CoCo the Clown was the most renown United Kingdom clown during the middle years of the 20th Century.
All market observers know about the “standard” factors that continue to buffet the stock market back and forth, up and down (but more often down lately) with atypical volatility:
The continuing collapse in the price of oil (and continuing build up of oil inventory — much of it floating in tankers around the world).
Ongoing pressure on commodity prices in general, feeding fears that many economies (and perhaps globally) are headed toward (or are in) a “deflationary spiral” (cycle of lower prices).
Global Central Bank Policies – particularly now that the U.S. Federal Reserve embarked in December on what it hinted would be a series of small rate hikes[1], thereby initiating “tightening” in a world of monetary easing.
And then, of course, we must remember China:
Chinese Economic “Slowdown”[2].
Devaluation of the Chinese Yuan (and the tumultuous price activity between the “onshore” and “offshore” Yuan).
Downward gyrations within the Chinese stock market (because of fear that the Chinese government has lost control … not to mention having lost the “confidence” of market participants).
However, within the past few months, and particularly in February, it has become apparent that a new and very unwelcome specter looms over the financial world… a specter that is exemplified by a relatively new financial term:
“CoCo”
If only those letters had an “a” tucked on at the end… it would be the beginning of “Cocoa Puffs” – something yummy and satisfying[3].
And of course, we have the most famous clown in Great Britain during the mid-20th Century:
“CoCo the Clown” (Nicolai Poliakoff in real life)
Alas, the “CoCo” that is related to the financial world is not anywhere near as interesting as the other “CoCo” listings one can find through a quick search of Google.[4]
However, apropos the referents above (Cocoa Puffs and CoCo the Clown), this particular CoCo has proven to be potentially deleterious to one’s (financial) health and was obviously designed by the clowns who regulate banks.[5]
This particular financial creation is the:
Contingent Convertible Capital Instrument
Notice that even its name sounds like one only a bureaucrat could love.
Why did regulators create this new security?
Hint: they were created during the 2008-09 period (although the first issuance took place late in 2009 (by Lloyds), the great majority of CoCos have been issued during just the past few years!)
Put bluntly, CoCos were created in order to boost capital levels at financial institutions – levels that were proven totally inadequate to survive the global liquidity crisis epitomized by the collapse of Lehman Brothers in September of 2008. At that point, governments were forced to step in to stabilize the financial system[6]; and we know that politicians detest becoming tarred and feathered through “blame” for anything – especially when that for which they are blamed cost billions of dollars (or Euros, etc.).
So CoCos were deemed to be (from the regulators’ vantage point, a least) a winning proposition by virtue of the following logic[7]:
1) Regulators needed to raise the levels of required bank capital/reserves;
2) The enticingly higher levels of interest paid by a CoCo security would attract investors – particularly within the low-interest rate environment we’ve had since the advent of Quantitative Easing.
3) The proceeds from CoCo issuance would prop up capital levels within banks.
4) In theory, those higher bank capital levels would insulate banks from future liquidity crises… thereby sparing governmentS from future bailouts.
A quite natural question to pose at this point is: “Where is the catch?
By the terms of these securities[8], under certain (defined) conditions, any bank that has issued a CoCo is permitted to skip interest payments on a CoCo without defaulting. So if such a bank experiences a period of financial/capital stress, that bank can suspend interest payments until such time as payments can safely be resumed … or else the CoCo is converted into common equity in that bank (or its principle is “written down”).[9]
In the chart below, the CoCo security is (almost always) a part of the “Tier 1 bonds” category at the very bottom of the “Subordinated Debt” section within the typical bank capital structure. Based upon my description above, that is where those securities belong… and because of the possibility of being converted into common equity, regulators actually refer to them as “Alternative Tier 1 Capital”.
Here is a view of a bank's "Capital Structure" as understood by European bank regulators.
Clearly, this is a security that only a government regulator could love!
