In a new bid to shore up its capital adequacy ratios (CAR) and meet the Financial Supervisory Commission's (FSC) 10% standard, Hanvit Bank is examining the feasibility of raising about $1.5 billion in new capital securities before the end of the year.
Deputy general manager Park Dong Young says that the bank is currently reviewing how marketable a hybrid equity issue, known as non-cumulative tier 1 perpetual capital securities, would be. "At this stage we are reviewing possible structures," he comments. "If we do issue tier 1 equity, we will then review an increase to our tier 2 capital before the end of December as well."
As of March 2000, the bank had a CAR of 9.44%, but now needs to raise significantly more capital than initially foreseen because of stricter NPL (non-performing loans) standards that require a further Won777 billion ($690 million) to be set aside. Previously, the bank raised $850 million in February from a combined upper and lower tier 2 subordinated debt issue led by JP Morgan.
However, with tier 2 capital now standing at approximately 96% of tier 1 capital, the bank is constrained from raising more subordinated debt until it has improved its tier 1 ratios further. Under Bank of International Settlement (BIS) regulations, tier 2 capital cannot exceed tier 1 capital.
Tier 1 capital, which ranks subordinate to all other creditors and bond holders in a bank's capital structure and event of liquidation, can be composed of common equity, preferred equity and hybrid securities which have both debt and equity characteristics. But since hybrid capital is deemed to be lower quality capital than common equity, the BIS only allow preference shares to represent up to 25% of a bank's total equity and hybrid capital 10%.
Goldman, JP and Lehman bid for mandate
Three banks, comprising Goldman Sachs, JP Morgan and Lehman Bros, have been the most aggressive in pitching the idea to Hanvit and formulating new regulations with the FSC. Of the three, JP Morgan is regarded as having a slight edge given its success with the bank's last issue and experience drafting domestic guidelines with the regulator for tier 2 capital issues.
By contrast, Goldman, which does not have a close relationship with the bank, is widely regarded as the global leader in the field. Lehman, on the other hand, is seen as the dark horse.
The bank just missed out on the mandate for Hanvit's last deal and some officials are said to believe that it is owed a fee-generating transaction after being forced to sit on loss-making positions from the $1 billion GDR it led for the Korean bank in August 1999.
Since hybrids were first regulated by the US Federal Reserve in 1996 and by Basel two years later, they have become increasingly popular instruments by investment grade credits in both Europe and the US. Typically, they are viewed by issuers as a more tax-efficient form of equity and by investors as a means of gaining higher yield without sacrificing credit quality.
How investors will, therefore, react to a borrower issuing out of desperation and likely to only just avoid a triple-C rating should the deal go ahead, remains to be seen. Observers are by no means sure that a market for such a deal actually exists and indeed, whether pricing will be too unpalatable for Hanvit to bear.
Seoul-based bankers also report that the Korean government is considering making fresh equity injections into Hanvit, Cho Hung and Korea Exchange Bank (KEB), a course which would prove far more cost efficient given that it holds large stakes in each. Yet since government policy towards the banking system appears to shift on an almost daily basis, this outcome is by no means certain.
Having previously floated the idea of merging Hanvit, Cho Hung and either KEB or Seoulbank into one jumbo government-owned bad bank, for example, the government now seems to have backed off and become more intent on withdrawing from the financial services industry completely. On Friday it said that it hoped to sell down its stakes in Hanvit, Cho Hung and KEB over the next two years.
For Hanvit to get a hybrid issue to work, bankers agree that a deal would need to be structured to give as much comfort to investors as possible. Top of the list would be some kind of mechanism to protect coupon payments.
Non-cumulative
In essence, hybrid securities provide a tax deductible form of capital raising that is priced and traded like debt, but treated from a credit standpoint as equity. To qualify as tier 1 capital, instruments have to be non-cumulative, able to absorb losses on an on-going basis, remain permanently on the books and rank junior to subordinated and senior creditors.
What principally distinguishes tier 1 capital from tier 2 capital is the fact that the ability to absorb losses is not optional and interest deferral has to be non-cumulative. Upper tier 2 debt also has interest deferral language, but the interest still has to be paid at some point, whereas investors are never re-imbursed for missed interest payments on tier 1 instruments.
