The Hunt for Yield Can Turn Bad Fast -- WSJ
June 09 2017 - 3:02AM
Dow Jones News
By James Mackintosh
When billions of euros of the riskiest bank bonds vanish
overnight at the whim of regulators, investors are entitled to
wonder if the reams of detailed documentation for similar bonds at
other banks are worth the paper they're written on.
Banks no longer go bankrupt, as the process has been renamed
"resolution." But the collapse of the contingent convertible bonds
at Spain's Banco Popular Español, from 100 cents on the euro at the
end of March to zero on Wednesday, summons to mind Ernest
Hemingway.
Asked how he went bankrupt, one his characters responded: "Two
ways. Gradually, and then suddenly."
In one way the swift execution of Popular was a successful first
test of Europe's new bank-failure regime, and the risky bonds that
underlie it. Taxpayers didn't pay a penny, there was no contagion
to other banks and Spain's sixth-largest bank opened its doors as
usual on Wednesday morning.
In another way it was a complete flop, showing the perils to
investors of relying on overengineered financial products. Popular
was the first failure of a bank with contingent convertible bonds,
supposed to provide a private-sector rescue by converting into
equity when capital falls below a specified level (in Popular's
case, one CoCo had a relatively high trigger at 7% of risk-weighted
assets). The extra capital is meant to keep the bank functioning on
its own, avoiding the need for painful bankruptcy or resolution
procedures.
Instead of converting the EUR1.25 billion ($1.4 billion) of
CoCos into shares, they were simply zeroed by the regulator, along
with the shares, while another EUR1 billion of junior debt was
turned into equity and sold for a symbolic EUR1 to Banco Santander.
Conveniently, this extra capital exactly matched the regulator's
new assessment of the shortfall, meaning senior debt and deposits
were untouched.
The process suggests that investors might as well not bother
reading the long and turgid CoCo prospectuses, and that time spent
building complex models of the options embedded within a CoCo is
wasted. If the regulator decides the bank is bust, the CoCo is
worthless; the rest of the time it trades like normal junior
debt.
CoCos are more like an insurance industry catastrophe bond
linked to unpredictable hurricane damage than they are like
ordinary corporate convertible bonds. Investors analyze the
political and regulatory winds, but like weather forecasts, their
reliability is limited. This unpredictability ought to make the
bonds look more risky.
"They [CoCos] are priced way too tight," says Brad Golding, who
runs a fund investing in bank bonds and stocks at hedge fund
Christofferson Robb & Co. "How do you price the non-modellable
risk of a regulator coming to your door the moment something looks
weird?"
Popular suffered a disastrous bank run in its final days, even
as it was trying to sell itself to bolster capital. A newly formed
post-crisis regulator called the Single Resolution Board said those
conditions forced it to act fast.
The rest of the CoCo sector was unperturbed by the Popular loss,
to the surprise of those caught up in the brief panic a year ago
around Deutsche Bank's CoCos.
One investor who lost money on Popular said everyone knew there
were problems, but thought the bank would manage to raise capital.
The lesson? "As soon as you get the first whiff of a problem you
should get out as quickly as you can."
Part of the reason is that CoCos haven't worked. In a bank
crisis a collapse in bond prices can be both an indicator of
trouble and self-fulfilling, as it shows the bank cannot tap
markets for more capital.
"When a bond really starts to trade down it's a signal to
regulators that the market doesn't believe in that institution, and
if the market doesn't believe in that institution, then it's not
viable," said Piers Ronan, head of financial institutions debt
syndicate at Credit Suisse.
This nasty cycle was one reason for the creation of CoCos, but
they can provide such a thin sliver of new capital to a bank that
they would make little difference.
CoCos are still one of the few places investors desperate for
yield can find something -- but dramatically less than a year ago.
One of Banco Bilbao Vizcaya Argentaria's CoCos yielded 16% last
June, but now offers 6%, and many European CoCos yield 4% to 5%.
With junk bonds yielding even less, this might attract some buyers.
But the speed with which Popular's junior bonds went from the
hospital to the graveyard should be a handy reminder of the risk
these CoCos bring.
Write to James Mackintosh at James.Mackintosh@wsj.com
(END) Dow Jones Newswires
June 09, 2017 02:47 ET (06:47 GMT)
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