From “CoCo: A Primer”[10], we learn that “the bulk of the demand has come from private banks and retail investors, while institutional investors have been relatively restrained so far.” That in itself should be a red flag for investors!
Let’s review the “Contingent” portion of the CoCo security structure. I consider myself a reasonably intelligent person. However, I confess that the details entailed in determining when a bank qualifies to exercise the “Contingency” features of any particular CoCo makes my eyes glaze over.
1) The only simple part of this determination is that it is triggered when a given bank’s capital ratios move below levels set through the Basel Agreements (ie. the Basel Committee on Banking Supervision);
2) The complex and technical part of CoCos involve the calculation of a bank’s “Available Distributable Items” (ADI).
a) In fact, the ADI calculation comes into play within a wide range of bank matters – from whether it can pay out bonuses to whether it is permitted to distribute dividends… in addition to whether it is in position to pay interest on its CoCo security(ies).
b) The calculation is made based on audited financials (to curtail shananigans)
c) However, complicating this matter considerably is the fact that not all banks follow an international standard with regard to the ADI calculation. We’ll very shortly see why/how this fact has become particularly germane this year! [See my detailed explanation later in this article.]
In light of all the above, I imagine that you are just as leery about the CoCo as I am. Given the origin of the CoCo (coming from the bureaucracy of European bank regulation) I do feel compelled to offer a nod of approval to the Financial Conduct Authority (FCA) in the United Kingdom! The FCA has determined that CoCo instruments are:
“not appropriate instruments to be offered or sold to ordinary retail investors in the United Kingdom.” [11]
Its rationale is as follows:
“it regards contingent convertible instruments as highly complex and as having unusual loss absorbency features which together create the risk that these instruments will be inappropriately sold to ordinary retail investors.”
So kudos to that UK bureaucracy for recognizing and publicizing what I should have thought would be obvious!
Why is the CoCo security relevant now? After all, the Basel I, II, and III agreements have made the world’s banking system more secure, correct? Surely governments and their bank regulation staffs have learned from the 2007-09 Financial Crisis and reformed the system’s weak points! Therefore, we can assume that it will be a “blue moon” before we have another such financial crisis!
Not so fast!
It was during the first week of February that my attention was drawn toward banks. As a sector, they under-performed the S&P 500 Index in January – despite the supposed “tail wind” of higher interest rates due to the U.S. Federal Reserve. In particular, the price chart for Deutsche Bank AG (DB) more closely resembled that of oil rather than a major global bank. So I started digging into the details.
During 2015, DB had quite a rough year:
Although the S&P 500 Index returned 2.49% during 2015, DB lost 16.44% on the year. As a point of reference, the iShares MSCI Europe Financials ETF (EUFN) only lost 5.75% during 2015.
Continuing this discouraging story about DB, here is the YTD chart of DB:
Through Friday, February 12th, 2016, DB had lost just over 26%, while EUFN lost 16.88% and the S&P 500 Index drooped just 7.35%!
What precipitated this steep drop in DB?
At the end of January, Deutsche Bank reported a 2015 fourth quarter net loss of EUR 6.8 billion (this was the bank’s first annual earnings shortfall since the 2008 financial crisis). In fact, the earnings report was so horrible that the decision was made to forego paying out any bonus to DB board members!
Surprisingly, during the days that followed, matters became even worse. In fact, market activity surrounding DB in January and early February serve as a great study in investor anxiety and market volatility. By February 8th, market perceptions regarding DB became so negative that the bank's CFO (Marcus Schenck) issued this public statement:
This is Marcus Schenck, the CFO at DB.
“In 2017, we anticipate that our AT1 payment capacity will be approximately 4.3 billion euros before the effect of this year's operating results, driven in part by the disposal of our 19.99 percent stake in Hua Xia Bank, which we anticipate in mid-year 2016, in addition to our existing reserves.”[12]
Perhaps thinking that the CFO's statement was not sufficient, the CEO (John Cryan… who took over that role at DB just 7 short months ago) distributed a letter to DB employees the very next day (Feb. 9th) as a boost to morale and a resource for employees who might receive inquiries about the bank's financial condition from clients and/or friends.
