Convertible Preferreds? In Canada?

Another hot tip from Assiduous Reader tobyone leads to more musings from Barry Critchley of the Financial Post:Flurry of Share Offerings:

And it seems OSFI is interested in other types of securities that would constitute Tier 1 capital. In yesterday’s column we mused the market was speculating that soft retractable pref shares — which used to count as Tier 1 capital before OSFI ruled to make them Tier 2 capital — would be on the list. The chance of such a return is low if issuers are talking about the former type of soft retractables. (OSFI ruled against them in part because of the potentially huge increase in common shares outstanding, in the rare event that the issuer opted to pay in stock and not cash.) However, if they come with new bells and whistles, then OSFI may be interested — but only after the security has undergone the normal review process. “Part of OSFI’s mandate is to see what they come up with and figure out if it works or not,” said the OSFI spokesperson.

One type of pref share that may cut the mustard is convertible pref shares.

An OSFI spokesperson said it would be interested in such a security counting as Tier 1 capital “if it had the right kind of features for capital. Convertibles is something that’s been floated. It has been discussed,” added the spokesperson, noting that issues of mandatory convertible prefs, are part of Tier 1 capital in some countries.

What else could OSFI be looking at?

Underwriters report that issuers would like an increase in the percentage of Tier 1 capital allocated to innovative instruments. Currently 15% of Tier 1 capital can be in the form of such securities. But that percentage hasn’t changed — despite the recent 10-percentage-point increase, to 40%, in the share of preferred shares in Tier 1 capital. (At the start of the year, the percentage was 25%, meaning a 15-percentage-point increase for the year.)

“Investors are more interested in taking the 15% stake up to 25% because the innovative Tier 1 market is an institutional market,” said one market participant, noting that the change would allow larger issues, certainly larger than issues of rate reset preferred shares which are largely bought by retail investors.

Mandatory convertibles have certain advantages for all issuers:

A relatively large proportion of convertibles are currently issued as mandatory convertibles. A mandatory convertible is automatically converted into equity at a specific maturity date, thus removing the optionality for the buyer of the convertible. The transfer of risk to the buyer is usually compensated by a higher yield. Companies want to issue mandatory
convertibles in order to avoid their experiences of 1999 and 2000, when many telecoms companies issued convertibles in the expectation that they would be converted into equity at the time of redemption. In most cases the conversion did not take place due to the sharp decline in equity prices, leaving them with much higher than expected debt/equity ratios. Another attractive feature for the issuer of mandatory convertibles is that they are in general not treated by the rating agencies as pure debt. The biggest mandatory convertible issues in the
first quarter of 2003 were a €2.3 billion offering by Deutsche Telekom and one of ¥345 billion ($2.9 billion) by Sumitomo Mitsui Financial Group.

As far as BIS is concerned, banking implications of convertible preferreds are (largely?) limited to the United States

Cumulative preference shares, having these characteristics, would be eligible for inclusion in [Tier 2]. In addition, the following are examples of instruments that may be eligible for inclusion: long-term preferred shares in Canada, titres participatifs and titres subordonnés à durée indéterminée in France, Genusscheine in Germany, perpetual subordinated debt and preference shares in the United Kingdom and mandatory convertible debt instruments in the United States.

… but I note a recent issuance by UBS:

At UBS, the government package provided significant relief to the balance sheet from the burden of illiquid positions particularly affected by the crisis. With this package, the SNB made it possible for UBS to transfer illiquid positions to a special purpose vehicle. The UBS provided this special purpose vehicle with equity amounting to USD 6 billion. The Confederation compensated UBS for the capital requirement arising for this purpose by subscribing to mandatory convertible notes (MCN). Since the announcement of the package, the UBS liquidity situation has stabilised.

The recent issue by Morgan Stanley gives an important clue as to the value of Convertible Preferreds in times of stress:

Under the revised terms of the transaction, MUFG has acquired $7.8 billion of perpetual non-cumulative convertible preferred stock with a 10 percent dividend and a conversion price of $25.25 per share, and $1.2 billion of perpetual non-cumulative non-convertible preferred stock with a 10 percent dividend.

