there may be a real life for contingent convertibles, after all

why I don’t like co-cos…or, (more) evidence investment bankers are on the dark side

Investing is conceptually very simple but emotionally very difficult.

Under most conditions, professionals can resist the Dr. Frankenstein-like impulses of investment banks to create bizarre security hybrids.  Not at the top of the market, though.  There’s something in the air that makes portfolio managers throw away their pocket protectors and revel in the purchase of the trashiest securities.

PMs will rue these buys for the rest of their careers–which may, incidentally, be quite short periods of time if they don’t recover their senses and sell the stuff on while a market for them still exists.

One of my favorites in this genre was a convertible bond issued in 1993 by Hong Kong-based New World Development, an indifferently managed family-owned property conglomerate.  It carried no coupon and was convertible on undisclosed terms into shares of a mainland Chinese company that did not yet exist.

And you ask me why I’m not a fan of investment bankers.

As it turned out, the issue met with high demand despite its dubious character–a sure sign that the markets were in the grip of speculative fever.  Right afterward, I was chatting about it with a highly skilled colleague, who confessed she had actually taken part in the deal.  Her reasoning?  In her peer universe there might be a half-dozen offerings during the year that would make or break performance versus competitors.  She felt she couldn’t take the chance that the deal would not only be successful but would trade up strongly in the aftermarket.  She didn’t want to be left in the unusual (for her) position of eating competitors’ dust.

co-cos, the brokers’ latest creation

Contingent convertibles are more recent spawn of the investment banking tendency to birth nightmarish creatures.

The idea is that the vehicles, known as “co-cos,” would be issued by financial companies, especially banks, that are required to maintain minimum levels of equity capital.  They start out as bonds.  But if the issuer’s financial condition deteriorates beyond a certain level, they automatically convert into equity.  Therefore, investment banking proponents argued, they should be considered as equity by the regulators even before conversion.  (True to form, when the original idea was floated, the intention was to not specify in the offering documents what circumstances would trigger conversion.)

not a winner…

Co-cos have never taken off.

The obvious flaw, other than that no one would know what would prompt conversion, is that the buyers would be bond portfolios.  They’d be reeled in with the promise of higher-than-average coupons.

If the issuer’s capital ratios deteriorated, its stock would sag significantly.  If conversion of the co-cos followed, that would leave large amounts of stock in the hands of PMs whose client agreements don’t allow them to hold equities.  So they’d have to dump the securities right away into a depressed market, sending the issuer’s stock lower and making its problems worse.  In fact, anticipation of conversion might launch the stock of the issuer into a severe downward spiral.

Also, the Bank of International Settlements said the idea wouldn’t fly.  Finally, the co-co idea also came too close to the disastrous demise of their close cousins, hybrid bonds.

…until now

It now looks like co-cos may actually have a use, according to the Wall Street Journal.  The buyers won’t be private investors, however.  They’ll be the governments of Spain and Portugal, which will use the vehicles to inject money into ailing banks.

Why use co-cos? Three reasons:

–the injections of money will look like investments, not the bailouts they really are,

–Spain and Portugal will get securities in return for the money they pour in, so their government deficits won’t increase, at least on paper, and

–Madrid and Lisboa won’t appear to be partially nationalizing the weak banks, which is what buying equity directly would mean.

I’ve never seen this before–an instance where a crackpot, top-of-the-market, caveat emptor ploy by investment bankers to boost their bonus pool is actually useful.  It’s nothing like what the i-bankers envisioned, of course, but still…

systematically important banks: BIS says “No, no!” to co-cos

the BIS and “too big to fail”

The Bank for International Settlements, the unofficial rule setter for the world’s commercial banks, is in the process of making new guidelines to govern the behavior of systematically important (read: really big, or “too big to fail”) banks.

extra capital needed…

A couple of days ago it aired new regulations that would force the biggest banks to hold more capital to back a given loan than a smaller bank would need.  The bigger the bank, the more capital necessary.  And if a jumbo bank tried to become jumbo-er by adding net new loans, it would need even a higher level capital to back those.

The thrust of the rules is to create economic incentives for banks not to get bigger, or even to break themselves up into pieces, so that the potential failure of  one massive bank would no longer threaten to bring down a country’s entire financial system.

…through co-cos?  No, thank you.

During the discussion, the question arose as to whether the BIS would allow this “extra” capital to be supplied, not just by equity, but by  convertible securities (co-cos) as well.  The BIS said no.

why not

It didn’t supply reasons, but I think it’s easy to see why (before I go any further, I should warn you that I’m not a fan of gimmicky securities like co-cos, as you can see from this older post.  I may have gotten a little carried away when I was writing it, but I still believe what I wrote then.):

bondholders and stockholders have different points of view about the issuers of the securities they own.  The former care mostly about collecting their coupon payments and getting their principal returned at the end of the bond’s life.  Shareholders want healthy growth of the enterprise, so that they get a higher stock price and greater dividend payments.  Shareholders tend to make waves; except in extreme situations, bondholders don’t.

