By guest contributor Christopher Joye from Smarter Money Investments
High profile hedge fund manager Sir Michael Hintze reportedly thinks bank “hybrids” are cheap, a position this column has held for almost a year and acted on in June (we bought hybrids following a new tax ruling).
This begs the question: how should one value these complex securities on an outright basis and relative to bonds further up the capital structure? Hintze says he “senses value” in the additional tier one (AT1) bank capital space on the basis regulators will not trigger their “non-viability” clauses that forcibly convert them into ordinary shares (or write them off).
“In the [AT1] market it is very difficult for [regulators] to exercise that option without truly making huge waves in the rest of the market,” the former Australian Army captain-cum-billionaire said.
We’ve repeatedly canvassed similar assessments: declaring a bank is “non-viable” and unilaterally swapping hybrids into equity could potentially blow-up that institution and the broader banking system. Indeed, these public bail-in rights have embedded a new and unpredictable form of regulatory risk into the banks’ cost of capital with no clear rules on when they will and will not be used.
Hintze cites the Bank of Portugal’s decision to randomly bail-in five senior creditors to a “good bank”, Novo Banco, to slash its liabilities by suddenly making these bond holders lenders to a worthless “bad bank” in late December 2015.
As we explained in January, this was the butterfly effect that propagated the enormous blow-out in global bank credit spreads in February 2016 because of fears German officials could behave in a comparably capricious manner when dealing with Deutsche Bank’s AT1 securities.
Portugal’s central bank subjectively selected five senior bonds for bail-in, and adversely discriminated against them vis-à-vis other equal-ranking securities. This was exacerbated by the government’s decision not to compensate investors for the fair market value of the bonds as is accepted best practice (they were left with virtually nothing).
To figure out whether hybrids are cheap or expensive we need to value them using a bottom-up, fundamentals-based approach. My quantitative researchers use an advanced version of the “classic Merton” model the RBA recently adopted to monitor real-time credit risk to estimate fair value returns, or “credit spreads”, above the cash rate on any debt security based on their issuers’ financial data.