Davy needs to convince in credit union bond debacle

BUSINESS OPINION:CREDIT UNIONS this weekend received conflicting advice as hundreds of volunteer officers met in Dublin at two separate venues. They were weighing up the merits of a settlement proposal put forward by their investment advisers - Davy - to mitigate substantial losses incurred to date on holdings of open-ended investments called perpetual corporate bonds.

The credit unions have until July 4th to decide whether to accept the Davy proposal and Davy itself reserves the right not to proceed unless a sufficient number of the 149 credit unions involved sign up to it. As part of the deal, the credit unions waive their right to complain to the financial services ombudsman or to take legal action in relation to the original sale of the bonds, and, for those already going down this road, to withdraw those complaints.

Davy says that corporate bonds form a necessary element of any well-rounded investment portfolio - "due to their diversification benefits and ability to produce income above cash rates". That is so. What sets these bonds apart, however, is that they are perpetual - ie there is no set maturity date and no obligation on the issuing banks to redeem them at any particular time. Equally important, the bonds contain no step up clause.

This is quite unusual in perpetual bonds. A "step up" clause usually kicks in at the "callable date", the date at which the financial institution has the right to redeem the bonds. It effectively increases the interest rate charged on the bond. If the issuer chooses not to redeem the bond, it faces higher borrowing costs and the purchaser of the bond gets a financial reward to compensate for the fact that there is no obligation to repurchase the bonds at that time.

Given that the banks involved in issuing the bonds at the heart of the dispute are Scandinavian - a region that has had more than its fair share of banking crises - the lack of a "step up" clause is more surprising.

Some 149 credit unions - including some of the largest in the State - bought €183 million of these bonds from Davy between 2004 and 2006. In general, credit unions look to maximise return without putting capital values at risk, although increased competition in recent years has seen some move into more exotic investments.

This has been a cause of concern for some, including the financial regulator - the Registrar for Credit Unions - Brendan Logue. Run by volunteers, credit unions rely largely on the advice of their advisers, including Davy, on investment policy. Without specific financial training or express information from their advisers, many credit union boards would be unaware of the nature of perpetual corporate bonds or step up clauses.

Disquiet emerged in late 2006 as the bond values fell and an adviser to a number of credit unions approached Davy with questions over the way in which they had been sold, the advice on accounting treatment and, as he sees it, the relatively poor interest rate - or coupon - offered.

Davy insists it did nothing wrong and that capital value will be protected as the bonds must ultimately be bought back by the relevant financial institutions at par - ie for the same money that they were acquired.

The problem for the credit unions is that there is absolutely no guarantee as to when the banks will repurchase the bonds. And, at a time of rising interest rates, the banks are paying less interest, or coupon, on these bonds than they would do on any replacement borrowings.

In the meantime, the credit unions have to account for these investments in their annual accounts. What is not in dispute is that the market value of the €183 million worth of bonds the credit unions acquired through Davy is now about 40 per cent less than their purchase price - about €108 million - at best. Accounting standards mean that credit unions now have to reflect this "paper" loss on their annual accounts given the lack of any guaranteed maturity date.

For those 149 credit unions, that puts a significant hole in the accounts and affects the dividend for members.

The ante was raised when Enfield credit union took Davy to the Financial Services Ombudsman alleging mis-selling in relation to €500,000 of perpetual bonds it acquired through Davy. The ombudsman agreed and ordered Davy to buy back the bonds at face value. Davy is now contesting that decision in the High Court.

Davy is now offering to fund the purchase of a separate 10-year bond from an Irish institution at a cost of €35 million which, it says, will grow to cover the losses incurred by the credit unions on six of the seven bonds in question.

The settlement proposal sent to credit unons in May does not refer to sales of a seventh perpetual bond issued by insurance group Axa. Instead, earlier this month, Davy announced it was buying back the Axa bond, which is also trading about 30 per cent lower.

The Axa bond is interesting because it appears not to meet the regulatory requirements of the Trustee Authorised Investment Order. This covers the range of products which credit unions are allowed to purchase. While they do cover bonds offered by banks - including the six underperforming Scandinavian bonds covered by the Davy settlement proposal - they do not automatically cover bonds issued by other financial services groups, unless they are rated AA or above.

While Axa itself carries a financial strength rating of AA, the perpetual bond in question is rated only A-. Davy will not state whether the Axa bond meets the requirements of the Trustee Authorised Investment Order, with a spokesman saying only that "if there is any confusion or any issue [with the bond], it would be addressed by the [Davy] decision to rescind it".

Opinions are divided on the proposed Davy settlement. Davy says the new bond will meet liabilities but that is not guaranteed. In any case, the credit unions will give up any recovery in the existing bonds as the settlement will give Davy the right to claim those gains.

The regulator, Mr Logue, has also warned credit unions to examine the proposal carefully to ensure it meets the requirements of the Trustee Authorised Investment Order. That intervention is being read by both sides as support for their position.

A settlement is an attractive proposition for credit unions who are worried about the hole in their accounts and its impact on dividends as well as questions from members about how these co-ops are being run. Significantly, it also avoids possibly significant legal costs.

Davy needs a settlement too. The constant dripfeed of information regarding the nature of its advice has damaged the reputation of a company that remains the State's dominant stockbroker.

However, of greater importance to investors - whether they be credit unions, people nursing heavy losses on the back of heavily marketed contracts for difference, or others - is the confidence they can have in the advice they receive. Settling the perpetual bonds merely sidesteps this issue.