If the idea of the extra capital is to have more people with a strong interest in preventing aggressive expansion of the loan book, you probably want to increase the number of professional equity investors with an interest in the bank, not replace them with bond fund managers.

no one knows how contingent convertibles will work in a crisis.  In particular, if the conversion provisions of a co-co are triggered and the security becomes an equity, bond managers who own it (and whose contracts with customers doubtless bar them from holding stocks) will be forced to sell.  Having lots of stock in a troubled company being dumped on the market and forcing the price down probably won’t make the bank’s situation any better.  If it prevents the firm from raising new equity, it could make things considerably worse.

a flaw in the terms of existing co-cos has been detected. Commercial banks and their investment bankers want the co-co conversion trigger to be based, as is the Lloyds TSB issue I wrote about in my original post, on the level of equity shown in the bank’s accounting statements.  We’re currently seeing in the EU financial crisis an example of the extreme unwillingness of governments and politically connected banks to write down the value of impaired assets (in this case, Greek government bonds).  But it’s the process of loan writedown that forces the co-co conversion into new equity.

In other words, in a future crisis, governments may not permit their banks to acknowledge that their capital is impaired.  So the conversion of co-cos may never be allowed to take place–meaning that the institutions will be seen to be even more leveraged than thought.




bondholders’ responsibility for banks: contingent convertibles and Anglo Irish Bank

Europe seems to want to change the culture of their banks and bondholders from one of “gentlemen’s understandings” that governments and equity holders will suffer all the pain in the case of bank failure to one where legal and covenant obligations will be enforced–meaning bondholders, too, will participate financially in bank restructuring.

One vehicle being pushed in the contingent convertible, an instrument that I’ve regarded as a top-of-the-market gimmick that looks good on paper but has the potential to end in tragedy.  European governments appear to be pushing it as a concept, however, because COCOs spell out explicitly what the bondholders’ obligations are in case the issuer has difficulties.  There’s no room for negotiation, no ability for a politically connected holder to put pressure on the bank regulator to take a soft stance on a certain tranche of bonds.

Europe appears to me to be taking this new attitude a giant step farther in the case of debentures of the failed Anglo Irish Bank, a property-oriented institution that proved to be a monument to opacity in lending.

The Irish government is offering to issue new, Dublin-guaranteed, bonds to holders of about €3 billion of various tranches of AIB debentures.  The rate of exchange would be: 1€ of the new issue for every 5€ of the old debt.  Holders of the affected AIB bonds, many of whom will, I think, prove to be hedge funds that bought in the secondary market after AIB failed, have squawked.  Their expectation apparently was to receive new bonds at something more favorable than a 4/1 rate.

Voting on the Dublin/AIB proposal will take place in December.

None of this is too surprising.  The rest of the government’s plan is, however.

According to the Financial Times, Dublin also wants accepting bondholders to agree to change the bonds’ covenants to provide that any holders who do not accept the offer will be forcibly redeemed at .001% of par–basically nothing.

Again, according to the FT, a result in favor of the exchange at the initial meeting requires that holders of two-thirds of the bonds vote and the 75% or more of the votes say yes.  If less than the required two-thirds attend the initial meeting, a second can be called at a lower quorum level.

Bloomberg says that investment bank Houlihan Lokey, representing a large enough proportion of the affected bondholders to defeat the proposal, intends to vote no.  The Irish legislature has also chimed in, suggesting it will pass a law allowing the exchange to occur without regard to the vote results, should bondholders reject the offer.  Houlihan Lokey apparently wants to negotiate with AIB, but the bank has refused.

This should be interesting.  Stay tuned.

More on hybrid bonds and contingent convertibles

Plato vs. Aristotle (the Greek version of Mr. T vs. Chuck Norris)

Ancient Greece, the cradle of Western civilization, lacked both bowling alleys and XBoxes.  This forced citizens to spend their leisure time debating the nature of reality.  On one side of the discussion were Platonists, who asserted that the physical world and all that is in it are imperfect copies of eternal, changeless and perfect Forms–the latter being the only truth. Aristotelians made up the other side.  They believed that truth was to be found through observation of the actual characteristics of things in the physical world–that there were no otherworldly Forms that worldly things aspired to be.

considering hybrid bonds

In looking at hybrid bonds (see my post earlier this week for a definition), Moody’s originally fell on the Platonist side.  In rating hybrids, the agency appears to have assumed that because the prospectuses called them bonds, that’s what they were.  It didn’t matter that they might have quirky characteristics–for example, not looking much like a bond at all (remember, too, that like all rating agencies, Moody’s was paid for its opinion by the issuers).

During the credit crunch, bank regulators have revealed themselves to be firmly in the Aristotelian camp, to a greater or lesser degree.  If it walks like an equity and quacks like an equity, they are saying, it is an equity and not a funny kind of bond.

