AIB Debt Buyback

I’ve been looking into the AIB debt buyback program, details of which were announced on Monday (Irish Times story here.)  Why in God’s name would I be doing that during a rare sunny week in this country? Well, between the state guarantee and NAMA, pretty much everything the banks do these days has implications for the taxpayer, so it’s worth taking a look at.  That and the fact that I’m a nerd. Wonky corporate financey post below the fold.

On the face of it, the announcement looks like good news.  AIB get to replace €2.4 billion of one type of debt with €1.3 billion of a different kind of debt.  (Full gory details here.) This reduces AIB’s liabilities by €1.1 billion and boosts the core (shareholder) equity capital of the banks.  To the extent that this gives the shareholders a greater cushion it’s good news for them.  From the point of view of radical nationalisation advocates like me and, um, the IMF, it also means more equity capital can be used to absorb losses before the call on making up the rest of the capital shortfall moves onto the State.

However, when you dig a bit deeper, there is less to be enthusiastic about:

  1. The new bonds are “10 year bullet dated subordinated Lower Tier 2” – the key is that they are dated, so now they count under the guarantee (See page 5).  So while technically, the loss-sharing burden on the state is reduced by the €1.1 billion profit that AIB booked, the contingent liability for the state is increased by the €1.3 billion that gets added to the list of guaranteed debt. And if you believe that the losses are such that they should wipe out the equity of the banks, then the extra €1.1 billion will still get wiped out and the state will have lost any opportunity to clean out non-guaranteed subdebt holders.  So this could cost the state more in the long run, provided we extend the guarantee in its present form, as it appears the government wants to do.
  2. The holders of the old bonds received 50 to 67 percent of face value of those bonds.  But the bonds were trading at 10 cents in February (click here for chart) so presumably the whole exercise would have saved a lot more money then. The NAMA announcements then increased confidence that overpayment would mean that the core equity capital wouldn’t get wiped out  (with these undated subdebt bonds being next in line.)  The announcements of debt buyback programs by the two banks also increased the price – as with when you mount a takeover bid for a publicly listed firm where you need to offer a premium relative to current prices, the banks needed to make the deal attractive to get large amounts of bondholders to be willing to crystallize the losses taken here.  The debt was trading in the 40-50 range prior to the purchase program.
  3. It’s been reported that the coupon rate on the new debt was 12.5% which will eat into future profits (or more likely make future losses even bigger.)

So, all told, this looks like a really good deal for the unguaranteed subdebt bondholders.  A few months ago they were facing total wipeout. Today, they’ve taken losses of between 33 and 50 percent but they’ve obtained a bond with a far higher coupon payment and, perhaps more importantly, they’ve now most likely got themselves insured by the Irish taxpayer.

From the point of view of AIB management, however, this debt buyback is the main step that they could take to boost their core equity capital by €1.5 billion as ordered by the Minister for Finance. So it might not really be that great a deal for AIB shareholders or for the taxpayer, but it lets AIB management live to fight another day.  (The rest of the money might be made up by the great American\Polish bank Goodwill boondoggle.)

So what’s the future for the bank subdebt holders? Here’s one potential plan for dealing with these guys: Make it clear that NAMA is going to pay fair price, so shareholders are wiped out (or given some small compensation).  Also announce that, despite this week’s legislation to make it possible to extend the existing guarantee, that any future extension won’t include subordinated debt.  Then offer subordinated debt holders a debt-for-equity swap.  This wouldn’t cost the state anything and it would provide some amount of private equity ownership that could keep the banks listed even if they’re 80-90 percent state-owned.

One interesting wrinkle to all this relates to everybody’s favourite financial instrument, Credit Default Swaps. It is possible that some of the bondholders who didn’t take the offer up may have hedged with CDS and are waiting for something like a delayed coupon payment which might be judged a credit event, which would then allow them to recover par value. This stuff is decided on by a body called the International Swaps and Derivatives Association (see here for examples of the decisions they have to make – they have, for instance, “deferred” a decision on Bradford and Bingley’s bonds, which I wrote about here.)

If it were the case that most of outstanding subordinated debt holders were holding CDS insurance, and a debt-for-equity swap offer was viewed as a credit event, then the government could end up negotiating the swap with the mysterious CDS issuers (to whom the bonds would then pass.) Ok, that’s enough speculation for now.

13 thoughts on “AIB Debt Buyback”

  1. How would you rate the deal the government got for our €3.5bn capital injection vs these bondholders?

    I have some magic beans, I wonder if Mr Lenihan would be interested. Imagine those green shoots, Brian, make me an offer.

  2. If the Bonds were issued in January 2007 before the financial collapse does the coupon of 12.5% not seem very high for what would have been regarded back then as AAA debt.?
    Or are you referring to the current yield after they were traded and bought back by AIB?
    If these bonds are now yielding 12.5% surely this will be posted on the asset side if AIB’s balance sheet.

    However it does show another ugly side to this guarantee with the addition of this buyback debt on the taxpayers back.

    I cant help feeling there are other forces operating here.
    Remember last september when the son of then chief of Irish nationwide,Mr. Fingleton sent e mails round London brokers hawking business because the banks now had a State guarantee.

    Recently,too ,Citibank was involved in large buybacks of its bonds at very low prices and was able to book a profit on the strength of it while the American taxpayer was guaranteeing its debt.

    The following is an extract from April 9th of Charting Stocks which explains:

    ………”It was only a month ago when Citigroup CEO Vikram Pandit assured the public that his troubled bank was “Profitable” for the first 2 months of 2009. The news sparked an immediate rally which lifted the oversold stock market from its March lows. We, at Charting Stocks, did not share in the new found optimism (See: Fool Me Twice: Citigroup CEO Shouldn’t be Trusted) because we’ve heard these assurances before from Mr. Pandit (Which proved to be false). It came as no surprise when Citigroup announced an $0.18/share loss (about $10 billion) yesterday. Keep that in mind for the next time Vikram tells you things are going swell.