This is John Cryan, the co-CEO of DB. He has been on the job for just 7 months. I feel badly for him!
The central point that Cryan emphasized was that the bank is “rock solid, given our strong capital and risk position.” Here is an excerpt:
“Volatility in the fourth quarter impacted the earnings of most major banks, especially those in Europe, and clients may ask you about how the market-wide volatility is impacting Deutsche Bank.
“You can tell them that Deutsche Bank remains absolutely rock-solid, given our strong capital and risk position. On Monday, we took advantage of this strength to reassure the market of our capacity and commitment to pay coupons to investors who hold our Additional Tier 1 capital. This type of instrument has been the subject of recent market concern.
“The market also expressed some concern about the adequacy of our legal provisions but I don’t share that concern. We will almost certainly have to add to our legal provisions this year but this is already accounted for in our financial plan.
“The Management Board also discussed its vision for the bank. For us, a vision defines our aspiration for the bank, and what we want it to be. It’s important because it creates clarity of purpose and unites all of us in achieving common and worthy goals.
“Our vision is to be a trusted and successful bank. We aim to deliver financial solutions, technology, products and services that exceed our clients’ expectations. We want to be the most respected financial services provider across all customer segments in Germany, our vital and strong home market; the number one bank for our corporate, institutional and fiduciary clients in Europe; and the best foreign bank in the United States and Asia.”
This concerted public relations effort on behalf of DB was further escalated that same day, when the German Finance Minister (Wolfgang Schaeuble) offered official governmental support, saying: “I have no concerns about Deutsche Bank.”
This is the German Finance Minister: Wolfgang Schaeble. I picture him lecturing Greece about poor fiscal management.
Of course it is uncertain whether Schaeble's support for DB was solicited by Cryan, directed by Angela Merkle (Germany's Chancellor), or self-initiated. But no matter who or what prompted the statement, it was clearly offered in the context of trying to calm a roiled stock market. That being said, despite all these reassurances, at the Market's close on 2/9, DB stock was down by 4.27% — after having fallen a scary 9.5% the day before!
The unfortunate truth is that DB is not the only Eurozone bank that has been struggling. In fact, the Stoxx Europe 600 Bank Index has (leading up to 2/12) suffered six consecutive weeks of declines, the worst such streak since 2008. Among the banks that joined DB in suffering significant market pressure have been:
BNP Paribas (BNPQY)
Barclays (BCS)
Intesa Sanpaolo (ISNPY)
In general, investment banking revenue in Europe has been shrinking due to a wide variety of factors – with the most obvious ones being the collapse of oil prices, ongoing concern about an economic slowdown in China, and struggling emerging market countries. As an example of these challenges, in February Credit Suisse Group (which has thus far escaped the level of concern about debt that has plagued DB) reported its largest quarterly loss since the financial crisis.
This independent investment research firm released a critical report about DB less than two weeks following its very, very weak 4th Q Earnings Report.
Adding fuel to the (proverbial) fire, in early February (less than 2 weeks after DB’s nightmarish earnings report) an independent research firm (CreditSights) published a detailed report that minced few words is questioning DB‘s ability to meet its corporate debt obligations amid ongoing restructuring costs, litigation charges and tough market conditions. [The report was so pejorative that it is referred to as: “Deutsche Bank Meltdown”]. The following comes from that report (by analyst Simon Adamson):
“It is certainly a weak credit story at the moment, undermined by the probability of a protracted and painful restructuring period.”
CreditSights focused particular attention upon CoCo’s, suggesting that DB could struggle next year in its effort to make its payments on those notes.
Within this time period, a fund manager at Brandywine Global Investment Management (Gary Herbert) offered this opinion:
“The worries about these bonds represent real fears that the European banking system may be weaker and more vulnerable to slowing growth than a lot of people originally thought. It’s the epicenter of growth concerns globally. And it doesn’t look pretty.”
