Co-operative Bank Preference Share and Bondholders Campaign (added 19 June 2013)
Following Co-operative Bank's 17 June announcement on its capital position and proposed exchange offer a large number of retail investors in Co-op subordinated bonds and preference shares have asked me to start a campaign on their behalf. It strikes me that all parties having to wait until October to find out the details of the putative deal's execution implies a continued negotiation on the divyying up of the losses and if so between whom and representing which stakeholders? Alternatively, if the details are available, they should be published now. The fact that they are not shows that the Bank will be talking to stakeholders and retail holders should have a voice in that process rather than be left out in the cold to be thrown whatever scraps are leftover from the master's feast.
I have set up a form for holders to enter their details at:
You can also follow me on (@MarkTaber_FII) on Twitter which I will use for quick announcements and updates.
You will then receive campaign updates and calls for action by email. I have also added a Co-op Bank Retail Investors Campaign Information page to this website as a library of useful resources and information for those involved in the campaign.
The immediate priority has been to generate publicity, reach out to retail investors in Co-op, stem the flow of scaremongering misinformation seemingly coming from the Co-op in the press and build a team to assist me in co-ordinating the campaign.
19 June 2013: Open Letter to PRA on behalf of Co-op retail investors
The Bank's announcement is as unusual as it is disturbing. Not only does it fail to give any more than outline details of the Co-op's proposals to raise the capital it requires but also it leaves until October before the full proposal will be announced. I understand from sources that this delay is due to the time it will take to obtain a listing for Co-op Bank shares (one part of the proposal) on the London Stock Exchange. However, 4 months of uncertainty is likely to be hugely damaging to the Bank and the wider Co-op Group and the desirability of obtaining (at great expense) a listing at this time in puzzling. The position of the Co-op Bank is highly unusual. Unlike other previously troubled banks, such as RBS and Lloyds which have hundreds of thousands of shareholders none with any semblance of control, Co-op Bank has a single substantial shareholder (the Co-op Group) with absolute control and responsibility for the management, accounting, major decisions, governance and stewardship of the Bank. Decisions such as the Britannia merger in 2009 and the level of due diligence done, the related management appointments, the bid for over 600 Lloyds Bank branches, the £250 million commitment to a redundant IT system and the approval, signing off and issue of accounts all lay at the door of the Co-op Group and its board. The Co-op Group clearly has has more than adequate assets and resources to cover the PRA capital requirements of £1.5 billion while honouring the Bank's creditors. However, the details that have been announced make it clear that the Co-op Group is seeking to maintain large majority ownership and control (over 75% of the ordinary shares) while seeking to obtain a £1 billion contribution from holders of the bank's subordinated debt and preference shares through an exchange offer with no cash or increased liability cost to the overall Group. Only then will the Group inject the £500 million proceeds from the sale of the 2 insurance divisions to make any sort of contribution. It is also highly surprising that the PRA have approved pursuit of a scheme, by a solvent bank with a controlling shareholder of substance, which upends the established capital hierarchy in this way. And given the extent to which vulnerable pensioners, small retail investors (over 15,000 by my estimates) and Co-op members are investors in the Bank I am sure this is not something which sits well with many within the Co-operative Group and wider Co-operative movement.
My attempt at a potted summary of the Bank's announcement is as follows:
The PRA (new banking regulator) is required the Bank to raise £1.5 billion of additional capital - £1 billion in 2013 and £0.5 billion in 2014. This is substantially more than the £800 million (my estimate) the PRA would have required to be raised based on the Bank's 2012 Accounts which were released less than 3 months ago. Embarrassingly the Capital resources (audited) note to the accounts states:
Adequate capitalisation can be maintained at all times even under the most severe stress scenarios, including the revised FSA ‘anchor’ stress scenario. A capital buffer above Individual Capital Guidance (ICG) is being maintained, to provide the ability to absorb capital shocks and ensure sufficient surplus capital is available at all times to cover the Bank’s regulatory minimum requirements.
