A Request For Proposals (RFP) went out yesterday (Thursday) for a $200 million deal that if successful will mark the world's first hybrid tier 1 issue by a non-investment grade rated credit. KEB is just one of many Korean banks contemplating tier 1 issues. Hana, for example, is already said to be tied up with Morgan Stanley and Hanvit, Kookmin and Koram are also said to be keen to follow.
But a deal from KEB faces a number of challenges not least of which is a lack of domestic regulations. A number of banks including Hanvit and Koram have previously examined the feasibility of hybrids, but until a couple of months ago, the FSS (Financial Supervisory Service) remained firmly opposed to the idea. In the wake of the financial crisis, the government's initial focus was on re-building the overall ratio and applied a 10% standard, although minimum requirements still officially permitted the BIS 8% standard.
Now, however, the government is slowly moving towards more prudential international standards and debating whether to cede more flexibility to banks' capital bases and increase the tier 1 capital threshold from 4% to 5.5% or above. Korean banks still fall well below the regional average in terms of core capital to overall capital and ideally, specialists say the government would like banks to boost core capital from 60% to 80% of the total.
At a time of decelerating asset growth, hybrids will allow banks to de-leverage their balance sheets and should encourage further industry consolidation, since the structure enables banks to replenish core capital after goodwill write-offs and share buy backs, which will in turn bolster ROE.
Specialists say that regulatory guidelines are about a month off, although some believe the FSS may not come up with formal guidelines until the end of the year. However, Korea is expected to follow Singapore's lead, where DBS became the first Asian bank to launch a non-cumulative tier 1 perpetual in spring 2001. The city state allowed hybrids to comprise up to 15% of capital and permitted perpetual step up structures with punitive call options, typically after 10 years.
Hybrids look like debt but are treated like equity for accounting purposes and appeal to fixed income investors because they typically offer higher yields without sacrificing credit quality. To qualify as tier 1, issues have to rank below all subordinated and senior debt issues and demonstrate a degree of permanence, hence the perpetual structures. However, since bond investors need the appearance of maturity in order to hold the securities, most deals have punitive step up coupons to ensure they are called at a given date.
But what principally distinguishes tier 1 from upper tier 2 is the fact that the ability to absorb losses is not optional and interest deferral has to be non-cumulative. With an upper tier 2 issue, an issuer can miss a coupon payment under certain triggers, but has to reimburse investors at a later date. With a hybrid, investors are never reimbursed.
KEB
An RFP is believed to have been sent to about four or five banks, although specialists say Credit Suisse First Boston is the clear front runner since it has previously lead managed KEB's only subordinated debt issue and its debut cross border securitization backed by credit card receivables.
Submissions are due in on Monday, but bankers remain divided whether the idea is feasible.
At issue is the fact that because KEB has been trying to re-build its retained earnings, it has not been paying a dividend and non-payment of a dividend is usually the chief trigger for suspension of interest payments on hybrids and upper tier 2 issues. Some bankers argue this means that investors will have to take a huge leap of faith if they buy a prospective KEB hybrid, since the Korean regulators are unlikely to allow dividend suspension clauses.
A second issue concerns KEB's weak capital ratios and the fact that nearly 40% of the bank's tier 1 capital is in the form of preferred rather than common shares.
At the end of 2001, the bank reported an overall CAR of 10.96% of which tier 1 accounted for 5.48%. By June this year, the ratio had fallen to 9.29%, with tier 1 accounting for 4.65%. KEB first announced its intention to raise common equity to bolster tier 1, but gave up on the idea after its stock price slipped below its par value of Won5000 per share. At yesterday's close, it was trading at Won3650. A $200 million issue will boost tier 1 capital by about 0.5%.
Bankers say that KEB has few options if it wants to bolster core capital, but a number question how cost efficient a hybrid will be and more importantly whether investors will buy it given the low rating.
KEB currently has a senior debt rating of Baa2/BB. Moody's rates subordinated debt one notch lower than senior debt and hybrids one notch below that, equating to a Ba1 rating. Key will be Standard & Poor's, which usually rates upper tier 2 debt two notches below senior debt and sometimes rates hybrids one notch lower again and sometimes flat. This means that KEB could either have a B+ or B rating from the US agency.
KEB's outstanding 13.75% upper tier 2 deal due June 2005 was trading at 324bp over Treasuries yesterday to yield 4.92%. Hybrids normally trade about 50bp to 100bp wider than upper tier 2 and some specialists believe that KEB could secure pricing close to these levels.
