Black is white COCOS

January 20, 2014

Falling Loan to Deposit ratios

Falling Loan to Deposit ratios

It should be interesting to observe the results of European stress tests on banks in 2014.

According to Christopher Thompson of the FT, there is a “Flood of higher risk EU bank bonds on way”(1):

Thompson quotes:

“Last year Europe’s banks issued $19bn of Tier 1 bonds, a nearly fourfold increase on 2012 and the highest figure since 2009, and $77.1bn of Tier 2 bonds, a 19 per cent year-on-year rise and the highest amount since 2008.”

“We expect record issuance in Europe of Tier 1 and Tier 2 bonds for banks to meet
their minimum capital requirements – something between €30-40bn would be
manageable,” said Antoine Loudenot, head of capital structuring group at Société

Bonds issued before the currency crisis that no longer fulfill regulatory requirements will have to be replaced with riskier and more expensive bonds costing the European banking sector more.

“Holders of Tier 1 and Tier 2 bonds sustain losses ahead of senior bondholders in the
event of a bank default, and get paid higher interest to reflect that risk.”

Thompson has got it right. Its possible the ratings agencies will lower the credit rating of the EMU on the foot of these policies. Risk of Australian banks through subordinated bonds of imposing creditor bail in has already led to downgrades there.–PR_281378

“Sydney, September 05, 2013 — Moody’s Investors Service downgraded the subordinated debt (Lower Tier II) ratings and selected junior subordinated debt (Upper Tier II) ratings for the Basel II compliant securities of eight Australian banking groups. The banks’ senior obligation ratings and their stand-alone baseline credit assessments were not affected.”

The irony is the methodology to impose greater credit security for European banks allowing European banks to pass regulatory stress tests under Basil 111 for 2014, will allow them to pass stress tests, but at the huge cost of  weakening of the overall European banking sector.

If Moody’s acts according to its Australian template, expect European bank ratings and European national ratings to decline further. Growth in Europe is the only way out of this self-perpetuating decline vortex. There is little to show on the periphery or in the core eg in Italy or France of the kind of economic growth  required to save the euro from slow decline.

According to Thompson, “Much of the recent issuance in European banks’ subordinated debt has been done using contingent convertible bonds, or cocos, which offer attractive yields on banks such as Barclays and Credit Suisse but are considered riskier investments. Coco investors can have their investment turned into equity or wiped out entirely if a bank’s capital falls below a pre-agreed level.”

What Is a Convertible Bond?
As the name implies, convertible bonds, or converts, give the holder the option to exchange the bond for a predetermined number of shares in the issuing company. When first issued, they act just like regular corporate bonds, albeit with a slightly lower interest rate. Because convertibles can be changed into stock and thus benefit from a rise in the price of the underlying stock, companies offer lower yields on convertibles. If the stock performs poorly there is no conversion and an investor is stuck with the bond’s sub-par return (below what a non-convertible corporate bond would get). As always, there is a tradeoff between risk and return. (For more insight, read Get Acquainted With The Bond Price-Yield Duo.)”

It would appear Cocos are to be the new European equivalent of US treasury bonds. Perhaps this is a G8 method of structural stabilisation of the euro by providing a means for global investments including investment instruments across forex foreign exchange markets to prop up the euro. Its benefit would appear to be short-term gain against long-term risk.

Wheels are being greased to allow for cocos. Italian and dutch banks prepare to sell riskiest cocos. Investors will be rewarded with higher rates of return 6-8 per cent. But if the deck of cards topples their investment could be burned by bail in.

Cocos would appear to be the means by which those at the casino tables already burned in the high stakes game, are recapitalised in order to play for riskier and higher stakes.

According to Aimee Donnellan, “Under the Basel 3 framework, banks can raise 1.5% of their 6% Tier 1 capital ratio in the form of non-dilutive equity-like instruments, which can also be used to improve banks’ leverage ratios.”

Following UK, Spain, Italy have now raised investment in these instruments as tax-deductible.

“This work appeared to pay off on Monday when the Italian government prepared an amendment, to be inserted in the 2013 budget law, to make it easier for banks to issue hybrid bonds to boost their capital starting from next year, according to a document seen by Reuters.”

There is no doubt the financial casino of shadow banking in order to ‘regulate’ itself more is doing so in a manner that increased tax avoidance for the rich, makes attractive investment strategies that are riskier, reduces regulation while appearing to increase regulation, induces instability to prop up stability in the banking sector.

The world of shadow banking now paints black COCOS white.




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