Banks caught bluffing

Samuel Goldwyn once said, ‘an oral contract is not worth the paper it’s written on’. He might have added, ‘particularly when it’s your stockbroker writing the contract’.

Investors in Bank of Queensland (BOQ) Perpetual Exchangeable Preference shares (PEPs) have just learned this lesson the hard way. The broker may have said they’ll be redeemed at the first opportunity but it won’t be happening.

PEPs were an earlier form of hybrid issued by BOQ, in 2007, with an option to redeem at their $100 face value in December 2012. The prospectus made it clear redemption was not a certainty but it’s been a long held belief, promoted by brokers, that Australian banks will always redeem at the first call date, if only for reputational reasons. That belief has just been shattered.

The Offer

BOQ have offered to exchange PEPs for a newly issued $100 Convertible Preference Share (CPS) on similar terms to those recently issued by Suncorp and Bendigo (see below). Those that don’t accept  (or non-Australian and NZ residents, who can’t) have been told their PEPs won’t be redeemed and might not even remain listed on the ASX.

Last week’s plunge in the PEPs share price, from $98 at 10am last Wednesday to a low of $87 on Friday, says it all. PEP investors expecting to get $100 cash are instead effectively underwriting the new CPS issue. But instead of getting a nice fat commission, their reward will be the removal of the gun pressing on their temples.

One shouldn’t blame BOQ. They are complying with the legal terms of the PEPs and may only be acting at APRA’s insistence (although we don’t know this for sure). APRA don’t like the fact investors have an expectation that hybrids will be redeemed early. This is a convenient but all-too-late way for it to highlight the risks.

PEP investors may hope that BOQ will ‘tidy up’ any PEPs that don’t get exchanged but it’s a high-risk strategy. Holding PEPs post-December is an unattractive proposition for most investors. Exchanging into BOQ CPS and hoping for the best on listing is their only practical option.

What about new investors?

Everyone else should give this offer a wide berth. It offers a similar rate to the recent Suncorp and Bendigo offers but comes from a company with a smaller market cap, a lower credit rating and which has just become the first Australian bank to fail to redeem a hybrid at the first call date. Assuming the margin is announced at the low end of the range, an extra 0.1% (vs Bendigo) and 0.45% (vs Suncorp) is inadequate compensation.

If the CPS issue ends up filled largely by unhappy PEPs investors, there’s a chance it will come under considerable selling pressure when it lists on the ASX. There’s a much greater risk than earlier hybrids of this offer trading at a discount after listing, not that this gets a mention in the prospectus.

Key terms

If you’re still interested (and you really shouldn’t be), this is another dose of CBA PERLS VI, Suncorp CPS2 and Bendigo CPS. We suggest you read those reviews to get a feel for this one and then examine Table 1, which explains the key terms on a comparative basis.

A point the subject of some confusion is that these hybrids do not require bank failure for investors to suffer large capital losses. The most worrying feature of the new class of hybrids, of which BOQ CPS is one, is the ‘Capital Trigger Event’, which requires conversion to ordinary shares if, at any time, the issuer’s Common Equity Tier 1 Capital falls to 5.125% or less. A large loss can automatically trigger this clause even if the issuer is in no danger of failing.

Fortunately, the change to the Relevant Fraction in some of the later issues, including BOQ’s, reduces the risk associated with the Capital Trigger Event. Despite this protection, bad news could still trigger hybrid capital losses. In BOQ’s case, it has advised it's current capital position is $736.5m above the Capital Trigger Event level.

So an $800m loss, for example, would see the share price plummet at the same time as the automatic conversion of the hybrid is triggered. The price may not fall below the 20% level where massive losses could arise, but you still shouldn’t expect to get your entire $100 back. The combination of a plunging share price and fleeing investors means you are unlikely to be able to sell the ordinary shares for their conversion price (and the 1% discount provides little protection).

What chance BOQ suffering this sort of loss? According to the CPS prospectus it provided for an extra $400m in bad debts against its loan book during the last year. So it got half way there. This figure was up from $200m the year before (2011) and an increase on 2010’s $100m in bad debts, the bank indicating on both occasions bad debts were on the way down. Over the same period BOQ has also managed to end up in court over $100m lent to Storm Financial clients.

BOQ may have the nasty surprises under control but there’s no reason for you bet your money on it. The only parties who need this hybrid are BOQ and the poor PEPs punters who expected to get their $100 back in December.

Final thoughts

If it turns out BOQ is up to its eyeballs in unnecessary bad debt provisions, ordinary shareholders win, not hybrid investors. They have capped upside and unlimited downside. BOQ PEPs investors no doubt wished they’d passed on the 2007 hybrid. We suggest you avoid this one.