Institutional investors are up in arms again; this time at Deutsche Bank’s decision not to call its 2009-14 subordinated bond. “We are disappointed and concerned at this action taken by Deutsche Bank, a leading global capital markets operator with no capital or liquidity issues,” fulminates the Association of British Insurers.
“We would urge other major banks to continue to support markets in the medium term by honouring calls on bonds as per normal market practice.”
Investors have had plenty to complain about in the past 18 months. Investment banks stuffed self-destructing mortgages into securitisations. The same banks also drip-fed shareholders with details of potential losses at a painfully slow pace. But on the question of calling hybrid bonds, it is becoming difficult to maintain sympathy for investors.
Did Deutsche Bank print something misleading in the prospectus for its hybrid issue? A call option. The clue is in the name – it is optional. Were rating agencies asleep at the wheel? Emphatically not. In mid-2008, noting the high proportion of hybrids in Merrill Lynch’s capital structure, analysts at Moody’s warned that these instruments had yet to be tested in a scenario of serious financial market stress, and their behaviour could be unpredictable.
Predictable behaviour
In fact, Deutsche’s behaviour was fairly predictable – especially for the very institutional investors who would decide the pricing on a refinancing of the hybrids. If that pricing were higher than the step-up coupon on the existing bond, then investors knew it made economic sense for Deutsche not to call the bond.
Nor did Deutsche really sacrifice reputation for the sake of capital preservation. For many months now, the two are synonymous – capital is reputation. Just ask any bank with low capital adequacy about how the markets respond to them. Yes, Deutsche’s capital is healthier than its competitors, but that is the product of better decision-making.
The whole purpose of hybrid capital is to provide banks with flexibility in their funding strategy. Today, we are not facing ‘normal markets’ but some of the worst financial market conditions ever seen. If banks are not going to use the flexibility now, then when?
The downward spiral in markets of the past 18 months has been about repricing risk. The only real question is why investors had chosen to exclude callable hybrids from consideration in that repricing process. If there is one lesson investors must surely have learnt from the parade of disasters, it is ‘buyer beware’.