Coupon payments are generally deferred when a bank has not paid dividends on ordinary shares. One of the main considerations is, therefore, whether there are sufficient profits for distribution to investors.
The rating agencies also state that in determining their ratings of hybrid securities, the latter's ranking in the event of liquidation is of secondary consideration compared to probability of repayment.
To protect payments and ensure a higher rating, some bankers believe that Hanvit is likely to structure a deal around an SPV incorporating quality assets that will enable a higher rating than the bank's stand-alone credit rating. Currently, Hanvit has a counterparty credit rating of BB-/Ba2 while it's lower tier 2 debt is rated two notches lower at B/B1 and its upper tier 2 debt up to three notches lower at B-/B1.
An SPV structure is the favoured means of issuing bank capital issues in the US. Generally, a trust will issue tier 1 securities to third party investors and on-lend the proceeds to the holding company (in this case Hanvit), which in turn issues subordinated debt to the trust with terms exactly mirroring the tier 1 issue. For the holding company, interest on the subordinated debt is considered a tax deductible expense, but the trust itself is not taxed because its earnings are passed through to investors.
Perpetual
One other complicating feature demanded by the regulators is that hybrid instruments demonstrate a degree of permanence in order to quality as equity and therefore tend to be perpetual in nature. However, since bond investors need the appearance of maturity in order to hold the securities in their fixed income portfolios, most deals have punitive step-up coupons which ensure that deals are called by the issuer in question.
In some circumstances, instruments can incorporate a first call option after five years, although 10 years is the norm. BIS regulations also state that the step-up coupon can be no greater than 50% of the initial credit spread.
And as one banker put its, "The perpetual and non-cumulative nature of hybrid issues shouldn't be downplayed and will weigh heavily on investors' minds. There is a very significant difference and level of risk between upper tier 2 and tier 1 even if they appear quite similar on the surface.
"Tier 1 is designed so that it can absorb losses and how the bank and its regulator reacts should it get into financial trouble is a critical factor."
Spread differentials between tier 1 and tier 2 capital
One consequence of this is that hybrid instruments are priced and traded at much higher spreads than subordinated debt. Most of the mainly A-rated banks that have previously issued tier 1 capital instruments have priced them at about 100bp wider than upper tier 2 debt.
Where Hanvit is concerned, however, bankers argue that a spread differential of at least 200bp will be needed. Given that its outstanding 12.75% issue due 2010 and callable in 2005, is trading at bid/offer spreads of 662bp/638bp, this would imply pricing around the 850bp level over Treasuries - a coupon just shy of 15%.
Other banks have in the past been able to bring pricing down by incorporating an equity kicker that allows for conversion into common or preferred equity. In Hanvit's case, however, this is not going to be possible since its shares are trading below par value and it cannot legally issue new equity.
That the bank is prepared to even consider these kinds of pricing levels is nothing short of astounding, particularly in the light of the fact that even at the height of the Republic's liquidity crisis, the whole banking sector refused to pay more than 225bp over Libor to get one year loans rolled over under a $24 billion exchange programme.
For bankers, the ever rising price hurdles over which this type of deal are getting done, has been a surprise too. Back in February, few were sure that a bank as lowly-rated as Hanvit would be able to raise subordinated debt in such size.
In late June, they were surprised again that KEB was able to get away with a $200 million upper tier 2 debt issue and prepared to pay 13.75% or 765bp over Treasuries for what is effectively five year funds.
For investors, the impact of the Asian and Russian crises of 1998 on the US perpetual step-up securities market, also remains a fresh and unpleasant memory. The whole sector collapsed in the autumn of 1998 and many of step-up structures became step-downs.
Hardest hit were the lowest rated banks that had tapped the market, principally the Japanese. Fuji Bank's $1.6 billion line had, for example, been priced at 412.5bp over Treasuries in March 1998, but by October was trading as wide as 2,140bp to its 10 year call.
Bankers also wonder what impact news of more tier 1 and tier 2 capital will have on the existing trading spreads of Asia's growing sub debt sector. Most conclude that such a heavy level of potential new supply from one bank can only have one effect and that will be to widen spreads further.