Half of the convertible preferred stock automatically converts after one year into common stock when Morgan Stanley’s stock trades above 150 percent of the conversion price for a certain period and the other half converts on the same basis after year two. The non-convertible preferred stock is callable after year three at 110 percent of the purchase price.

With other examples from Citigroup, we may conclude that Convertible Preferreds can be very useful in times when the common dividend is in doubt, or is otherwise thought to be insufficient for the risk of holding the common.

The Federal Reserve allows inclusion of convertible preferreds in Tier 1 in a manner analogous to the Canadian treatment of perpetuals:

The Board has also decided to exempt qualifying mandatory convertible preferred securities from the 15 percent tier 1 capital sub-limit applicable to internationally active BHCs. Accordingly, under the final rule, the aggregate amount of restricted core capital elements (excluding mandatory convertible preferred securities) that an internationally active BHC may include in tier 1 capital must not exceed the 15 percent limit applicable to such BHCs, whereas the aggregate amount of restricted core capital elements (including mandatory convertible preferred securities) that an internationally active BHC may include in tier 1 capital must not exceed the 25 percent limit applicable to all BHCs.

Qualifying mandatory convertible preferred securities generally consist of the joint issuance by a BHC to investors of trust preferred securities and a forward purchase contract, which the investors fully collateralize with the securities, that obligates the investors to purchase a fixed amount of the BHC’s common stock, generally in three years. Typically, prior to exercise of the purchase contract in three years, the trust preferred securities are remarketed by the initial investors to new investors and the cash proceeds are used to satisfy the initial investors’ obligation to buy the BHC’s common stock. The common stock replaces the initial trust preferred securities as a component of the BHC’s tier 1 capital, and the remarketed trust preferred securities are excluded from the BHC’s regulatory capital [footnote].

Allowing internationally active BHCs to include these instruments in tier 1 capital above the 15 percent sub-limit (but subject to the 25 percent sub-limit) is prudential and consistent with safety and soundness. These securities provide a source of capital that is generally superior to other restricted core capital elements because they are effectively replaced by common stock, the highest form of tier 1 capital, within a few years of issuance. The high quality of these instruments is indicated by the rating agencies’ assignment of greater equity strength to mandatory convertible trust preferred securities than to cumulative or noncumulative perpetual preferred stock, even though mandatory convertible preferred securities, unlike perpetual preferred securities, are not included in GAAP equity until the common stock is issued.

Nonetheless, organizations wishing to issue such instruments are cautioned to have their structure reviewed by the Federal Reserve prior to issuance to ensure that they do not contain features that detract from its high capital quality.

Footnote: The reasons for this exclusion include the fact that the terms of the remarketed securities frequently are changed to shorten the maturity of the securities and include more debt-like features in the securities, thereby no longer meeting the characteristics for capital instruments includable in regulatory capital.

Section 4060.3.9.1 of the Fed’s Bank Holding Company Supervision Manual extends this treatment to convertible preferreds that convert to perpetual non-cumulative preferreds.

I have no problem from a public policy perspective of allowing the inclusion of Convertible Preferreds into Tier 1 capital, provided they meet the basic requirements of subordination and the potential for having their income suspended on a non-cumulative basis without recourse for the holders.

If such are issued, however, they will almost certainly not be included in the HIMIPref™ database, as there is considerable potential for such issues to “sell off the stock”. In fact, I would consider such issues – in the absence of even more innovation – to be equivalent to common stock with a bonus dividend; not fixed income at all.

I have a much bigger problem with the second proposal in Mr. Critchley’s column – the expansion of the Innovative Tier 1 limit to 25% from its current 15%. I will not accept that further debasement of bank credit quality is justified by prior debasement; let’s see a little more analysis and stress-testing than that!

One Response to “Convertible Preferreds? In Canada?”

  1. [...] The potential for a significant market in this asset class in Canada was discussed when the market was just about at its bottom in December 2008 in the post Convertible Preferreds? In Canada?. [...]

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