Brave men knocking on our door

Mint – Blain’s Morning Porridge

These are brave men knocking on our door. Let’s go kill them!

I had to giggle when I opened the Financial Times on the train this morning to the news the European Central Bank (ECB) has finally woken up and is having “second thoughts” about contingent convertible (CoCo) bonds. Ha! I've been warning about these illegitimate Frankenstein spawn of delusional regulators and desperate banks ever since their first inception! When they were first mooted I warned they were dangerous - so good to know the ECB's finally listened.

More to the point, they are an object lesson in the failure of overzealous, ill-considered and rushed policy making in the wake of the financial crisis. I really wonder if policy markets truly grasp the complexity and connectivity of modern markets, globalisation and political economy.

The CoCo saga is a small facet of the underlying failures of policy - but one worth understanding. CoCos exemplify the laws of unintended consequences and regulation for the sake of being seen to regulate. The good news is the ECB has figured out that the capital instruments that the Bank for International Settlements (BIS) blueprinted and they supported to strengthen bank balance sheets with additional capital are pants. They actually make the underlying bank more vulnerable due to the uncertainties about the possible triggering of CoCos, meaning volatility in these instruments triggers nervous overreaction across the board, potentially causing banks to spiral into chaos. This was vividly illustrated a month or so ago when rumours of trouble within Deutsche Bank caused its CoCos to collapse, triggering a wave of doubt on the bank and sector as a whole.

As I sat on the train this morning I racked my brains to think of any other security format that's been specified and driven by regulators the way CoCo were? Nope. But the same mindset has created the conditions that underlie today’s illiquid ossified markets, and the failure of growth. The first question to address is why were CoCos ever invented in the first place? For some 400 years banks had happily financed themselves with a mix of deposits from customers, senior debt, and capital in the form of non-voting "preferred" debt and ownership risk represented by equity. The system and its clearly defined subordination ladder worked well, but by the early 1990s was becoming increasingly complex as banks stretched the definition of debt to allow themselves the luxury of issuing tax-deductible hybrid preferred debt, which regulators agreed could form a limited part of a bank's capital basis - hybrid perpetual Tier 1 Capital.

At the same time globalisation, and the role of banks as the transmission mechanism for capital and funding from savers to industry, was becoming ever more complex. When the global financial crisis came, and fears that failing banks would cripple the interdependence of the financial system, central banks and governments blinked and stepped in to prevent bank failures for fear they might trigger a whole run of dominos to tumble.

The excuse was "too big to fail" thus bail-outs. (I remember writing in 2007: all it would have taken to avoid the queues outside Northern Rock was the Bank of England to surreptitiously extend them some credit to tide them over the busted short-term markets.)

And when the bail-out dust settled, regulators and journalists noticed something they hadn’t previously understood. While equity holders had been crushed by the crisis, and taxpayers financed the bail-outs, debt holders were essentially unhurt. As the banks had never gone bust, even the riskiest preferred and hybrid Tier 1 debt was left intact. Despite the fact the market had understood subordination for aeons, this was immediately perceived by regulators as "unfair". It was decided in future debt holders should suffer and equal burden to equity holders.

Thus the CoCo. This grand new form of contingent capital meant debt holders would hold a debt-like security that converts to equity in times of stress. They would be rewarded for this risk with an enhanced coupon/return. But CoCos are essentially a fixed rate security with all the downside risks - if the bank is failing CoCos will be triggered giving holders, at best, increasingly worthless stock. In contrast, equity gives holders all the upside in the stock price in return for assuming true ownership risk. 

For any investor who could look past the inherent contradictions of CoCo structure, and figure out how to value them, at a certain yield there was a price that made sense. So in the early days of the market, hedge funds were buying them. As yields fell more credit players started to play, and inevitably they started to work towards private banks - where we reckon the majority of CoCo bonds are now held. Dimly understood, but with seductively attractive coupons.

Interestingly, the UK, and then other financial watchdogs, became nervous. In the FT article this morning, HSBC's Chief Financial Officer, Iain McKay, is quoted saying the fact the UK's Financial Services Authority watchdog banned banks from selling CoCos to retail "tells you everything you want to know" about the products. Regulators have woken up to the risks.

CoCos are one example of how the regulatorocracy has overreacted and potentially made the crisis longer and deeper. While the central bankers pump money into banks through quantitative easing and long-term refinancing operations, they simultaneously and contradictorally demand greater capital levels – making it less efficient and more costly for banks to lend. As they demand openness and transparency, they demand banks do less. They are centres of compliance rather than innovative financing. As interest rates fall they expect banks to lend more as margins diminish, returns contract and risks rise. The result is dysfunctional banks.

As they demand austerity in zero interest environments, they wonder why no one is lending? Time for change.. Perhaps the acknowledgement that CoCos were a truly stupid idea is a start…

Meanwhile, lots of other stuff happening in markets… but how would I know.. It’s difficult to write about markets when office internets have been disabled to comply with the latest compliance directives.. Hey-ho.. We are mushrooms.

Bill Blain

44 207 786 3877

Head of Capital Markets / Alternative Assets

MINT Partners