El Coco Loco: European Banks' Contingent Convertible Bond Woes

by: Kevin Wilson


European Coco bonds were designed to lower the risk to taxpayers from potential failures in the banking system, by forcing shared losses on bondholders under certain conditions.

Recently EU bank stocks (DB, CS, SAN, BMDPY) and Coco bonds have plummeted in response to perceived risks associated with high NPLs, weak capitalizations, NIRP, and new bank bail-in regulations.

Due to reflexivity and the way the Coco bonds were designed, they are now viewed as both risky and scary.

Market psychology may mean that Coco bonds have actually increased risk rather than lowered it.

European banks have taken a massive hit in the last few months, but have been accelerating their downward movement over the last few weeks. There are some pretty good reasons for investor fear at the moment. Firstly, as the Acting Man blog has noted, there are about $1.12 trillion in non-performing loans (NPLs) on their balance sheets. Secondly, about $110 billion of the Tier 1 capital at these banks is held as "Coco" (Contingent Convertible) bonds, which give banks the option to skip the high (often 6%) coupon payment when necessary, and investors see recently falling profits, layoffs, and restructurings as indications that a skip might happen. Thirdly, increasingly negative interest rates at the ECB and other central banks (e.g., Sweden, Switzerland) imply that bank net interest margins will eventually shrink even further than they already have. Fourthly, the new Eurozone regulation that allows for bail-ins of investors and depositors (in order to save taxpayers some money) has scared savers with assets in troubled banks, resulting in huge capital outflows, further weakening these banks.

The market sell-off has been so drastic that many banks dipped to the levels they reached in early 2009, and at least one (Deutsche Bank, DB) was briefly at a 25-year low last week. This was an over-reaction perhaps, so there has been a strong bounce since the low, but it is unlikely that the crisis is over. The cost to insure bank debt via Credit Default Swaps (CDS) has soared, although it is still far below where it was in the 2011 debt crisis. After a very good year in 2015 with returns of around 7%, the prices of some Coco bonds - those issued by Deutsche Bank, Banco Popolare (OTCPK:BPSYF), and UniCredito (OTC:UNCFY) - have fallen as low as 75 cents on the Euro this year. As pointed out by the Financial Times, Coco bonds are perpetual, which leaves investors guessing when they might be paid off. Banks have the option but not the obligation to pay them off after five years, but this feature obviously makes them less valuable than an equivalent-yielding standard 5-year bond. These bonds are relatively risky then, and it was apparently not the intent that they would be owned mainly by retail investors, but the trauma of ZIRP (and now NIRP) more or less forced many investors to take on that risk and buy Coco bonds. These investors liked Coco bonds at first, but now they have discovered the true level of risk, and not only do they fear the potential for a coupon payment skip, but also the possibility that the bonds might at some point be converted to equity to bailout a failing bank. There are a few banks - Deutsche Bank, Credit Suisse (NYSE:CS), UBS Group (NYSE:UBS), HSBC Holdings (NYSE:HSBC), Banco Santander (NYSE:SAN), Banca Monte Dei Paschi (OTCPK:BMDPY) etc. - that could potentially end up using some of these Coco bond features.

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It is likely that Coco bonds add to what George Soros has called reflexivity (feedback loops of cause and effect moving investor sentiment) that can exacerbate market declines. Therefore they can't be evaluated fully unless one considers the other factors in the feedback loop now operating. This loop seems to include the new bank bail-in rules, which also have this same quality of reflexivity. It also seems to include NIRP, now that banks are viewed as risky. Taken together with recent historical evidence like the debacle of the "haircuts" (bail-ins) in the Cypriot banking crisis, and the recent bail-in of several small banks in Italy and one in Portugal, the case can be made that savers who bought Coco bonds in the Eurozone have made a deal with the devil, and will soon realize the losses they now fear. In this environment they are naturally likely to sell first and ask questions later, as indeed they have done. The goal of Coco bonds makes sense and is laudable in theory, in that they were intended to slow down or stop taxpayer bailouts of the banking system. This is a very reasonable thing to seek after the GFC. However, shifting losses away from taxpayers, even after adequate warning was given, may not be efficacious under current conditions unless the NPLs at the banks are also brought down dramatically at the same time. This has not really been done.

The potential mistakes made in constructing Coco bonds were really typical ones for regulators and academics, in that a theory was applied seemingly without any practical support from regulators, nor with any real consideration of basic human psychology. The regulators failed to force banks to write off their bad loans, so that a recession now would potentially drive them to the brink immediately. This makes Coco bonds more risky than many expected. And the lack of consideration for how the human psyche would react to the features of a regulatory measure or investment idea, while a common shortcoming throughout economics, has the potential in this case to actually make things worse in the near term within the European banking system. Recent progress in the field of behavioral finance has started to compensate, however for what is an otherwise dismal record in economics, and may have lessons for us in the present crisis.

As Jason Zweig has shown in his book, "Your Money & Your Brain" (2007, New York, NY, Simon & Schuster, 340p), research by Daniel Kahneman and Amos Tversky demonstrated that people are not very rational when it comes to investing. Of course, any experienced financial advisor could give you vast anecdotal evidence that this must be true. But more specifically, people experience different levels of risk tolerance in investing situations based on their level of anxiety or general mood. The earlier gradual decline of bank stocks, media reports on bank bail-ins, widespread implementation of NIRP, and lack of understanding of Coco bonds has set up a sharply lower level of risk tolerance in investors over the last few months, and they have reacted decisively. In their revised view of risk, they seem to be thinking that Coco bonds are crazy, hard to understand, and scary - in a sense, "el Coco loco." Regulators should perhaps have thought about how people owning Coco bonds might react when troubled banks become media targets relatively soon after they were sold. With over $250 billion in Coco bonds issued in the last five years, this is a problem that is unlikely to go away. It is possible in fact, that in their attempt to save taxpayers some money (without actually reforming the European banking system), EU regulators may have inadvertently created a new "virus" to spread contagion.

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