The Bank is proposing that £1 billion will be raised from a Liability Management Exercise (LME) in the form of an Exchange Offer to all of its subordinated bondholders and preference shareholders. The announcement indicates that holders will be 'invited' (no doubt backed up by the mention of Special Resolution / Nationalisation under the Banking Act 2009 in the Risk Factors) to exchange at a discount to book value into some combination of:
- a new Co-op Group bond
- new ordinary shares in Co-op Bank and;
- possibly a new fixed income security issued by Co-op Bank
Considering the Bank is also listing ordinary shares I would guess that the latter is planned as form of Contingent Convertible - ie a bond convertible into ordinary shares if the Bank's capital ration falls below a certain trigger level.
No figures have been announced for each item but I have seen press mention of the Co-op Group Bond being £500 million. I think it is safe to say that Co-op Group will be seeking to retain at least 75% of the ordinary shares so less than 25% will be offered if the Group gets its way. The combination of these 3 elements that accepting holders will receive will most likely be derived from a complex 'waterfall' or priority list in which holders of the securities highest up the capital hierarchy will be given priority on the choice new Co-op Group bond. This will would leave the masses of holders of the retail issues (the 13% and 5.555% Perpetual Subordinated Bonds and 9.25% Preference Shares) being essentially herded into accepting the leftovers - sorry I meant new ordinary shares of questionable value with little prospect of a dividend until the transformation of the Bank is complete.
Incidentally I am not quite sure how the Bank's 9.25% Preference Shares have come to be included as Target Securities for the proposed Exchange Offer. The rights of these shareholders are enshrined in the Bank's Articles of Association and having read these I think that any repurchase or exchange which reduces the share capital constitutes a variation of class rights which cannot be done without consent from a super majority of holders at an extraordinary general meeting.
The Bank is using the following 'stick' in an attempt to beat holders of its retail bonds into submission:
Until further notice, the Bank will only pay discretionary coupons on any Target Securities left outstanding if permitted to do so by the PRA, and in particular will not pay the coupon on the 13% Perpetual Subordinated Bonds (ISIN GB00B3VH4201) that would have been due on 31st July 2013 without such permission.
What the Bank conveniently failed to mention is that the interest on its 13% and 5.5555% Perpetual Subordinated Bonds is cumulative and must be paid in full before any dividend is ever paid on its ordinary shares. Furthermore the dividend on its 9.25% Preference Shares must be paid in cash if the Bank is meeting Capital Adequacy Requirements or in 4/3 the cash amount in additional Preference Shares if it does not meet these but has sufficient distributable reserves. Unfortunately (some cynics might suspect something more sinister) a couple of national newspapers got the wrong end of this stick and reported that interest on the retail issues would be cancelled rendering the bonds effectively worthless. Not only grossly inaccurate and misleading but also implies that the Ordinary Shares in the bank will never pay a divided and will also be worthless which I am not quite sure is the message the Bank and its advisers are intending to get across !
Finally, having given them and the market value of their investments a good beating the Co-op has thrown a tantalising olive branch to its retail investors with the following snippet:
The Bank Board is mindful of the different interests of retail investors holding Target Securities. Ahead of the launch of the Exchange Offer, the Bank is considering a number of alternative options for small retail investors. In addition, the Bank is considering the manner in which it can facilitate the provision of independent financial advice to retail holders at the Bank’s cost.
The novel idea of attempting to provide financial advise to 15,000 private individuals makes a great soundbite but looks completely unworkable. Not only are there very few financial advisers who would be able to advise on something as complex as this but also the costs involved would be astronomic and possibly more than the value of the investments involved. The prospectus for the exchange offer will likely be of 500+ page biblical proportions, individuals circumstances, risk tolerance etc, would have to be assessed, RDR requirements complied with. And even then it is unlikely that any financial adviser could recommend that someone holding bonds for essential pension income should exchange them for ordinary shares which would not pay a dividend for some years. Paying for the advice would cost the Bank many thousands of pounds per investors and tens of millions overall so it would be cheaper to offer to buy back their bonds at par in cash !
Attempting to give retail investors a voice and engaging with the Bank and its advisers on 'alternative' options for them will be a key focus of the Campaign.
Original Blog Post
I was tempted to make all sorts of puns based around coops, chickens, turkeys and fowl (foul) but will resist as events at Co-operative Bank are serious and clearly a large number of investors are very concerned. Since the massive downgrade of the bank's credit rating by Moody's last Friday I have received scores of emails on the subject, over 200 people have registered on this site for more information and The Motley Fool discussion thread has had 170 new posts and counting ! I will start with the most asked questions:
What does the Moody's downgrade mean?