Obviously, it was this type of negativity that the DB CFO, then its CEO, and finally the German Finance Minister, were each attempting to reverse. So here we have a case within which German officials and bank executives have been making every effort to reassure the market… while most analysts remain, at best, cautious, if not skeptical. Which do you place more faith in?[13]
The market itself has been answering this question since the latter part of 2015. Market sentiment regarding the risk of a DB default on its bond obligations is on display on a daily basis within the chart for Credit Default Swaps (CDS):
Here is the CDS Chart on DB Credit Default Swaps (CDS).
First, let me offer a condensed explanation of CDS:
The cost of Credit Default Swap contracts can best be understood as a price mechanism that reflects the market’s perception regarding the likelihood of a default (in this case, a default by DB). Just as is the case with insurance policy costs, as a risk increases, so does the cost for protection against that risk!
To put all of this in further context, there have been two other occasions during which CDS have risen to this degree:
1) the 2007-09 Credit Crisis
2) during the 2011-12 crisis that surrounded the PIIGS (Portugal, Ireland, Italy, and Spain).
In addition, causing (or merely reflecting) increased market anxiety has been the substantial widening within investment-grade credit spreads … a widening which started months ago within the junk-bond market (because of its outsized exposure to oil and gas companies)… and has been expanding further since then.
All of this activity with regard to earnings, analyst reports, and market movement has placed a bright spotlight on CoCos [which as you’ve already read, are not “standard” bonds].
Ironically, during most of 2015, CoCos were “hot” in the market – netting lucky investors an 8% return on the year [per data from the Bank of America Merrill Lynch Index]. They were in high demand because high yields have been very hard to find.
However, as 2015 drew to a close and 2016 dawned, investors started to be aware that the high yield attached to CoCo securities came attached with considerable risk [as we detailed earlier]. Take a look at how quickly these former “high-fliers” have fallen since January 1st:
One of the most telling (and entertaining) of the descriptions of the CoCo security which I uncovered has come from a portfolio manager at Axiom Alternative Investments (Gildas Surry):
“instruments of regulators, by regulators, and for regulators!”
One credible source has pegged the total volume of all existing CoCo securities at EURO 91 billion ($103 billion).
To oversimplify the dynamics involved in this issue, pressure on banks come from three sources:
1) Souring Loans (aka “Bad Debt”):
a) If banks today have a surfeit of anything, it is souring loans based in (among others)
i) Greece, Spain, Italy, China, select Emerging Markets
ii) And don’t forget the Middle East and oil and gas companies in any number of nations
2) A dramatic and systemic shift in the ways banks do business and generate profits. Regulatory changes that arose following the 2007-09 Financial Crisis have been “deep and wide”.
a) By most accounts, these changes have left banks somewhat less vulnerable to crisis due to their higher capital requirements;
b) However, that has come at a significant cost on the profit margin side. In the past, several historically high margin bank activities served to offset losses in the inevitable “lean years” a bank suffers.
c) Consider “debt trading” as an example.
i) It used to be one of the most lucrative businesses with big banks.
ii) Ironically, since 2010, trading volumes on corporate and government bond debt have (generally) been trending upward.
iii) In addition, yields on riskier corporate debt have been increasing (providing wider spreads and more profit for trading desks).
iv) However, just as this business has been growing and profit margins increasing… banks have been cutting back…. and (I emphasize) not by their own choice!
v) As one example, BNP Paribas SA still plans to cut more of its trading business, despite the fact that it just reported higher trading revenue in the most recent quarter! Why? As analyst Michael Seufert opines:
“all banks are under pressure to shrink capital intensive trading businesses, especially in fixed income.’’
vi) In addition, more trading has been moving to electronic trading networks… greatly reducing the big “value add” that banks formerly provided:
“Price Discovery” and timely, market moving information.
vii) As a result of these developments, those bank traders who remain in position are younger, less experienced, and much more comfortable and equipped for the distribution of newly issued bonds rather than successfully (and profitably) managing the complexities of the secondary market – which formerly thrived as a mini gold mine for banks because its old-style bankers had built (over the years) such large and active trading networks (ie. they milked their long-term relationships).
