Sometimes I want to elevate a discussion contained in the comment section of this blog into a post, particularly if there are a number of readers interested in the topic. The following discussion was made today in response to a comment from a reader in the Netherlands:
"DutchPerplex: I think that the emphasis has to be on paragraph 26 rather than the footnotes (fn. 34: ec.europa.eu.pdf.) Merely announcing the policy will cause the deleterious results which the EC professes to comprehend in the footnotes.
Of your two Dutch firms, I would view Aegon to be in better shape than ING to avoid a deferral for a number of reasons. ING is into state aid much deeper than Aegon. The amount of the aid is higher at 10 billion Euros vs. 3 billion for Aegon, but ING also did a subsequent arrangement where the Dutch government guaranteed some Alt-A mortgage loans, called liar loans in the U.S. That is, the borrower states their income and the mortgage originator says I believe you. Moreover, Aegon is further along in paying the State back. And the argument that AEG has already triggered a mandatory payment event until March 2010 is a good one, due to its payment on a Junior Security in May 2009 (plus the argument for a 4 quarter mandatory payment linked to buying any junior securities which AEG said it intends to do in Dec)
A lot may depend on the earnings for the next quarter. A good recovery in profits would alleviate some of the pressure for deferral.
I do not see a strong connection myself between the burden sharing policy, where junior bond holders have payments deferred even when the firm has the ability to pay and is otherwise solvent, and the EC policy of promoting fair competition by looking hard at state aid. I do not see the connection between the fair competition goal and paragraph 26. If there was some concern that state aid in the extraordinary circumstances of last Fall was too generous, then dictate changes in that aid package. But the terms were not too generous. They would not distort competition. After all 8.5% is not a low rate, and ING has to pay a 50% premium to buy back the State's shares. In short, it was not state aid that would distort competition under the dire circumstances from last year.
Thus, the EC policy aimed squarely at junior bond holders is more of a penalty than an implementation of any policy objective in my view.
In the U.S., the source of the problems, there was never an official burden sharing policy for debt holders, let alone an attempt to implement one, and the EC has already done both ( e.g. KBC & Allied Irish). Even the disasters like Fannie and Citigroup have kept paying interest on their bonds, even the most junior ones. The intervention of the EC into a boardroom type of decision based on what I view as a primarily political decision, with at best a tenuous connection- if any- to any EC policy objective, makes all hybrid securities less desirable for investors around the world. For me, I have said many times in my blog that I had an unfavorable view of the hybrids due to the lack of a promise to ever pay the principal back, and then they have these liberal deferral provisions with no maximum time limit on deferral. The U.S. Junior bonds will typically put a maximum of five years on a deferral.
There is an alternative payment mechanism in the Aegon prospectuses where AEG would sell common stock to pay a deferred dividend. The Fitch analysis said that the EC might look more favorably on using that method to make a payment rather than using cash on hand."
I would hope that any deferral on the hybrids by either ING or Aegon for the December quarter is met with the immediate filing of a lawsuit. This needs to be done with a thunderbolt and not a whimper. The position that I have outlined of four mandatory payments triggered by the payments on Junior Securities in May 2009 is a good faith position that needs to have its day in court in the event of a deferral for the next quarter payments. Contrary arguments would undoubtedly be made, and that is why we have a judicial system. A deferral caused by the EC in implementing its burden shouldering policy has to be met immediately with any and all courses of action in the judicial system. My purpose for writing these blogs about the possible Mandatory Payment Events for Aegon and ING is to show others that we are not helpless, we do not have to take it lying down, a good fight can be waged and even won.
The best and clearest case would be the purchase of a junior security during what is clearly now an annual payment period for the Junior Securities.
It has to be remembered that the payments on the Junior Securities in May 2009 were for a short period, roughly a semi-annual period, from the time the agreements were executed by the parties to May 2009. So, the contrary argument would be to match up two quarters for the hybrids with the roughly two quarters of the annual period for which payment was made in May 2009 on the Junior Securities. Now, both the Junior Securities issued by ING and Aegon in connection with the bailout last year are in annual payment periods.
Another point is that these hybrids will soon become less appealing to those considered to be "well off" by the the Democratic Party. Currently, the ING and Aegon hybrid distributions are taxed as qualified dividends subject to a maximum 15% tax rate (Preferreds eligible for the 15% Tax Rate Table - QuantumOnline.com-free site registration required). It would be reasonable predict that in 2011 or sooner that this will change for the well off American taxpayer. Then, one of the primary reasons for owning them will evaporate. When you add to that the EC burden shouldering policy for the hybrids, the lack of a maturity date, no time limit on deferrals, and a liberal deferral provisions, why on earth would anyone in the U.S. in the well off tax bracket want to own them.?
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