Moody's is a credit ratings agency retained by the Co-operative Bank to rate their bonds. In essence this means that Co-op Bank pays Moody's to rate the credit-worthiness of its bonds. These ratings are used by bond investors such as fixed income funds, pensions funds etc. to assess how safe a bond issuer and its bonds are to invest in, their value relative to other bonds of the same rating and whether they are suitable investments for them to hold. Many funds have internal guidelines or rules that they will only invest in or hold bonds of a certain credit rating or above.
Moody's has 21 notches in its credit rating scale; 10 are investment grade ratings, the rest are junk. Usually ratings move by one or two notches at a time so the sudden six-notch rating cut for the Co-operative Bank is massive, and the difference between investment grade and junk is significant. Many funds can only hold investment grade bonds so a sudden cut to junk status can make them forced sellers at any price and cause the big price falls seen in Co-op Bank bonds since the Moody's downgrade.
What has happened recently to cause this sudden massive downgrade?
This is a very valid question and the answer seems to be that not a lot has happened recently but rather it relates to what happened back in 2009 when the Co-op Bank merged with Britannia Building Society. Based on a recent Telegraph article:
The Britannia had an operating model akin to the likes of the growth-obsessed HBOS, with a focus on highly aggressive commercial property lending and high loan-to-value buy-to-let mortgages. In 2008, months before the announcement of its merger with the Co-op, the Britannia was forced to write off bad debts of more than £40m in one of its specialist lending subsidiaries, threatening its sacrosanct dividend. One analyst noted that the mutual’s exposure to the worst parts of the property market was “nothing short of alarming for what should be a staid building society”.
Britannia brushed aside the warnings, describing its commercial property portfolio as “low risk”. The Co-op appeared to accept this version of events, taking a relatively small write-down on the mutual’s holdings and handing Britannia chief executive Neville Richardson control of the combined business. The subsequent performance of the Co-op Bank appeared at first to support the wisdom of the deal, with the business reporting a pre-tax profit in 2009 of £165m, against multi-billion losses at larger rivals such as Lloyds and Royal Bank of Scotland. For instance, Lloyds lost £6.3bn in the same year as it was hit by £24bn of impairments as a result of its merger with HBOS. Yet at Co-op Bank the total annual impairment charge was just £112m, which the mutual said was down to “the cautious approach taken by both heritage businesses”.
A year later, impairments had fallen further to less than £100m and such was the Co-op’s confidence in its financial strength that in 2011 it launched a, now aborted, bid for the 632-branch Project Verde business being sold by Lloyds. In December 2011, Lloyds confirmed the Co-op was its preferred bidder. Yet, in its moment of triumph were laid the seeds of its disaster. As Lloyds staff and regulators began to pore over the Co-op Bank, they became troubled by what they found. “It became clear very early on that they didn’t have the experience or the skills to manage an integration of this size. From what we could see, the Britannia integration had barely been begun and they appeared to have no concept of what it would take to fix the business,” said one senior banker. Of particular concern was the apparent capital hole in the business. Lloyds had planned to sell the Project Verde unit with assets of about £60bn. But this had to be more than halved.
There were also problems with the infrastructure. On taking over the Britannia, the Co-op had begun spending heavily to develop a new IT system to manage the combined business. Disclosures from the bank show that in 2009 nearly £80m was spent on the project, roughly half the amount the business made in profit that year. In total, the Co-op spent close to £250m on building the new system.
However, as the Verde deal came complete with it own IT system, the Co-op was forced to write off much of these costs, adding to the pressure on the capital base.
As the problems continued to grow executives began to leave. At present, the business has an acting chief executive, interim chief financial officer and an interim head of risk.
Then in March came the killer blow, as Co-op Bank made a loss of £634m as it reported a tripling in impairment losses to £469m.
I feel investors have every reason to ask questions of the ratings agency, auditors, regulators and directors in the case of Co-op. In the case of Moody's why it issued such a sudden and severe ratings action in the absence of a fresh credit event? There are plenty of reasons to cry foul.
