Friday, November 13, 2009

The Debts of the Spenders: Are CoCos the Answer to Solving Systemic Risk?

CoCos or "contingent convertibles" are bonds that convert to equity at a pre-determined event. But unlike regular convertible bonds, their trigger is based on a regulatory event instead of a price change. Risk managers, attorneys, and regulators are having a heated - if somewhat arcane - discussion about the value of these bonds. Supposedly, they will buffer banks' capital bases w/o resorting to dipping into the taxpayer base or diluting common equity with the issuance of new shares.

So, will it work?

Last week, Lloyd's of London offered £ 7.5 billion of CoCo bonds. So, now other banks are watching developments closely to see if the market will respond positively. I am aware of this issue and covered it earlier here: The underlying assets of these bonds can vary but include RMBS, CMBS, and other illiquid securitized tranches.

In the shady world of OTC (over the counter) finance, the big secret is that many European firms are huge holders of agency debt (Fannie and Freddie bonds) as well as more esoteric holdings.

1) CoCos are a stop-gap measure in the race to plug "Too Big To Fail" (TBTF). While regulators and politicians have publicly wrung their hands that they are going to "do something" about large financial institutions they have really done nothing except waste taxpayers' money on endless task forces, roundtables, and mutual myopia. The more effective solution would be to simply break up the banks into several smaller pieces. But alas, that solution would end Wall Street's and Europe's oligopoly on global finance.

2) Another aspect to consider is the dollar. As the value of the greenback continues to devalue so is the cost of carry for non-US (foreign banks). Many non-US banks - especially in the traditionally volatile emerging markets but also Western Europe - hold a large number of dollar denominated loans. Banks hold these loans because for historical reasons, the dollar is the world's reserve currency and offered a safe haven in the face of political and econoic volatility (a critical factor for emerging markets). But the value of these loans improves as payment conditions ease up for borrowers. Accordingly, these banks can book an increase in their asset values and/or a decrease in their liabilities.

Conclusion: In the meantime, I am bullish to steady on these bonds. After all, they are a bet on the status quo doing everything it can to perpetuate itself.


Disclosure: I hold some of these aforementioned convertible bonds. Not in Lloyd's though.
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