3) Negative Interest Rates: which have been expanding.
a) Negative yields (intentionally or not) act as a punitive tax on banks (since it materially reduces their profits from interest rate spreads).
b) In recent articles we have quoted from a number of learned, respected skeptics who have seen (for some time know) the inevitably of the global economy continuing to struggle (and even slump). The most telling skeptic has been Jeffrey Gundlach (See: https://www.markettamer.com/blog/gundlach-on-the-feds-amazing-blunder) who is not afraid to offer his opinion regarding the inept management of monetary policy by the U.S. Fed and other central banks.
c) As market pundit Mike Larson has opined, after a number of central banks cut rates into negative territory, bank stocks plunged and markets became spooked – making the situation materially worse.
d) It didn’t help that during her testimony before Congress on February 11th and 12th, Fed Chair Yellen refused to rule out negative rates in the U.S.
As we can see, the world of global banking isn’t exactly rosy at the moment! But even beyond all the headline “bad news” upon which we have touched, the EURO 1.75 billion (just under $2 billion) of Deutsche Bank’s CoCo securities face an additional obstacle in terms of their attractiveness to investors:
German Generally Accepted Accounting Principles
“Huh?” you gasp!!! “What does that mean?”
Let me try to explain it as simply as possible:
- The key metric that determines the appeal of a CoCo from any German bank is what is referred to as:
- Available Distributable Items (ADI)
- This metric is defined within the official German “Commercial Code”
- The calculation of ADI determines whether or not any particular German bank has any assets available with which to pay the interest due on a CoCo in any given month or quarter!
- As we know, if the bank has no “ADI” available, the bank is not required to pay interest!
- The accounting rules for income, assets values, and “ADI” is considerably different in Germany than that reflected within the accounting standards required by International Rules!
|
International Rules |
German Commercial Code |
|
| NET INCOME | Mark Asset Values to market prices | Apply a much more conservative standard |
| Unconsolidated income of the bank’s parent company, as defined by German accounting principles | ||
| Commentary | More typical definition of income as seen globally | The code can be perceived as focusing upon the needs of creditors rather than those of shareholders |
| Example for DB Net Income in 2014 | 1.691 billion euros per IFRS (Int’l Fin’l Reporting Stds) | 1.263 billion euros |
To complete a calculation of ADI for a German bank, one then adds to Net Income the following:
Distributable Reserves
Profits carried forward from previous years
However, there are amounts that must then be subtracted:
Losses carried forward
Funds that are blocked (by German commercial code) from distribution:
Value of self-developed intangible assets
Unrealized gains on assets held for pension liabilities
Deferred tax assets (the biggest category in a DB calculation)
[Example: In 2014 DB reported 5.483 billion euros in blocked assets… of which 65% were deferred tax assets!]
What this means (to far oversimplify) is that if an investor held $10,000 in CoCo bonds from DB and $10,000 in CoCo bonds from Barclays Bank in the U.K. … and by some nearly impossible quirk of fate those two banks had identical financial reports for any given period, it is entirely possible that the owner of a Barclays Bank CoCo would receive the entire amount of interest due for that period while the owner of a DB CoCo would receive less than the full amount due (or possibly, nothing).
Somehow I sense that Lewis Carroll is yearning to return from the grave to write a new novel that takes the Alice in Wonderland storyline and reshapes it around the current world of the stock market, Quantitative Easing, the German Commercial Code, and CoCo bonds!!
INVESTOR TAKEAWAY:
Yes, more and more frequently, as I participate within the investment markets in 2016, I feel like Alice in the Lewis Carroll classic. It is certainly nothing like the world I knew when I first started investing in the 1970’s!
