Sale conditions put Novo Banco bondholders in prisoners’ dilemma

Sale conditions put Novo Banco bondholders in prisoners’ dilemma

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As part of Novo Banco’s sale process, senior bondholders may be asked to exchange their securities for subordinated bonds at a deep discount to book value.

Last week the Bank of Portugal confirmed that it had reached an agreement with private equity firm Lone Star Funds over the sale of Novo Banco.

Lone Star will inject €750m of capital into the Portuguese bank, which was created in August 2014 to carry forward the good assets of failed lender Banco Espirito Santo (BES), and a further €250m over the next three years. Following both capital injections, the private equity firm will own 75% of Novo Banco, while the Portuguese resolution fund will retain the rest.

But the transaction depends on Novo Banco also raising €500m of common equity tier one capital through a liability management exercise.

According to a statement on the Portuguese central bank’s website, senior bondholders will be asked to swap their instruments for subordinated obligations. The release did not confirm whether or not the bank would issue additional tier one (AT1) or tier two bonds.

Analysts at BNP Paribas said the agreement was “very onerous” for senior bondholders, because it would have to be completed at a deep discount to book value.

They said investors would have to accept a haircut of at least 20%-30% of book value on the €3bn of bonds outstanding if the bank were to stand a chance of raising the necessary capital.

“The senior debt exchange appears to target CET1 generation of more than €500m but, in reality, it is intended to take out as much of the senior debt as possible on a voluntary basis, while leaving capital in the bank that can be bailed if losses in the future are higher than anticipated,” said the analysts.

Somewhat loosely employing a game theory metaphor, they said: “This is a big prisoners’ dilemma for bondholders. They can either accept an exchange that in reality is coercive, or risk a resolution of the bank that likely involves a good/bad bank split, with the debt left at the bad bank and senior debt recovery of less than 50.00, by our calculations.”

Ratings cut

On Wednesday, Moody’s weighed in by downgrading Novo Banco’s long-term senior debt ratings from Caa1 to Caa2, which is eight notches below investment grade. The rating agency also placed Novo Banco on review for further downgrades.

Maria Jose Mori and Carola Schuler, analysts at Moody’s, described the offer as a “distressed exchange” because it will have been made only to avoid a liquidation of the bank.

The European Commission had imposed an August 2017 deadline for the Portuguese resolution fund to sell Novo Banco. But failure to find a suitable bidder would result in the firm being liquidated.

Moody’s estimated that senior bondholders would face losses of 10%-20% as a result of the proposed debt swap, a little lower than the estimates drawn up by the BNP Paribas analysts.

“Losses could be higher should the liability management exercise apply to a more limited stock of debt, and the review for downgrade will consider the potential for further losses for these instruments once the rating agency has more information on the terms and conditions,” added the rating agency.

The developments have had a significant impact on Novo Banco’s senior bonds. At the beginning of the week, the financial institution’s 5% 2019s were trading in the high 80s in cash terms, but on Thursday morning they were quoted at just above 80 and yielding up to 16%.

“We expect the bonds to continue to move lower into the 70s,” said analysts at BNP Paribas.

Once bitten

Some of Novo Banco’s bondholders have already faced heavy losses during the bank’s recovery process, after the Bank of Portugal decided in December 2015 to take five of the bank’s senior notes and transfer them back to the bad bank BES.

Market participants criticised the move because it contravened the principle that holders of the same asset class retain equal standing within the capital hierarchy — a principle that had hitherto been considered sacrosanct in capital markets.

The Bank of Portugal’s decision to breach the concept of pari passu has also had consequences for the funding costs of other Portuguese banks, with some investors citing the treatment of Novo Banco as a reason for avoiding buying Caixa Geral de Depósitos’ additional tier one transaction last month.

“I did have a wry smile on my face when I came across the ‘special event redemption’ section that states ‘subject to approval from the Competent Authority’ — which seems a bit ironic, given the actions of the same Portuguese authorities towards international investors back in December 2015,” said Gary Kirk, a partner and portfolio manager at TwentyFour Asset Management.

“It is exactly those international investors that the Portuguese Central Bank is relying on for supporting this new [Caixa Geral] deal and boosting the capital ratio of this state-owned entity.”

‘Contingent capitalisation mechanism’

Lone Star’s acquisition of Novo Banco is subject to approval from the European Commission and the European Central Bank, but the Portuguese authorities hope the agreement will enhance the credibility of the country’s banking sector.

According to the sale conditions, the Portuguese Resolution Fund has agreed to inject capital into Novo Banco under what the Bank of Portugal called a “contingent capitalisation mechanism”.

The statement did not set out the precise conditions required to make the resolution fund pump more capital into the bank, but said it would depend on the capitalisation levels of Novo Banco and the performance of a selection of its assets.

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