2009) : RBS announced it has made a £4.5 bln pre-tax profit on the debt which it recently bought back at a discount to par.
Tags: Banking 101, institutions, liability management, LLOY, perpetual FRN, private partnerships, RBS, subordinated debt, tier 1 capital