The fact is that the problems stem from provisions not previously made against commercial property loans taken on with the Britannia merger back in 2009. That merger was very similar, albeit on a smaller scale, to Lloyds acquiring the stricken HBOS around the same time. Like HBOS Britannia was in the mire due to its reckless commercial lending. But whereas Lloyds realised and came clean about the extent of the problem soon after the acquisition (the massive writedowns required were the main reason for the State bailout) Co-op Bank has kept quiet, made low provisions and reported profits until now. Even then I suspect that coming clean has been forced upon them by what was discovered during due diligence for the Project Verde acquisition.
This begs the question what on earth have the regulators being doing in respect of Co-op for the last 4 years? They would have been heavily involved in arranging for Co-op to rescue the stricken Britannia, knew exactly what happened at Lloyds post HBOS, yet never took a good look at the quality of Co-op's assets or the sufficiency of provisions? Perhaps Co-op Bank's strong political ties and bank-rolling of the Labour party gave it a get out of jail free card.
The auditors should also have been fully aware of the risks arising from the Britannia merger and taken a good look at the legacy loans. Yet they have been signing off accounts with minimal provisions for years?
The directors must have known as the Britannia management team took the helm at Co-op Bank after the merger. But in the case of bankers turkeys voting for Christmas is not something we have come to expect.
What will happen now?
Now that the loan book issue is out in the open it is clear that Co-operative Bank will need to raise capital. The big question for bondholders is now much will be required to plug the gap and meet new regulatory requirements? If it is a sum which the Co-op can raise internally then the subordinated bonds could well escape unscathed. Co-op are indicating that they are looking to raise about £600 million. However if, as several analysts are now indicating, it is substantially more (Barclays have indicated up to £1.6 billion) then the prospect of enforced burden sharing or a 'bail-in' becomes a real risk. This risk is what is implied by the massive Moody's downgrade. By 'enforced burden sharing' I mean Government intervention using the Special Resolution Regime under the Banking Act 2009. The possibilities are well summarised in the following extract from a recent Bank of America analyst report on the Co-op:
The Co-op may present a real life ‘test case’ for all the developments there have been in terms of bank resolution since the financial crisis started in 2007. Its relatively small size compared to the clearing bank giants also could mean that it would be tempting to use it as a laboratory for the new ideas that have swept the world in terms of banking resolution.
That would not be good news for subordinated bondholders, in our view. We have identified about £1.3bn of subordinated bonds with varying degrees of subordination from the bank’s accounts (see Table 3). This number looks eerily close to the amount of loss-absorbing capital that the bank may need, yet the bonds are not at present of course in loss-absorbing format. Though it depends on the severity of the losses, our first take would be that there are sufficient subordinated bonds here to exclude the haircutting of any senior bonds.
There are many resolution options for the Co-op if it ends up that this is needed. Some could be:
1. The Co-op’s healthy banking business is transferred to a Newco, leaving the toxic assets behind with the subordinated debt to capitalize them.
2. The UK sells the Co-op’s healthy business to another bank (we doubt this – we think they will keep the Co- op as a functioning stand-alone bank).
3. The sub bonds are expropriated, SNS-style, on the grounds that the bank is already insolvent. This would entail nationalizing the bank.
4. A Statutory Instrument such as we saw with Bradford & Bingley is passed changing the terms of the sub bonds, potentially making them cocos or just zero coupon, loss-absorbing, perpetuals.
5. A straight haircut is applied to subordinated bonds, to reflect the severity of the loss.
6. The UK forces a debt-for-equity swap.
If any of these scenarios were to come to pass, arguably current prices would still be on the high side, we feel. Should bondholders be involved in any resolution of the bank, it will also be key as to whether the capital structure is respected. We would anticipate so but precedents are mixed.
The trouble is to work out whether or not there will be a bail-in the single biggest bit of data we need is the capital shortfall which is a big unknown. Which leads neatly onto the next question -
How can the bank raise capital and how much can it raise?
The most common way for a bank to raise capital is by issuing shares or securities convertible into shares in certain distressed circumstances to external shareholders. However mutuals, such as building societies, do not have this option as they cannot issue shares. A new instrument, known as Core Capital Deferred Shares (CCDS), has been developed to help mutuals with this problem and the Nationwide Building Society is looking to make the first such issue.
