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Sunday, 20 April 2014

Mutually assured destruction

Bondholder pain eases Co-op’s political problem

Co-op Bank has unveiled its capital hole, and it’s massive. The UK lender, controlled by the British Co-operative mutual organisation, needs 1.5 billion pounds to recapitalise itself: almost as much equity as it reported having in the 2012 annual accounts. But the Co-op may have solved the knotty political problems that come with a hole of this magnitude.

The plan is to raise three roughly equal chunks of equity. Around 500 million pounds will come from selling the bank’s insurance operations. The bank’s mutual parent will also raise debt which it will use to buy new shares in the bank. And a “bail-in” of the 1.3 billion pounds of subordinated debt will turn a similar amount of debt into equity. In total, that comes to enough equity to give Co-op a shiny 9 percent-plus core Tier 1 ratio.

The last part is the clever bit. Under normal circumstances, the bondholders would end up with 1 billion pounds’ worth of the bank’s equity, enough to give them a majority stake. Instead, they will swap some of their bank debt for new bonds issued by the parent group.

That arrangement can be presented as a co-operative kind of burden sharing, and some bondholders might prefer parent-group debt to the bank’s equity. But the bottom line looks like a hefty haircut on the value of their bonds: perhaps 20 to 30 percent, although the details haven’t been sorted out. That looks strange when the mutual group, who as equity holders are legally lower down the capital structure, retain control. They do that without raising more equity by, for example, selling the pharmacy or funeral businesses.

The outcome is cushy for the UK mutual movement. It’s also politically convenient. Somewhat ironically, the UK’s ruling coalition supports mutual banking and the opposition Labour party has traditional ties, both cultural and financial, to the movement.

Bondholders, a group that includes 7,000 retail investors, could balk. But Co-op and its political supporters are not merely counting on the spirit of mutuality to prevail. They have included some threats, including skipping coupon payments for any bonds left behind, to encourage a co-operative attitude.

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The Co-operative Group announced on June 17 a plan to cover a 1.5 billion pound capital shortfall at its bank over the next 18 months.

The capital raising will see bondholders in the Co-operative Bank take a haircut on their investments and receive a combination of equity in the bank and bonds in the parent group in exchange.

The parent group will retain majority control of the bank by using the proceeds from the bonds issued to itself buy shares in the bank. This “bail-in” of the bondholders will contribute 1 billion pounds of the total, with the remainder due to be raised through asset sales next year.

The Co-op said that the injection of equity this year would give the bank a pro-forma common equity Tier 1 ratio of more than 9 percent and a leverage ratio of above 3 percent by the end of 2013.

The Co-op’s new shares issued as a result of the capital raising will be listed on the London Stock Exchange.

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