Why does this make a difference?  In a reorganization or liquidation, equity holders generally lose everything but bondholders retain at least a part of their original investment.  Also, although I’m not aware that this issue has come up formally yet, investment management contracts with clients normally specify very clearly what kinds of assets a manager is permitted to buy.  Bond managers, who appear to be the majority holder of hybrids, are supposed to buy bonds, not equities.  If they buy a security outside their mandate and lose money on it, they expose themselves to possible lawsuits aimed at forcing the management company to compensate the client for those losses.

Moody’s has a new rating method for hybrids

Moody’s appears to have shifted to the Aristotelian side of the debate last week, although it is still referring to the securities as bonds.  It announced that it has developed a new methodology for rating hybrids.

The new scheme (unlike the original one) incorporates the  possibility that:

–the issuer might exercise its right to defer or eliminate payment of income on the hybrids and that

–in a reorganization an Aristotelian bank regulator would classify the securities, less favorably for the holder, as equities.

Individual hybrid results will be made known over the next three months.  It appears that the vast majority will be downgraded, some by more than one notch.  From the Moody’s announcement, it sounds like at least part of the downgrading will be a result of the differing behavior of bank regulators as to how they regard hybrids.

Contingent convertibles

The press is now calling them CoCo bonds.  Despite the cute acronym, the concept doesn’t appear to be going over well with bond buyers.  Over the past few days, regulators have been eager to say that they aren’t solely focused on CoCos, but have lots of other ideas as well.  Myself, I hope the other ones are better than this.  It’s a little disconcerting, though, that they talked about this one first.

Just for the record:  I think CoCos are non-starters in today’s world, where the chances of financial company restructuring are way higher than zero and where the scars of investor losses, in part due to carelessness, lack of analysis and excessive optimism, are still fresh.  Give it a few years though.  When the sun is shining every day and profits are rolling in, CoCos will likely come back–and be eagerly bought by bond investors with short memories (meaning almost everyone).

Hybrid bonds and contingent convertibles

Investment banking “practical jokes”

Every upcycle, clever investment bankers devise exotic securities that they sell to gullible portfolio managers, who come to regret their purchase decision almost immediately.  They continue to rue their bull-market impulsiveness for the many months it takes them to find (if they can) some even more gullible person to sell them to.

One of my favorite issues of this type was a wildly oversubscribed issue made by Hong Kong property company New World Development in 1993, at the height of an emerging markets mania.  It was a zero-coupon bond, convertible into shares of a China subsidiary of New World that did not yet exist, except as a name on a certificate of incorporation.

The hybrid bond

This time around, a leading candidate for purchase blunder of the cycle is the hybrid bond, a type of security issued notably by financial institutions.

What made these securities hybrid?  They had terms of 40-60 years, or sometimes were perpetual, that is, principal was never returned–just like stocks.  Also, the interest payment could be reduced or eliminated without causing a default.

What made them bonds?  A good question. That’s what they were called on the front page of the prospectuses.  This naming made them eligible to be purchased by bond fund managers.  The inducement to purchase was a relatively high yield.  The instruments ranked below all other bonds, just above equities, in the pecking order in case of bankruptcy.

If bonds were food, I think the Food and Drug Administration would have been alerted to hybrids, just like it was when Aunt Jemima was selling “blueberry waffles” that had no blueberries in them.  In fact, some tax authorities or industry regulators do classify the hybrids as equity. But a couple of years ago, this was regarded as another beauty of the hybrids, because having regulators count them as equity bolstered the issuers’ capital ratios.

Fast-forward to the present

Lloyds Banking Group  of the UK has a bunch of these hybrids on its balance sheet.  It wants to swap them for a new type of securities, which it is calling contingent convertible bonds.

The idea is that under normal circumstances the securities will be bonds, paying interest and having a bond’s liquidation preference over equity.  But if Lloyds gets into trouble (again), the securities would convert automatically into equity, losing their bankruptcy advantage and presumably their income payment as well.  The trigger for conversion would be Lloyds’ tier 1 capital ratio falling below 5%.

Yes, this is kind of like having medical insurance that terminates if you get sick.  No, it’s not a joke.  On second thought, though, this could be a little more investment banking humor. Sometimes, it’s hard to tell.

I can’t imagine contingent convertibles finding any takers in an original issue, other than at the tippy-top of the business cycle.  But Lloyds and the EU are playing hardball with the conversion offer.   Unswapped hybrids are set to cease making interest payments after the swap period ends.

The offer situation isn’t as bad as it looks at first blush, however–it’s worse. Not taking it may be very difficult to do.  Depending on their current carrying value in portfolios, post-exchange, post-interest-elimination hybrids may have to be considered as further impaired and written down.   Also, it seems to me that any remaining hybrids have got to be much less liquid than they are now.  So they may be impossible to dispose of, thereby having to remain on the lists of holdings sent to clients for some time to come.

Moral to the story?

I’m not sure there is one.  If we consider hybrids and contingent converts as two parts to one story, the combo probably rockets to the top of my list of bull market follies.  My only other thought is that this is Liar’s Poker all over again.

An update from Nov. 22nd

Here’s the link.