Based in Las Vegas, Douglas french writes about the  economy and book reviews. 

The Trouble with CoCo

The Trouble with CoCo

Holger Zschaepitz‏ tweeted Friday morning,

Good morning from #Germany, where the situation at Deutsche Bank continues to deteriorate. The yield on the 6% coco bond has shot up to 10.3%, the highest level since 2016. Investors do not trust Germany's biggest lender to survive the next recession unscathed.

In another tweet Zschaepitz pressed the point,

It looks like Deutsche Bank is in a downward spiral where shareholders and credit investors are frightening each other. Share price keeps falling while 5y default probability jumps >15%.

This Thanksgiving weekend, the German banking behemoth's shares (DB) closed friday at $9.25.  Back in 2007, these same shares changed hands for over $145 apiece.

Most folks know what shares are, CoCo bonds are a more esoteric financial animal.  Almost Daily Grant’s explained,

CoCos are a peculiarly-structured investment specimen; perpetual debt securities which are convertible to equity or written down when the sponsoring bank runs into trouble and capital falls below a certain level.  Issuers’ ability to raise equity at times of stress earns these CoCos the seal of approval of European bank regulators.    

CoCos are similar to trust preferred debt that community banks in the U.S. stuffed balance sheets with in the early 2000s.  While trust preferred was debt, the terms were so liberal, banking regulators allowed banks to count the debt as equity. When real estate crumbled, causing banks to seek re-capitalization, selling stock to replenish capital was a non-starter as trust preferred holders required any new capital raised be applied to their debt first.  Failures ensued en mass.

The Wall Street Journal weighed in trust preferreds in 2011,

Banks, which won approval to issue Trups in 1996, once saw them as a way to quickly raise cash while using the proceeds to bolster their regulatory capital requirements. But unlike dividend payments or preferred stock, interest they paid on Trups was tax-deductible, like other debt, making them a win-win for banks. But interest has dropped after the 2008 credit crisis felled a number of big banks, making investors wary.

CoCo demand is reminiscent of the rush to issue trust preferred debt 20 years ago.  When all goes well perpetual debt sounds great, then it doesn’t. CoCo demand was on a tear in May when Grant’s wrote,

Naturally, CoCo’s solid recent performance and friendly stance from regulators have paved the way for bustling growth. MSCI calculates global CoCo supply outstanding at $675 billion as of September. That compares with €80 billion ($93 billion) in July 2014.

Grant’s calls CoCo debt “untested investment contraptions,” however the CoCo debt looks a lot like Trups, which were only as good as the bank assets rested atop the pseudo equity.

In 2014, Grant’s wrote that what happens with CoCos doesn’t stay with CoCos.

Conversions or write-downs, when they’re finally forced, won’t take place under wraps. The news will start a highly focused reassessment of the creditworthiness of the stricken CoCo issuer or issuers. Providers of short-dated liabilities – certificates of deposit, uninsured deposits, commercial paper – are likely to arrive at the same conclusion more or less simultaneously.

Meanwhile, whistleblower Howard Wilkinson said “a European Bank” was used to siphon off nearly two-thirds of the $230 billion of suspect funds handled by Danske Bank.

The “bank” is widely believed to be Deutsche Bank.  

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