Megabanks prove it pays to repay early

  • 04 Jan 2008
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Japanese banks have in recent years sold buckets of regulatory capital and featured in some landmark equity sales. But by late autumn 2006 the megabanks had repaid the government and now have more straightforward needs. But the ‘turnaround banks’ still owe huge sums to the state, and with depressed stock prices they are struggling to repay on time.

The three megabanks — Mitsubishi UFJ Financial Group, Mizuho Financial Group and Sumitomo Mitsui Financial Group — repaid the government in entirety in the autumn of fiscal 2006. Accordingly, any issuance in 2007 has been for normal maintenance of tier one capital ratios, not for funding.

That was certainly the case for the combined Eu500m and $1.65bn perpetual tier one capital issue by Sumitomo Mitsui Financial Group, then rated Baa2/BBB, in the middle of December last year. The deal raised the equivalent of ¥300bn.

In a report published on October 24, the Nikkei newspaper noted that the government injected public funds into 26 banks from 1998 to 2006. The three megabanks completed repayment last year. The Nikkei estimated that the government was still due about ¥3.5tr in repayments from 15 banks, having so far collected roughly ¥9tr of the total funds extended.

As SMFG had finished repaying the government last October, the December 2006 transaction was entirely about SMFG’s capital ratios and financial flexibility. SMFG wanted a hybrid issue in order to diversify its funding options and re-establish capital ratios diminished by the repayment programme.

SMFG deal signals end of era
While Mitsubishi UFJ Financial Group and Mizuho Financial Group had tapped dollars in the preceding months, the sterling market was at the time liquid and receptive, while the yen market was not sufficiently deep for a deal of that size. The sterling tranche was priced at 147bp over the 10 year Gilt, while the dollar portion, also a perpetual non-call 10 and with the same leads, was priced at 153bp over Treasuries. Both were led by Daiwa SMBC, Goldman Sachs, Merrill Lynch and Morgan Stanley.

"The SMFG deal concluded a remarkable 2006 for FIG issuance from Japan," says Gen Nakahara, managing director at Merrill Lynch Japan in Tokyo. "But it also signalled the end of what had been a period of sustained issuance by the megabanks across the globe as they sought to repay the government and to recapitalise themselves after the financial crisis."

In 2006, there had been numerous bank capital issues from Japan. MUFG had, for example, raised $4.2bn equivalent in a triple tranche tier one deal in dollars, euros and yen in March. Norinchukin raised Eu2bn equivalent in lower tier two format across euros and sterling in September. Mizuho had priced a Eu1bn euro and dollar tier one in March, while Resona Bank and Shinsei Bank both priced £400m upper tier two deals in August and November.

"During 2006, the global investor community passed all examinations the Japanese FIG sector had put in front of them," says Nakahara. "Looking to the future, the pace of [megabank] issuance will henceforth be determined by economic and asset expansion and on the speed at which the banks generate retained earnings, and by refinancing needs. But the issuance will not be driven by obligations to the state. In short, megabank deals will emerge in the normal line of business."

Normal business includes refinancing and all three megabanks have a large volume of subordinated debt issues coming up for refinancing in the next year or two. The deals in question date back to highly priced offshore sub debt issues for bank issuers whose names have become cloaked in the mists of time, such as Fuji Bank, Industrial Bank of Japan, Sumitomo Bank, Tokai Bank and others that have since been amalgamated inside the three megabanks.

The deals were sold mostly in 1998 and early 1999, before the March 1999 government bailout package. Estimates for the amount due for refinancing include $1.8bn for SMFG, $2.6bn for Mizuho, and $1bn for MUFG.

‘Turnaround’ banks struggle to repay
"The actual volume of refinancing that will end up in the capital markets depends greatly on the retained earnings these banks will produce," notes Nakahara. "The more money they make, the less pressure they have to refinance. This is an interesting time in late 2007 as the credit market is recovering globally, but the cost of funding for any Japanese FIG issuers would be higher than the pre-summer levels, so they are now all biding their time and waiting for spread conditions to improve. If they need to refinance in the markets, they will surely take the debt route, because given where the bank sector stock prices are this year few would think they would go the pure equity route."

The banks that owe most to the government now are the so-called ‘turnaround banks’, Shinsei, Aozora, Resona Holdings and Chuo Mitsui. However, as the share prices of all of them have suffered precipitous falls this year it has been difficult, nigh on impossible, for them to draw up repayment schedules that they can stick to.

Pure equity sales are not viable — the government’s paper losses on Shinsei and Aozora preferred shares will only move into the black if their stock prices climb about 50% from their October 7 close.

Shinsei Bank’s share price on November 13 stood at ¥332, near the one year low of ¥301 on September 14 and roughly half the ¥761 the stock hit on January 16, and roughly one third of the value of the shares on March 18, 2004, not long after the bank listed.

However by December 18 its share price was quoted at ¥402 after a group of investors led by US fund JC Flowers & Co announced in late November they were buying 32.6% of Shinsei for almost ¥203bn. Aozora was trading at ¥338 on December 18, some 36% below its high of ¥517 on November 14 2006.

