the problem

To an American, one of the striking aspects of the financial crisis has been the reluctance, both of politically powerful bondholders (many of them state-controlled entities) and of country governments, to accept any impairment in the value of the debt securities of ailing financial institutions.  The prevailing thinking seems to have been that, no matter how the debt documents read, there was an implicit social promise that the negative consequences of default should fall entirely on shareholders or government.

(In the US, in contrast, it’s very clear that bondholders, too, participate in the losses from a bankruptcy–though with the quirk that the treatment a class of bonds receives is more dependent on its size and the bargaining power of its representatives than the explicit promises in the bond indenture.)

contingent convertibles

The European way of doing things has proven to put excessive strain on public finances.  One of the possible solutions being discussed to this problem is issuance of contingent convertibles or “CoCo” bonds.  Cocos would spell out in the issuing documents specific circumstances of deteriorating issuer finances that would trigger conversion of part or all of the bond capital into equity.  Conversion would simultaneously reduce the amount of debt on the balance sheet and shore up shareholders’ capital.

The idea really hasn’t gotten off the ground so far.

contingent capital bonds

However, Rabobank of the Netherlands sold a contingent capital bond last weeks that pundits are hailing as an instances of a successful CoCo bond.  The issue, $2 billion at a yield of 8.375%, was more than 3x oversubscribed.  If Rabobank’s equity falls below 8% of total capital, the value of these bonds automatically shrinks–even to zero–until Rabobank’s equity ratio reaches the 8% level again.

Although I’ll admit the issues is interesting, I’m not sure it’s a harbinger of anything.  Why?

–Perhaps least important, this isn’t really a coco at all.  Rabobank is a cooperative society.  It was formed two centuries ago by a large number of agricultural banks, which hold its ownership interests.   So there’s no publicly traded stock for the bond to convert into.  The bond principal vaporizes instead.  I’m not sure there’s a big difference, though, between getting a share of stock in a dud bank or getting nothing, other than how fast you get to recognize your loss.

–Rabobank has a AAA credit rating (although S&P has put it on watch for downgrading) and is mostly a retail bank.  So it has a very different risk profile from the troubled big universal banks of the EU.

–According to the Financial Times, 70% of the issue was taken up by individual investors.  My guess is they don’t have much of a clue about what they’ve bought.  They see a high coupon from a conservatively managed bank–and little else.

the question of pecking order

This bond brings up another question.

Rabobank already has second contingent capital bond outstanding, this one about $1.7 billion and issued last year.  Its terms call for holders to lose 75% of their capital, and have the remainder returned to them, if Rabobank’s equity ratio falls below 7%. (By the way, Rabobank has just over $50 billion in equity, which makes up about 14% of capital).  Because the newly issued bond’s vaporization clause is triggered prior to the 2010 bond’s, it gives some protection to the latter.  That should mean an uptick in price for the 2010 issue.  The question I have is that this seems so arbitrary. Could investors in 2010 have known in advance that they would receive this extra protection?  Probably not.

On second thought, if they had an optimistic enough disposition a year ago, maybe they could.  Rabobank seems dedicated to continue to issue its coca bonds.  One would assume that the cooperative will try to make the vaporization line as high as possible.  This desire will likely be tempered by the thought that, since its retail customers may be large holders of the cocas, the line should be set at a level where there’s only the remotest possibility that the vaporization clause will be triggered.  Last year that number was 7%.  This year it’s 8%.  My guess is that as/when confidence continues to build in Europe, Rabobank will push the vaporization threshold higher.

Maybe the Rabobank cocas will become a bellwether for retail investor sentiment in the EU.  But it seems to me their success will be very little indication of prospects for other banks’ issuing cocos–particularly to institutional investors.