FT.com vandaag
Cocos: Ingenuity that’s proving too good to be true
By John Dizard
An awe inspiring level of ingenuity is being concentrated by capital markets experts on perfecting a product line of financial perpetual motion machines. If you’re a fixed income person you’ve heard of them before: bank-issued contingent convertible debt instruments, or “cocos”, which are intended to give investors the reliable coupon of a bond and issuers the balance sheet and income flexibility of equity.
Depending on the perceived creditworthiness of the issuing bank, they will have coupons ranging from 7 per cent to 9 or even 10 per cent. That is higher than long-term bank debt, but much lower than today’s implied equity returns.
Oh, and regulators and governments have the comfort that any future bank bailouts are paid for by the private sector, not the taxpayer. I used the term “perpetual” without irony; these are perpetual instruments, which cannot be called back by the issuer if rates go down. They would pay the coupons until regulator-determined “going concern” capital dips below some trigger percentage of assets, which may be as low as 5.125 per cent or even as high as 8 per cent. The concept is to turn debt into equity to forestall an event of default if excessive losses on the asset base are incurred. It goes without saying that lawyers and capital markets teams get their end of the deal up front. They’re not waiting for perpetuity. I spent a lot of time over the past several months staring at documentation and analyses of cocos before it finally dawned on me how they violated the Second Law of Thermodynamics, which is usually the problem with perpetual motion machines. Step back from the complex structure of coupons, conversion triggers, tax opinions, etc, and ask yourself the question: who is going to pay the revenue needed to support this expensive paper?
Right now, in the European bank capital markets, there are about €20bn of “Tier One” cocos outstanding. The capital markets people are projecting that over the next three to five years there will be up to €400bn of cocos floating around the continent. Given general price inflation below 2 per cent and falling, added to real growth of maybe 1 or 2 per cent in the good years, how will there be enough nominal GDP to support these coupons? Keep in mind that eurozone banks have assets of about three times GDP. Where will the banks’ customers get the income in ready money to pay for this increasingly equity-financed bank lending or securities buying?
European bank capital markets people are well aware of the internal contradictions created by simultaneous demands by the authorities for higher capital ratios, more lending to finance economic growth, lower losses, and lower incentive compensation for the banker-alchemists who are supposed to do all this. Cocos are a regulator-and-government-driven attempt to square the circle and reconcile the unreconcilable. Someone has to lose money here with the consequent career damage. The euro-level authorities and national governments don’t intend to have future writedowns come out of their tax revenues or borrowing base. The bankers know that, if the coco perpetual coupon-paying instruments are turned into loss-bearing equity, they will not have, technically, failed. The player at the table who doesn’t know how the cards are marked has to be the institutional investor who buys the cocos.
That would be European pension funds or insurance companies, which need higher returns than are now on offer in European markets if they are to pay the benefits promised to policy holders or pensioners. The complexity of the coco documentation, and the effective impossibility of accurately assessing the probability of a forced conversion into equity, make it easier for management to ignore the real risks. Their confusion is a feature, not a bug.
One of the closest recent analogies to coco paper was the $5bn in preferred stock Goldman Sachs sold to Warren Buffett just after the collapse of Lehman in September 2008. Buffett’s Berkshire Hathaway received a 10 per cent coupon and five-year warrants giving the right to buy Goldman stock at a distress-sale price. Goldman redeemed the shares for a 10 per cent premium in 2011, and redeemed the warrants this year by effectively giving Buffett over $1.5bn worth of stock without his having to put up any cash. Hey, it was a crisis, and they were consenting adults.
But cocos are being priced at high rates, in perpetuity, to underpin not one highly profitable firm, but most of the European banking system. It’s just too good to be true.