Since the sub-prime crisis of 2008/2009, ASIC have had a history of warning investors of the perils of hybrid securities. The GFC forced investors to re-evaluate the price stability of hybrids as almost all securities of this type were sold down dramatically. While the prices of all hybrids with known maturity date’s rebounded back to pre-GFC levels, ASIC decided to pay attention to hybrids as the majority of hybrids were owned by retail investors.
Starting around 2011, ASIC began to periodically warn retail investors about the risks of hybrids. ASIC summed up the risk as follows:
- Hybrids had not been redeemed at a time when some investors had expected because directors had discretion as to the timing.
- Hybrids are often subordinated and while they rank ahead of ordinary shares they rank behind other types of debt holders and creditors.
- Interest or distributions is often at the discretion of directors or subject to some financial ratio test. In some cases, hybrids issued by companies such as PaperlinX and Elders ceased to pay distributions
- Hybrids issued by financial institutions since 2009 have “non-viability” clauses which, if triggered, cause the hybrid to be converted to ordinary shares. For this clause to be triggered, APRA would need to hold the opinion the institution is not viable without more ordinary share capital.
- Some hybrid offers allow the company to suspend interest payments for a number of years and thus the security’s market price may fall.
In a recent newspaper interview, ASIC chief Greg Medcraft has taken another opportunity to label hybrids as inappropriate for retail investors, noting they are banned in the U.K where they are known as “cocos”, short for contingent convertibles. His main objection is the presence of certain clauses, such as the non-viability clause, which would be invoked at the discretion of APRA (see above). So far, this clause has not been used in Australia but there was a recent example of it in the case of Spanish bank Banco Popolar Espanol (BPE). Holders of tier 1 and tier 2 securities were wiped out when their securities were converted to BPE equity which was worthless.
“If a bank has any trouble they’re the first line of defence,” he said. “If you wipe out retail and all those retail investors are superannuation investors you are robbing Peter to pay Paul.
There is one glaring problem with his approach. If hybrid securities are too complex and retail investors are precluded from buying them, then what restrictions should be placed on ordinary shares? Obviously, shares are more risky than hybrids and they have more unknowns. After all, shares do not have maturity dates and thus they are a type of perpetuity. Distributions, otherwise known as dividends are discretionary and, in the event of a company’s liquidation, shares rank lowest in the capital structure. Should not retail investors be protected from such uncertainties? Medcraft’s comments could be applied just as easily to shares as well as hybrids but somehow YieldReport expects ASIC and its chief would be reluctant to take such a step.
ASIC may also wish to consider the consequences of hybrid issuers ever becoming financially-stressed. It is worth noting if the issuers of these hybrids, who are mostly the major banks, do ever get into trouble (refer 1991/92), there are hundreds of billions of dollars at risk via the ordinary shares. The $30 billion or so of hybrids which are currently on issue is but an hors d’oeurve when compared to the main course which comprises ordinary shares.
And yet critics noted that in its 2016 stress test of the EU’s largest banks, Popular did not come across as a bank that would fail, even though it was struggling under the weight of 37 billion euros ($41.4 billion) in non-performing loans, a legacy of Spain’s property bubble. The stress test projected that Popular would have a capital ratio of 13.45 percent of assets in 2018 under the normal scenario. This was only slightly lower than the sample average of 13.8 percent — meaning Popular should have been able to carry on just fine in the absence of shocks.
Perhaps that would have been the case under different circumstances, but Vitor Constancio, the ECB’s vice president, said last week that Popular had faced a bank run. Traditionally, central banks act as lenders of last resort to solvent banks which are experiencing a liquidity crisis, provided these can post sufficient collateral. In the case of Popular, the issue seems to have been that the lender had ran out of acceptable collateral.