Notes From Underground: Who’s COO COO For CoCos?!?!?

The newswires over the weekend were quiet except for the continued mounting tensions in Egypt.  At this juncture It is too difficult to measure the impact of the political crisis on global financial markets as the situation is “fluid” and rumors run rampant. There is talk that the U.S. is cancelling scheduled military manuevers with the Egyptian army over displeasure with the crackdown on the Muslim Brotherhood. Soon after that rumor, news from Russia was that President Putin was putting the Russian military resources to the backing of the Egyptian army, reflecting the “fluidity” of the situation and Russia again reminding the world that the U.S. is not the only game in town. Even the Saudi foreign ministry has come out in its support of the Egyptian military in its efforts to combat the “forces of global terrorism.” I return to Yra’s first rule of global finance: “Money is FASCIST and craves stability.” While all this uncertainty clouds the political scene in the Middle East, the only constant is that the Europeans are meeting to decide what actions to take against the Egyptian military, so any sense of certainty about Egypt is probably a false algo-driven headline or TWEET.

***Two key pieces about the recent effort to sugar coat the economic news out of Europe. First, William Thayer has a piece in Barron’s, “Don’t Ignore the Greek Problem.” Thayer breaks down the recent Greek bailouts and shows how the bottom line is that the effort to smooth the debt situation has failed and Greece has used up most of the funds and the result has been almost no growth. He cites the Troika’s second bailout package of $220 billion that was supposed to keep Greece solvent until 2020. According to Thayer, just $14 BILLION remains, “barely enough to get the Greeks past the German elections in September.” The German elections have been a key event for Europe but with all the positive stories about European growth the outcome seems to be a sure victory for Chancellor Merkel. We will watch the polls to see if the ALTERNATIVE for GERMANY (AfD) Party is gaining any sort of strength heading into September. A political party has to have at least 5% of the vote to attain seats in the Parliament, a threshold that the AfD is presently polling below. Manfred Gullner, head of the German polling group FORSA, maintains that many of the AfD‘s voters are loath to admit it and that makes the polling numbers difficult to ascertain. If the AfD were to begin gaining momentum it would create some anxiety in the present complacent markets, especially the yields on European sovereign debt.

The SECOND key story was in the weekend Financial Times and was an article by one of my personal favorite financial journalists, John Dizard. In the piece, “The Pricing of COCO Bonds is Proving too Good to Be True,” he challenges the calm currently presiding in the European financial system. COCO is an acronym for CONTINGENT CONVERTIBLE debt instruments. It is a bond issued by a bank with a higher rate than market interest rates because it has a “reaction function” that causes it to convert to equity if a bank’s capital falls below a certain level, thus it acts to BAIL IN bondholders to become equity owners and ease the debt burden of the troubled institution. (It’s making sure that the private sector is the first line of defense in any banking crisis.) These COCO bonds are not callable and therefore act as perpetual financial instruments. In comparison, the preferred stock issued by financial institutions is callable and as I can attest much of the high yield preferreds issued during the debt crisis to shore-up financial institutions balance sheets has been called. Even my AIG preferreds have recently been called.

The difference is that Europe is now creating more of this high-priced debt just as the U.S. is paying down the high yields that the debt crisis demanded for institutions to rebuild their capital base. As Mr. Dizard asks: “Who is going to pay the revenue needed to support this expensive paper?” The European banks will continue to be saddled with high capital costs and it is just another peek behind the curtain of financial uncertainty. Why do sound institutions have to pay so much to rebuild their balance sheets and a European-wide nominal GDP growth of 0.5% is just not going to provide the economic strength to repair the financial system and the debt to capital ratios being demanded by financial regulators. Nothing is as it seems, which is why 2+2=5.

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8 Responses to “Notes From Underground: Who’s COO COO For CoCos?!?!?”

  1. Dan Says:

    Yra – 1) Any wagers on how the German Court will rule on ECB Bond buying program 2) If German Court rules Bond Buying Program unlawful what would ECB plan B look like, if any?
    3) Would love to hear any other thoughts you have on this event.

  2. Mario Says:

    Thank you all for the great feedback everyone and KEEP this coming it will be such a great compilation of minds within the finance world.

  3. Alex F Says:

    To definitively end the crisis, the eurozone needs to either introduce euro bonds or take major steps towards outright fiscal union.

  4. Notes From Underground: Looking Backwards … Again | Notes From Underground Says:

    […] Notes From Underground: Who’s COO COO For CoCos?!?!? […]

  5. Notes From Underground: Draghi is Laughing All the Way To the Bank | Notes From Underground Says:

    […] am linking a previous blog post from August of 2013 titled, “COO COO for CoCos.” After Mario Draghi’s market-stabilizing “Whatever It Takes” speech in July 2012, […]

  6. Notes From Underground: Time To Tidy Up a Few Issues | Notes From Underground Says:

    […] As Jim Grant reported, a Santander spokesperson said: “When making call judgements we have an obligation to assess the economics and balance the interests of all investors.” Translation: Owners of COCOS got “screwed” as the bank was able to save some money by reneging on the call and forcing the bondholders to accept a floating-rate instrument at a lower rate than the CALL. In August 2013 when financial institutions were gaga about COCOS to shore up the TIER 1 capital, NOTES FROM UNDERGROUND wrote a piece on August 18, 2013 warning about the shortcomings of these bonds (“COOCOO FOR COCOCS”). […]

  7. Notes From Underground: How Many `Whatever It Takes’ … | Notes From Underground Says:

    […] that caused so many Credit Suisse investors a great deal of financial pain. (Speaking of which, here is a post from 2013 in which we warned about the proliferation of COCO bonds.) The markets achieved a sense […]

  8. Srjean Says:

    What a prescient post.

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