In the case of Co-operative Bank it is important to understand the group structure which is summarised as follows:
So while the Co-operative Group is a mutual owned by its members the bank arm is actually a limited company with its shares held by parent entities within the group. The Group itself is large and diversified (food retail, travel, funeral, legal, insurance etc.) so there will be capacity for the Group to cash 'downstream' to the Bank in order to provide capital. This cash could come from a number of sources as follows:
Group Cash Reserves & Credit Facilities: I understand that the Group's primary bank line is a £500 million revolving facility of which £495m remains unused. The Group needs agreement from the lending banks to 'downstream' drawdowns to the Bank. It has not yet sought this agreement from the 8 syndicate banks (mostly UK clearers, the Co-op bank itself and a couple of ‘international banks’). Apparently group treasury do not think consent would be withheld. In considering how much cash the Group would provide to the Bank as capital I think we have to work on the basis that management will not put the Group at risk. On this basis perhaps a number of £100 - £200 million would be the maximum.
Sale & Leaseback: The Group undertook a sale and leaseback of its Headquarters in early 2013 which raised £140 million. The cash can also be deployed if necessary down to the Bank. Other property could be sold and leased back albeit it is not being actively pursued at this moment.
Asset sales: The life insurance business is being sold for £220 million. The non-life business is also up for sale. It has a book value of the business is £276 million. Management is targeting as close to £400m as possible but mindful that they are not in the strongest negotiating position.
Loan Portfolio Disposals: According to the Financial Times the Co-op has appointed the investment bank UBS to advise on options for improving the Bank's capital. They will likely look for easy disposal targets in the non-core portfolios as well as some possible core. Of course prices achieved will need to exceed the breakeven required for the Risk Weighted Assets (RWA) reduction to outweigh the charge to the Profit & Loss account.
Liability Management: The current unsecured debt of Co-op Bank is as follows:
It is unlikely that senior notes would be subject to liability management. However, the £1.3 billion of subordinated issues are a likely target for LM made all the more attractive by recent falls in market prices. The carrying values of these issues in the 2012 accounts are as follows:
How much capital will the Bank be required to raise?
Based on current market prices there is certainly potential to generate a significant sum from liability management. For example the £200 million 5.5555% PSBs are currently bid at 52.5 in the market. While aggressively coercive LMEs appear to be off limits as a result of the Assenagon judgement there would be potential to use mention of the possibility of State intervention using SRR powers if sufficient capital is not raised as a stick. We saw this approach in the revised voluntary offer for the Bank of Ireland PSBs back in 2011. I shuddered when I read the Financial Times reporting that the Co-op has appointed my old foes at the law firm Allen & Overy to advise on options for raising capital. Those veterans of my Bank of Ireland 13.375% PSBs Campaign may recall that Allen & Overy advised the Bank of Ireland on its coercive offer which we defeated and subsequent voluntary offer backed up by the threat of State enforced bail-in.
ADDED 10 JUNE 2013: The market was further spooked last weekend by a Daily Telegraph article which suggests that pensioners and other retail investors may be forced to take a 'haircut' through being switched into some form of Profit Participating Deferred Shares (PPDS) as happened to West Bromwich Building Society PIBS and subordinated bond holders back in 2009. It is an annoying piece of journalism because it does not consider whether such a cramdown could be worked at Co-op given how different it is to WBS. In particular:
- WBS is a mutual and so has / had no shareholders to take the first hit or be called upon to contribute capital. Whereas Co-op Bank plc is a limited company with ordinary shares (held by the Co-op Group). If an approach is to be made to the large holders of Co-op sub-debt to seek agreement to such a conversion (as happened in the case of WBS) then I am sure they would want to see a sizeable contribution from the shareholder before agreeing to convert into an instrument with materially worse terms.
- The terms of Co-op Bank sub-debt are much stronger than those of the old WBS PIBS. All coupons are at at least cumulative and there is an argument that even those which can be deferred will become mandatory at 10% per annum under Basle 3.
