Thursday, December 18, 2008
Deutsche's strategic debt move may haunt banks
Deutsche's strategic debt move may haunt banks By Paul J Davies in London Published: December 18 2008 02:00 Last updated: December 18 2008 02:00 Deutsche Bank jolted bond and equity investors yesterday when it became the first big bank to say it would not repay €1bn ($1.4bn) of a particular kind of bond as expected in January. The move raised fears about Deutsche's capital strength and signalled a much higher likelihood that other banks would follow the example in not repaying so-called hybrid-capital bonds. This could be highly damaging to the market for hybrid-capital deals, which occupy a kind of grey area between debt and equity. They have been hugely important in squeezing extra funding into bank balance sheets - and in propping them up since the financial crisis exploded. More than $800bn of such bonds have been issued globally this decade, according to Dealogic, hitting a peak of $175bn in 2007. Most of the issuance has come from banks. Their importance in supporting bank balance sheets during the crisis is shown in the $137bn of deals in the past year. The bonds are typically repaid at the first opportunity after an initial period when redemptions are not allowed. If an issuer does not redeem then, they must pay a higher penalty coupon rate. Deutsche Bank decided it was more cost effective to pay this penalty rate than to replace the funding in current conditions, which have made financing more expensive. When banks decide not to redeem the bonds at the earliest opportunity, the market value of the instruments falls, hurting investors. Analysts and bankers said this would turn investors off buying these deals in the future - further harming banks' ability to raise new money at a time when many need it most. "Deutsche Bank is running the risk that this may be seen as more symptomatic of capital and funding pressures which the institution may be facing," said Roberto Henriques, credit analyst at JPMorgan. Another Frankfurt-based analyst added: "[This decision] is being seen more as an indicator that Deutsche's situation with its capital and losses could be worse than expected." Yesterday, the bank's shares were down 7 per cent to €26.04, while the bonds in question dropped by up to 10 per cent to be worth less than 90 per cent of their original value, according to traders. The €1bn bond, which is part of Deutsche's tier two capital, an important, but not core, element of its balance sheet, has its first call date in midJanuary. Hybrid bank debt was always about a nod and a wink - regulators and agencies saw it as capital, investors saw it as debt. But in the coming year a lot of those implicit understandings are going to be broken. They were sold as so-called tier one and tier two bank capital that, along with equity, is meant to support bank funding and absorb losses. But the market was always underpinned by the assumption among investors that they would be repaid at the earliest opportunity and so they were priced more like debt than capital. Now many think the entire market might have no future. Gerry Rawcliffe, group credit officer for banks at Fitch Ratings, sums up the problem. "On the one hand, banks need to repay these deals at their call dates to keep investors happy and to keep the market open, but on the other hand if they are all called during the worst banking crisis in living memory then they are arguably not capital and they should not be treated as such by regulators." More than €33bn worth of such bonds are due to be called in Europe alone over the next 12 months, according to analysts at JPMorgan, including about €2bn from Deutsche Bank. There is widespread suspicion that the reasons given by Deutsche for its decision might only be half the story. Not repaying the bond means that Deutsche must pay a higher penalty coupon. In this case that increase, or step-up, amounts to only about 16 basis points to a total of a little over 4 per cent on current interbank rates. Deutsche said in a regulatory announcement that this was cheaper than would be the coupon on a new deal. But many say this is not the point. The decision is likely to be economically beneficial only in the short-term, analysts say, as it is likely to make similar instruments and other senior debt more expensive in future. "Until recently it was widely assumed that major banks would call these bonds to maintain future access to the market, even if it didn't work economically," said Hans Peter Lorenzen at Citigroup.