Last month Bank of America announced its intention to exchange some of its preferred stock and trust preferred securities for common equity or senior notes. The bank said a month later that these exchanges generated $2.9 billion of Tier 1 common equity capital and increased B of A’s Tier 1 common equity ratio by 21 basis points.
What allowed B of A to take advantage of such an opportunity to raise capital was the steep drop in the market value of its traded debt. In fact, credit spreads widened for basically every bank on Earth.
Many banks have tried to act along the same lines to retire debt at a discount to par and generate gains that flow right into equity: Spanish, British, and French banks have all announced either debt exchanges or cash tenders to retire capital securities. Last week, Barclays came out with a tender offer for £2.5 billion of securities and Germany’s Commerzbank did the same for €600 million. On Monday, ING announced tender and exchange offers for €5.8 billion of various capital securities with offers ranging from 58 to 87 cents of par value. ING has the potential of generating €1.5 billion of a pre-tax capital gain.
Some banks are more generous than others and investors have various considerations to weigh in deciding whether or not to accept the banks’ offers. Yet all these moves have the same motivation on the part of the banks: getting rid of securities that do not count as capital under Basel III and doing so at a discount to notional so that equity capital is generated on the balance sheet, all the while reducing future interest expenses.
Is this a rational strategy by the banks? Absolutely. But the zeal in which banks have been doing this in recent weeks raises the following question: is retiring debt at a discount the only avenue open to banks right now to raise capital in the market? Unfortunately, the answer might be yes.
In a perfect world, banks could raise large sums of capital quickly in several ways. First, earnings build common equity over time. Yet future profits do not seem like a dependable source of capital in the current environment where banks face ever tighter net interest margins, the possibility of higher loan loss provisions because of asset quality deterioration, and potential writeoffs on their sovereign debt holdings.
Further, regulators want banks to come up with capital sooner rather than later as part of new stress tests in the U.S. and Europe: the Federal Reserve wants large banks to submit capital plans by Jan. 9, and the European Banking Authority wants banks under its supervision to raise €115 billion by the end of June 2012. Earnings will have a limited benefit for banks in these timeframes allotted by regulators.
Second, banks could issue common equity to investors. It should go without saying that market conditions right now make this an unrealistic option, and banks want to avoid dilutive equity offerings given the fact that those needing capital the most are trading at substantial discounts to their tangible book values.
Third, banks can raise capital by deleveraging through the reduction of assets. Banks have begun getting rid of some trading assets, which they consider to be “low hanging fruit” in this regard: the assets are typically more liquid and are already marked-to-market so there should be no further hits to capital when the assets are sold.
More problematic are the banking book assets: these parts of bank balance sheets are much bigger, less liquid, and assets there are held at historical cost so banks would take losses upon sales.
Let’s put the deleveraging challenge in perspective. Suppose European banks tried deleveraging to generate €29 billion, or a quarter of the capital the EBA wants them to generate. At a 9% core Tier 1 ratio, this translates to €319 billion of risk-weighted assets. If the average risk-weighting of bank assets is roughly 45%, then the actual face value of assets that need to be sold is more than €700 billion. That is a large number. Who will take all of these assets?
Deleveraging through the sale of entire business lines is also a difficult proposition for banks; in fact, some banks are still writing off goodwill from acquisitions completed in the height of the credit boom.
There certainly are successful examples of entire divisions being sold by banks: ING is selling ING Direct USA to Capital One, Santander is selling its Colombia unit, and B of A sold businesses and stakes in transactions that have raised capital. But there is limited capacity and limited appetite for these transactions.
Regulators also seem to understand that capital raising options for banks are quite limited. Many distressed banks that received some form of government aid during the financial crisis had severe restrictions put on the management of their balance sheets. Institutions like Bank of America, Commerzbank, or Lloyds, whose solvency was a function of state support to a large degree, were allowed very little flexibility in altering their capital structure. Now, however, regulators have implicitly or explicitly given them and others the green light to take advantage of the opportunity debt markets are affording them.
Governments and regulators could potentially step in once again and offer help through capital injections, debt guarantees, or asset protection schemes. But many banks want to avoid state aid altogether this time around, and extinguishing outstanding debt cheaply is one benefit banks have in a worsening credit environment. There should be no surprise if this strategy takes hold even more strongly in the coming months.
Michael Shemi is a director at Christofferson, Robb & Co., a money management firm with offices in New York and London.