In what is tantamount to a vicious circle for these banks, and for the government bodies that want repayment, the weakness in the stock prices is also compounded by knowledge of the overhang implicit in the state’s holdings.

Only the government’s Resolution and Collection Corp. has this year managed to make a large public offer of bank stock related to the repayment programme.

In a global offer managed by Morgan Stanley and Nomura the RCC sold 82.2m shares in Chuo Mitsui Trust at ¥1,054. With 35% of the stock allocated to the international offer, the deal was more than 30 times covered.

However, investors who thought they were getting a bargain — the stock had been trading at ¥1,445 in February — are now sitting on paper losses of about 17% as the stock on December 18 was trading at ¥874.

Merrill’s innovative solution
Investors must therefore be breathing a sigh of relief that the biggest debtor of them all, Resona Holdings, which received a total ¥3tr of taxpayers’ money in 1999 and 2003 in a de facto nationalisation, did not in April attempt a jumbo equity issue in an effort to repay state funds.

Resona’s share price has collapsed since hitting an all time high of ¥499,000 in December 2005. Its stock was worth just ¥193,000 a share on December 18. That is roughly 38% of its highest valuation and very near its recent low of ¥163,000, plumbed on September 25.

It is also well below its April 23 level, when, spurred on by adversity, Merrill Lynch conjured up a unique and creative investment banking solution for Resona’s immediate repayment problem in the form of the privately placed ¥350bn jumbo convertible bond issue of late April.

In the transaction, Resona Holdings issued ¥350bn of convertible preferen ce shares to Merrill Lynch, thereby enabling Resona to repay part of its dues to state by buying back convertible preference stock held by the government’s Deposit Insurance Corp (DIC).

The bank had nearly 11.4bn shares in issue, of which the government directly held about 49%, not including the shares that would be issued if the ¥1.998tr of preference shares the government holds were converted, which would boost the state’s holding to 73%.

Had Resona chosen to work with the government to sell ordinary shares in order to repay ¥350bn of convertible preference stock — the DIC had asked for proposals for such an exercise from investment banks — a deal of that size would have been near impossible to pull off, and even if it had succeeded, investors would have demanded a hefty discount.

"Having substantially rehabilitated its business and needing to repay large amounts of government money, the transaction was characterised by a diverse number of constraints," says Andrew Cooper, head of Pacific Rim equity-linked capital markets at Merrill Lynch.

This he explains, meant a complex and arms-length financing structure that had to offer a guaranteed success, without launch risk. It could not cannibalise demand for any possible selldown of the government’s own stake later. It had to allow Resona scope to use its considerable future forecast earnings to buy any new capital issue back, and lastly it had to be above criticism as regards any effect on the share price.

Resona in focus
The result was a private transaction priced in a rapid ‘club’ bookbuild. The preference shares pay an annual yield of 0.93%, have an effective conversion premium after the contingent conversion (CoCo) mechanism of 32.25% and carry four downward-only conversion price resets.

Merrill Lynch agreed to hold the preference stock on its balance sheet for up to two years and a small group of less than 10 institutional investors sub-participated in the transaction, thereby reducing Merrill’s exposure.

Resona has a soft mandatory call provision after five years, which if exercised would result in dilution of just 2%. From the capital management and return on equity perspectives, the deal allowed Resona to sidestep increasing its issued share capital.

The new convertible preference stock counts as pure tier one capital, as they are perpetual securities with an option but no obligation for Resona to redeem them in the future.

"The soft call feature is vital to the transaction," says Cooper. "As Resona is forecast to be very profitable, the soft call was appealing as Resona has some years to prove its profitability and buy back the instrument if it deems appropriate. After Resona had substantially fixed its business and regained financial stability, it was imperative to make progress in refinancing its capital structure, which bore the scars of the distress it suffered five years ago."

The transaction was worth more than 10% of Resona’s then market capitalisation, and 21% of the freefloat. Moreover, the foreign institutions that might in more bullish times for bank stocks have supported an equity issue were not on the register in the first place — foreign ownership of Resona was then less than 11% at the end of March, whereas for the megabanks such as MUFG and SMFG, with vastly higher market valuations and free floats, the average was 33.7%, headed by SMFG at 40.4%.

The running yield of 0.93% is also cheap, compared to issuing time - limited preferred debt securities, which would cost at least 4% a year. Moreover, to raise ¥350bn through subordinated debt would be extremely tough at home and far from easy offshore.

With stock prices in the bank sector so uniformly weak — SMFG, for example, is trading 43% below its 52 week high — the prospect for bank equity issuance in the near future remains slim.

The megabanks might need funds for refinancing old subordinated debt, but that requirement, as well as their need for additional regulatory capital, will be limited by the retained profits they generate and the
relatively low demand for loans in a low growth Japan. The turnaround banks cannot fill that gap, other than in a piecemeal way.

All of which means that unless someone creates another Resona-style solution, Japanese banks will feature less large in the global capital markets than they have for quite some years.

  • 04 Jan 2008

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