As one says, "There will be strong domestic demand for this kind of deal and particularly since there are a lot of Won redemptions coming up from the sub debt sector. Investors are looking for instruments that give them yield pick up and they feel comfortable with KEB's credit."
On the plus side, many were sceptical when Hanvit first laid plans for its subordinated debt issues of spring 2000 and yet investors have done extremely well out of all the Korean dollar denominated sub debt issues that followed. Having been forced to pay 13.75% for its deal in 2000, the huge contraction in interest rates since then means that KEB will be able to take advantage of favourable market conditions and benefit from first mover advantage.
KEB has historically traded 50bp to 70bp wide of both the Cho Hung and Hanvit, yet analysts believe the differential should be disappearing. Like most Korean banks, KEB is benefiting from positive ratings momentum and was upgraded by Standard & Poor's at the end of September.
At the same time, JPMorgan made the bank one of its top picks. "We see the gap in relative credit quality narrowing between Woori and in particular Cho Hung as KEB makes progress on addressing balance sheet challenges," it said.
One of the chief credit drags has been the bank's exposure to Hynix, which has always been classified as pre-cautionary rather than an NPL and never been fully provisioned.
But as the JPMorgan report concludes, "While KEB's net exposure to Hynix remains sizeable relative to equity (19% at 1H02), the Hynix risk factor should diminish as KEB plans to fully provision all unsecured loans in 2H02 (coverage was 80% in 1H02). Our industrial analyst's view on Hynix is that with provisioning levels in excess of 70%, domestic banks should see recoveries on their Hynix exposures within the next two to three years."
HANA
FIG specialists agree that a prospective $200 million hybrid from Hana will be more readily welcomed by the market and may possibly be more urgently needed if the bank ends up having to buy out its own minorities as well as government-held shares in the merger Hana/Seoulbank entity.
At the end of September Hana, which was being advised by Morgan Stanley, beat Lone Star in a bidding contest to take over Seoulbank. It entered into a share swap agreement with the Korea Deposit Insurance Corp (KDIC), guaranteeing payment of Won1.15 trillion ($937 million) at a price of Won18,900 per share. This will leave the government with a 30.9% stake in the merged entity, which will in turn become Korea's third largest in terms of assets, displacing the Shinhan group.
At the same time, Hana agreed to purchase a further 60% of the government's remaining stake (18.54% of the bank) over an 18 month period following the merger at a price of Won18,831 per share. At yesterday's close, Hana was trading at Won15,200.
The buy-back can take the form of Treasury shares, which will then be cancelled, a third party trade sale, or ADR/GDR format.
However, should the bank's shares fall to such a level that its CAR would also drop below a certain trigger point in paying for the shares, the bank has the option to complete the purchase through a capital neutral tier 1 security such as preferred shares. If this is rejected by the government, then the bank's obligations are waived.
Most analysts agree that raising hybrid tier 1 capital to fund the buy-back and remove potential share overhang concerns will be positive for the bank's share price. Hana also has a Baa2 senior rating from Moody's, placing a potential hybrid only one notch below investment grade. It has no rating from Standard & Poor's.
But its capital ratios may be severely impacted in the interim period because of appraisal rights in the merger agreement, which allow Hana's minority shareholders to sell shares back to the bank if they oppose the merger agreement. The selling price has been set at Won17,252 and the exercise period runs for 10-days starting November 15.
Prior to the merger, Hana had a freefloat of 43.2% and 136.4 million shares outstanding. Should all the minorities oppose the move, this means the bank could end up having to pay up Won1.016 trillion ($822 million), wiping out all its Won854 billion of retained earnings and putting pressure on its ratios, particularly tier 1.
Pre-merger, Hana had an overall CAR of 10.11% of which tier 1 accounted for 6.38% and tier 2 3.78%. Seoulbank, by contrast had a CAR of 10.4%, but will lose half its capital as a result of the merger. Post merger and post funding requirements, the bank has said that it is aiming to maintain its CAR around the 10% level.
In terms of credit quality, analysts view the purchase very favourably. As CSFB credit analyst Jae Ahn says, "Seoulbank was cleaned up by the government and its asset quality isn't that bad. Most of its NPL's were sold off to Kamco and it has no exposure to Hynix. It also has a fairly balanced lending portfolio between corporates, consumers and SME's."
