It is hard to believe that NOTES FROM UNDERGROUND is approaching its 1,000 blog post. Many of the themes touched in my analysis have had an echo effect. Certain themes have continued to provide trading opportunities over and over. 1. The European financial crisis; 2. The Fed’s destruction of the bond market; 3. The ECB‘s destruction of European sovereign debt markets in an effort to preserve the Maastricht strait jacket. 4. Russian geo-political moves on a timely basis to affect Putin’s desire for an increased role for Moscow on the world stage; 5. Japanese desires to fabricate an inflationary backdrop to ease the burden of debt overhang; 6. Too much or too little growth in the emerging market economies; 7. China’s desire too have an enlarged impact on the global financial system in fact and fiction; and oh so many more.
Presently we are saddled with an important financial problem that I wrote about in August 2013. The reason for republishing is not to blow my horn but to allow ourselves to understand how problems swept to the side by the algo headlines still remain a problem. The European bank stocks are the heavy drag on the markets. Today’s trading activity was a perfect example. The Asian markets were higher last night as the Chinese foreign reserve data was far more sanguine than the market had feared but once Europe opened this morning the downward pressure on European financials began a selloff of global equities, a rally in GOLD and BONDS and an eventual selloff in the DOLLAR.
The issue plaguing the European banks is the vast amount of COCO bonds that were sold in 2012, 2013 and 2014 in an effort to shore up bank balance sheets with contingent convertibles (or CoCo bonds). In a yield-starved world the large EU banks were raising capital by selling higher-yielding notes but the catch was that if a bank’s tier-one capital dropped below a certain level (5%) the bank had the RIGHT to convert the bond to equity, the worst possible outcome for investors. This has the property of a convertible bond except it is the borrower making the decision rather than the investor. The forced conversion of debt-to-equity is an investor’s worst nightmare as it loses a credit position to become an equity shareholder in a badly weakened institution.
I issued many warnings to personnel friends to avoid these instruments as all the large institutions were pushing yield-starved clients into these toxic instruments. It seems that banks such as DEUTSCHE BANK are being sold as investors try to keep ahead of the tsunami of equity issuance. Again, I reissue the previous piece in an attempt to explain the present situation and even the opening geo-political piece has relevance.
The Russians are now firmly implanted in the Middle East negotiations and been able to secure a position in both the Sunni Arab camp and well as the Shia Iranian group. Russia is siding with the Sunni Arabs and is leaving the Erdogan Turks for the U.S. but at some point Putin will push the envelope to find how far NATO powers will go to aid Turkey. This will continue to be a theme for I think that President Putin will try to demolish NATO by seeing how far Western powers will go in defending Turkey. Putin will choose his time and place to embarrass Erdogan and provoke him into another ill-advised action. I would advise dusting off the Franco-Prussian War of 1871 to see how Bismarck so successfully baited Napoleon III into a war he didn’t want. I’m just hypothesizing but it’s worth watching, especially as the world will be distracted by refugees, the Olympics, debt crises and U.S. politics. Never a dull moment.
The SECOND key story was in the weekend Financial Times 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.