    Sure, the media has touted the results as positive and even echoed the company’s talking points in which the claim that the bank was actually profitable for the quarter if you exclude the payments made on preffered shares. Is that accurate? Well, yes it is but it excludes a very important fact which was not advertised in the banks press release – More than half of Citi’s reported fixed income revenue came from a $2.5 billion write-UP, thanks to an accounting rule tied to credit default swap positions on Citis own debt.

    Morgan Housel in a recent Motley Fool article explains “The rule exploits the notion that a company could buy back its own besieged bonds on the cheap, leading — however bewilderingly — to profit.

    In other words, Citigroup was able to book a massive profit because investors are betting that’s it’s still on a road to bankruptcy. ”

  3. Seen as we’re onto speculation, here’s an interesting possible future scenario.

    Section 10.4 of the legislation says it will cover “Asset covered securities”.

    Also known as covered bonds. The same thing that the ECB are spending billions buying at the moment. It is a badly kept secret that the banks are buying government debt and refinancing their purchases through the ECB.

    So, we are now in the situation where the government are potentially guaranteeing their own debt. If (and remember. I said this is merely speculation) a bank was to default on one of these covered bonds (whether to the ECB or some other investor) the government would then have to pick up the tab for the bond, while at the same time having to pay the underlying debt…

    Speculation out of the way, if your figures are correct Karl, AIB will be paying €325m in coupons on the new debt annually for the next ten years. This will certainly make it more difficult for the bank to grow its core tier 1 through ‘retained profits’.

    This story is a long way from over yet.

  4. @ LorcanRK
    Thank you!

    @ Sean O’
    It is less of a secret now for sure! It is worth repeating as otherwise people may cling to false hopes that the banks are solvent. Their lives are slipping away when they could be elsewhere starting again. The last desperate acts of those engaged in offloading worthless stocks onto pension funds require that the hope be kept alive for a few more months. Most cannot escape. But some still can, albeit at a loss. By staying they are being bled dry.

  5. @ Karl

    Thanks for confirming what I intuitively saw as a bad deal from my French campsite.

    The driving force behind the deal is a desire by existing AIB management to retain their jobs. As you point out, the way they have booked this increase in equity for AIB bank is by beggaring us as taxpayers.

    I would love to know what proportion of our major two stockbrokers incomes come from commission on marketing bonds to investors. They are remarkably good at putting the wind up Minister Lenihan and defending professional bondholders interests.

    These self same gentlemen were not so considerate of their less sophisticated clients when the regulators forced them to buy back perpetual bonds which they had sold to credit unions.

  6. its ironic that nama is about mark to marking bank assets but when banks not simply m2m their liabilities but realise the profits we intuitively cry foul – rational analysis or prejudice.

    As far as I am aware subordinated debt is not covered by the government guarantee and certainly no issue beyond sept 2010 (which excludes the current aib issue) is covered by the guarantee. that why the coupon is 12.5% and not 120bps above the risk free rate which is the rate on issues covered by govt.

    it appears kw’s analysis is incorrect. the bank’s have raised additional capital to negate the state’s option to purchase an additional 25% in bank capital for a couple of cents. In aib’s case the three most senior managers have announced their retirements and the management team in the irish business has been completely changed. Kw’s assertions are incorrect its not about retaining managements position/jobs.

  7. @Jim O’Leary (NUIM Jim, FG Jim, or some other Jim?)

    A couple of points.

    1. I don’t have any problem with the banks doing a debt exchange of this sort. I am just pointing out that it has some implications that I didn’t see reported elsewhere.

    2. Dated subordinated debt is covered by the current guarantee. Look at page 5

    The government can choose to extend the guarantee to cover a smaller class of assets. However, the recent bill that passed the Dail allows the guarantee in its current form to be extended. It does not mean they have to do so and I think they should not.

    3. I am aware that Sheehy and some others are going but there are other people in AIB management who have a very strong incentive to come up with the €1.5 billion in core equity capital requested by the Minister. Strong enough incentive that perhaps the swap isn’t really such a great deal and also has some risks to the taxpayer.

  8. @ Karl
    so we agree a) core capital is increased; b) the new debt is not covered by govt guarantee.

    we do not agree on risk to tax payer which to my simple mind is not evident. ironically the bank is behaving as explicitly incentivised by the govt!

  9. Jim, as I’ve written above, the new debt is dated not perpetual, so it is covered by the guarantee. So I can’t agree with (b) because it’s false.

    The guarantee was going to expire in September 2010 but now the Minister can, if he chooses, extend the guarantee in its current form if he feels like it.

  10. @Jim O’Leary, you seem fond of spotting irony, so can I suggest that the true irony here is that the only reason AIB could engage in this exercise to increase their core capital is that their capital position had become so precarious?

    If their position had been sound they would not have been able to buy their bonds at such a discount. They can only celebrate the strengthening of their capital position because it had become so weak.

  11. @KW
    My apologies you are correct and I was incorrect. the new issue should be guaranteed till sep 2010 – although that will need to be confirmed in next issue of OI to ensure it AIB has complied with sections 36 to 43 of the SI. Section 37 deals explicitly with the actions of institutions to reduce taxpayer exposure.

    there is no celebration for shareholders or taxpayers. the irony is in the reaction of those who confuse economic commentary with conspiracy theorising! m2m assets per nama good, m2m liabilities through buy back crony capitalism.

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