- The Co-op Bank 9.25% Preference Shares are an additional complication. The dividend pushes payment on the discretionary subordinated bonds (unless the preference dividend is mandatory under the terms which it seems to be providing the bank meets its regulatory capital requirements) and the directors can only pass payment if paying would cause the bank to breach its capital adequacy requirements. Even then there is an additional protection clause whereby unpaid dividends must be settled in additional prefs at a rate of 4/3 of the missed dividend. The NatWest 9% Preference Shares have a similar clause and it is worth noting that their dividend was not stopped during the EC suspension despite the commitment not to pay discretionary coupons. Another complication if that if a Co-op 9.25% Preference dividend payment is missed then holders (according to the Bank's annual reports there are over 2,500) get the right to be heard and vote at the Bank's AGM. Something which could get very messy.
I believe the 9.25% Preference Shares are virtually all retail held which limits the Bank's ability to do a WBS style deal with holders or even take the failed BOI coercive route. The large retail base also gives the Bank a PR headache if they try to hurt them. It is interesting that the Daily Telegraph article claims that:
'Of the £370m of bonds, which pay annual interest of between 5.55pc and 13pc, some £30m is held by members of the public.' and 'Co-op insiders claimed its retail investor base was made up largely of high-net-worth individuals rather than pensioners.'
I have tried to confirm this with Co-op Bank's press office and investor relations without success. However, in my experience issuers have little clue who holds their bonds, let alone whether they are 'high net worth' or not, and former retail PIBS, such as the Co-op 13% and 5.5555% issues which both started life as Britannia PIBS, are majority held by retail investors. This was certainly my finding when I successfully co-ordinated a Campaign on behalf of holders of Bank of Ireland former Bristol & West 13.375% PIBS. These were issued around 1992 at the same time as the Co-op former Britannia 13% PIBS and the following Daily Mail article from the time, which refers to both of these PIBS, shows the extent to which they were promoted to the public as safe alternatives to savings accounts. It is worth noting that while the 13% coupon sound astronomical in the current low interest rate environment UK Gilts with a 12% coupon were issued around the same time and it did not reflect a high risk investment.
In respect of how much the Bank could raise from a LME the Telegraph refers to a Morgan Stanley estimate of £172 million. The Morgan Stanley report I have seen estimates £222 million but does not provide any analysis. A separate JP Morgan report estimates £199.4 million as follows:
Coupon Deferral: There has been some interesting debate on the technicalities of Co-op Bank deferring discretionary coupons. One issue is that it is not at all clear that doing so would actually generate any CET1 capital for the Bank. This is because payment of the two UT2 issues which can be deferred is pushed by payment of the T1 9.25% Preference Shares. However, if a preference dividend is skipped then holders must be compensated in further preference shares to the nominal value of 4/3 of the skipped dividend. Originally the point of this type of 'dividend paid in more shares' suspension (the NatWest NWBD Preference Share has the same) would have been to generate more capital in the form of preference shares from the deferred coupons. But under Basel 3 the new preference shares issued would not qualify as CET1 so the mechanisms do not really work as intended anymore. Furthermore both the 13% and 5.555% UT2 PSBs are cumulative which means any deferred interest still has to be accrued and so the P&L saving of deferral is minimal. Having said all that, if I was advising the Co-op Bank on strategies for liability management I would suggest that coupon deferral could be used as a mechanism to suppress market prices of the bonds in advance of a tender or exchange offer and so increase the potential gain for the Bank and amount of capital raised. Alternatively the threat of coupon deferral could be used as a stick to encourage holders of accept a tender or exchange offer much as Lloyds did with its ECN exchange back in 2009. Another reason the Bank may go down the coupon deferral route is to make a statement of intent to the regulator in order to soothe relations and buy time to implement its plan. It has been reported that the PRA is heavily involved in the recruitment of a new Chief Executive for the bank which indicates that Co-op Bank could be on some form of heightened supervision already. (ADDED 20 May 2013)
As already mentioned this is the big unknown. Having been through the accounts and analysts reports I think the best stab at quantifying the range has been provided by Barclays. This is summarised below:
This is based on the Bank being required to achieve Core Equity Tier 1 ratio of 7% for 2013. Barclay's base case shortfall of £800 million could probably covered by a combination of the measures listed above including voluntary LME of sub-debt without the need for enforced bail-in. However, if the shortfall starts to creep over £1 billion the probability of bail-in being required becomes much higher.
I intend this post to be a working piece and will update it as the picture becomes clearer. I will format new additions in Blue text and also date them so as to make tracking of new content easier for readers. So please do share your thoughts with me by email to email@example.com