Banks, Bonds and Bail-ins .....CoCo's revisited

Monday 15th February 2016

Banks, Bonds and Bail-ins .....CoCo's revisited

ref :- "Borrowed time" and "Discomforting brew" , the Economist February 13th - 19th

Good to see the markets staging something of a relief rally today. Equities from Japan to the US are being marked pretty sharply higher and if China seems to have missed the boat it's only because its markets have been closed for New Year celebrations and missed last week's rout. The Chinese Yuan/Renminbi however has posted  large gains on the back of a bullish daily fix and helpful comments from PBoC officials. Even oil is attempting to sustain the rally seen at the end of last week prompted by talk of a possible OPEC production cut. (WARNING : Be very careful on this .... the likes of Venezuela and Nigeria can say what they want and start any kind of rumour, but don't believe anything until you hear it from the Saudis. Frankly, it doesn't seem any more of an imminent possibility now than it did a week ago).

Anyway, it gives us a moment to ponder on last week's action and why tumbling equity markets were led by shares in the Financial sector, in particular by those in the big banks. US banks are down 19% this year, European ones by 24%. There are legitimate reasons why shareholders in banks might be a mite nervous .... they get hit at least as hard as other industries by what's troubling the world (China slowdown, commodity prices, debt levels etc). Beyond that, as we discussed last week they now have to cope with a growing negative rate scenario that severely undermines profitability. But when CEO's and Finance Ministers feel that they have to emphasise the "solidity" of various organisations  it's probably fair to say that things have become a little exaggerated -- but of course that's just a legacy of the last crisis.( Incidentally, we of course understand why these people have to come out and say these things, but wonder whether sometimes they resemble a chairman of a struggling football club giving the dreaded "vote of confidence" to the manager.)

But anyway, aren't banks much better capitalised and regulated these days, precisely so we can avoid the sort of bank crash and bail-out process that we saw at the time of Lehman Brothers and its aftermath ? Well, as so often the answer is "Yes and no". US banks are some way ahead of their European counterparts in going down this route. And investors in European banks may well be getting twitchier as they get to grips with new rules only fully implemented at the start of the year that mean they may be shouldering greater risk than they imagined.

There has long been considerable anger that holders of bank bonds escaped losses in previous years when banks failed and the bill was picked up by the taxpayer. The new rules state that troubled banks must deal with capital shortfalls by "bailing in" bondholders before any funds can be made available by the government. This is a new and seemingly sensible measure but in a Europe awash with non-performing debt ( about 1trn Euros at the end of 2014, according to the IMF) held by less-than-adequately capitalised banks it's a real issue  When the rules were applied in order to save four small banks in Italy last year, the resulting losses to individual investors and a high-profile suicide made the kind of headlines that all politicians dread . Perhaps that's why some countries have been so slow to get their banks to clean up their act.

What the regulators really want is for banks to fund themselves with less debt and more capital than can absorb losses. The simplest form of capital is equity  --  the money raised by selling shares or retaining profits. But since issuing more shares dilutes the value of existing ones, bankers and regulators reached a compromise in devising a new instrument that protects share value unless funds are urgently needed  --  yes, it's our old friend, the "coco", and much of the focus was on these fellas last week. You may remember that a coco (or contingent convertible bond) offers an attractively high coupon(interest) rate in return for the fact that should the bank run into problems, it has the ability to suspend coupon payments, convert the bond into equity or even in extremis write it off altogether. Last week's rout in bank shares was in part ignited by speculation that certain banks might not be able to continue to make payments on cocos indefinitely. At this point that seems like a large overreaction, but let's hope we don't find out anytime soon.

Cocos have proved pretty popular, as you might expect when they offer a typical coupon rate of 6-7% at a time when most bond yields are so low. That doesn't make them easily tradeable however, and that illiquidity means that moves tend to be exaggerated. It's another factor that investors in cocos should take into account, just as they're getting their heads round the fact that their investment may not be as safe as they once thought. We wish them well, but rather than complain that the coco may not after all be everything they believed it to be, they might do better to remind themselves as they rake in all those juicy coupon payments that there's no such thing as a free lunch.