How to Create a New Bank Capital Crisis

By | March 1, 2011

Also published at TabbFORUM.com

Credit Default Swaps (CDS) are so 2005.

My new favorite derivative is the contingent convertible bond – better known as the CoCo. CoCos work like traditional convertible bonds in that the buyer buys a bond that can be converted to equity at an agreed upon price. The difference is that CoCo bonds are automatically converted to equity when the net equity of the issuing bank falls below an acceptable floor. The floor value is set by the issuer, but in reality it is designed to mimic banking requirements set by international and/or local regulators. Think of the former as an option and the latter as a stop limit.

It’s not the structure of the CoCo that puts the product in the structured derivative hall of fame next to the CDS and the CDO, however. The CoCos’ intrigue lies in the fact that regulators allow banks to count these instruments toward their Tier-1 capital. Basel III will raise these minimums over the next decade and local legislation in key markets will likely set rates even higher, making capital ratios a key area of focus for the bank; hence the resurgence of the CoCo.

As the thinking goes, if a bank with outstanding CoCos has a capital shock in which its Tier-1 capital falls below the regulatory minimum set by the Basel committee or other regulator, the CoCos will automatically convert to equity from debt, magically injecting capital into the firm while simultaneously reducing its debt load.

Genius.

If things get really bad again, the banks are hedged. No government bailouts, no too big too fail, no complaining tax payers. Unfortunately, we shouldn’t take anything at face value anymore and the concept of a perfect hedge is pure fiction. Furthermore, when regulators think a single financial instrument can create a quick fix, it’s akin to a dieter thinking he or she can take a pill, eat lettuce for a week and suddenly be in shape for the rest of his or her life.

Ironically we saw a similar situation with Basel II in the early part of the last decade. Banks needed more capital and they figured out they could improve their capital ratio by using CDSs to flatten out bond positions synthetically. Regulators quickly caught on to this idea and allowed the practice, the derivatives markets were around the same time deregulated and yada, yada, yada, 2008.

The CDS theory for reducing debt exposure was accurate – just like the CoCos theory of today. CDS do, in fact, act as a great hedging tool (and yes, as a speculation tool as well). It is certainly true that counterparty risk was mostly ignored back then, but that lack of foresight aside, the product performed as advertised. The problem, as I just stated, was that banks and regulators treated it as the solution rather than a tool in the arsenal. Similarly, CoCos are a great risk management tool for banks (not to mention they pay the borrower interest rates similar to that of riskier junk bonds), but they are not a magic pill.

Let’s paint the picture for the CoCos financial collapse.  In 2014, Bank XYZ gets in trouble because of huge municipal bond defaults in the US (assuming of course Meredith Whitney is right).  Capital levels at Bank XYZ get low enough to trigger the CoCos, flooding the market with liquidity in stock for XYZ.  Since the equity market saw the problems coming for XYZ, short sellers already had the price of the stock down 60% from its 52 week high.  The sudden flood of shares into market drives the price of the stock down to 90% below the high.  So now although XYZ has less debt outstanding in return for more shares outstanding, the downward spiral in the equity market has actually left the bank less capitalized than it was before the CoCos run began.  This says nothing of the mess created by the CoCos hedges gone wrong – long term equity puts, for example.  Multiply this by several banks and hedge funds trading CoCos derivatives (CDS on CDO of CoCos anyone?), we have a real problem.

This level of pessimism is uncharacteristic of my generally free market, derivatives are innovative thinking. Maybe I’m reading too many anti-Wall Street books or maybe I’ve been on the Street long enough to see history repeating itself. Whatever the reason, the near-definite surge in CoCos issuance must be watched.

Time to create the first CEF – CoCo Execution Facility?

2 thoughts on “How to Create a New Bank Capital Crisis

  1. Pingback: Deutsche Bank y la crisis. La ópera no se acaba hasta que quiebra la gorda. - Communia

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