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Hohni soit qui mal y pense

19 June 2012 By George Hay

Hedge fund managers are not known for their altruism. So when Chris Hohn offers free advice to the UK regulator about Lloyds Banking Group, there’s a fair chance the activist investor is talking his own book. But that doesn’t mean he’s wrong.

Hohn’s letter to the Financial Services Authority concerns Lloyds’ 10 billion pounds of so-called “Enhanced Capital Notes”, created during its mega capital raise in 2009. These ECNs are contingent capital: if Lloyds’ core Tier 1 capital ratio falls below 5 percent, they convert into equity. Hohn thinks this trigger is too low, and wants to turn the ECNs into ordinary shares.

This seems self-defeating for both the hedge fund manager and the government. The investor hasn’t spelled out his position, but he appears to own ECNs paying a 12 percent interest rate to maturity which would be exchanged for ordinary shares that currently pay no dividend. Meanwhile, the government’s 40 percent stake in Lloyds would be significantly diluted.

But factor in the euro zone crisis, and things look different. If the single currency breaks up, banks whose capital looks strong on a Basel III basis will command more confidence. Hohn says that Lloyds’ Basel III core Tier 1 ratio is 7 percent, which is not terrible. But 10 billion pounds of additional loss-absorbing capital would certainly help. And if the government was forced to bail out Lloyds again without converting the ECNs, the coupons would be at risk.

The FSA hasn’t yet given chapter and verse on how contingent convertibles (CoCos) will count towards capital. But ECNs, which have a fixed maturity and no ability to waive coupons, don’t look like they will meet the Basel III criteria. The FSA is already trying to restructure similar contingent capital held by Royal Bank of Scotland so that it converts into shares at a higher capital ratio.

It’s also important to bear in mind Hohn’s self-interest. Turning the ECNs into CoCos with a higher trigger would require Lloyds to offer holders an even more attractive coupon. And in order to persuade ECN investors to swap their notes into shares, Lloyds would have to offer a sufficiently attractive premium. But if the euro zone gets even worse, even a market solution that dilutes the state would be better than the taxpayer funding yet another capital hike.


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