What can we learn from this article? I hope you agree that the following can serve as a handy summary of key points to remember:
1) Never buy an investment unless you can truly say you “understand” it!
a) I doubt that more than 50% of those who bought a CoCo bond in 2015 truly “understood” them!
2) Never ever (ever) think that central bankers have your interests at the forefront of their mind! Their agenda has little (or more likely nothing) to do with your welfare!
3) If you are tempted to jump into European bank stocks (such as DB) because their price has been beaten down to incredible low levels… remember that the only thing that any of us can guarantee about DB stock (or any stock) is that it can never go below $0 in value!!
Let me end by offering you some observations offered in a recent letter written by Deutsche Bank’s own Dominic Konstam (the global head of interest rate research at the DB office in New York City).
In that letter, Mr. Konstam offers analysis and opinion regarding the current global economic environment and market conditions.
In particular, Konstam suggests that we understand the following:
- The problem is not the banks or oil… the problem is a run on central bank liquidity – in particular, dollar-based liquidity.
- There needs to be more dollar liquidity.
- John M. Keynes said that to deal with an over-investment boom, you should not raise rates.
- QE has been impractical, but getting the value of the dollar down would greatly increase dollar-based liquidity.
- Mario Draghi (head of the ECB) should open up the “Re-Fi” spigot for banks and thereby ease liquidity concerns.
- China should come clean, stabilize reserves, and shore up strategically important institutions. In particular, Beijing should stop intervening in equity markets!
- Basel III should be delayed, specifically with regard to leverage ratios. As a token effort, there should be de-emphasis of the SSM/bail in rules until there is clarity from the ECB on liquidity sources for stressed banks.
- The world needs some fiscal stimulus.
- Regarding “Negative Rates”:
- Instead of making them punitive on the banks…. We should allow them to earn the spread!
- Cash should be charged interest.
- Put the “micro chip” in large denomination notes… tax cash withdrawals… encourage spending rather than saving.
- The spread is the problem (banks must be able to earn the spread)… not the rate.
You know friends, these days it is really difficult to know for certain who the key players are. For example,:
Here is the Chesire Cat
but the only character who more or less “stands apart” from the madness of Wonderland and helpfully instructs Alice that “to be in Wonderland is to be ‘mad’, [revealing] a number of points that do not occur to Alice on her own.”[14]
This is the Queen of Hearts
Of course, we all know that the Queen of Hearts is Dr. Janet Yellen (and consider this from the same source as that referenced above):
“the Queen of Hearts’s power lies in her rhetoric. The Queen becomes representative of the idea that Wonderland is devoid of substance.”
DISCLOSURE:
The author has never owned DB. More to the point, he tends not to trust banks as investments. He has positions in the S&P 500 Index. Nothing in this article is intended as a recommendation to buy or sell anything. Always consult with your financial advisor regarding changes in your portfolio – either subtractions or additions.
FOOTNOTES:
[1] We’ll see how that goes. I remain skeptical. See: https://www.markettamer.com/blog/gundlach-on-the-feds-amazing-blunder
[2] It is ironic that although its economy is one of the strongest growers in the world (at least 6%, compared with the U.S. growth hovering around 2% and Europe’s nearly non-existent growth), this ongoing, incremental slowing is exerting such a huge impact.
[3] Albeit quite non nourishing.
[4] Those who Google “CoCo” will quickly see that I have inelegantly bypassed the “CoCo” referent that has (by far) the most numerous listings!!
[5] It so happens that the “CoCo’ security was designed by European bank regulators… but I have complete confidence that U.S. regulators are entirely capable of designing a security equally as atrocious.
[6] Such as through TARP in the U.S.
[7] Note that I use the term “logic” with great reservation.
[8] Terms contained in detail in the fine print of a prospectus.
[9] A sobering thought: If CoCos existed in 2007-08, how comforting would it have been to have your Leman Brothers CoCo converted into Lehman Brothers equity???
[10] “CoCo: A Primer” byStefan Avdjiev, Anastasia Kartasheva, and Bilyana Bogdanova: www.bis.org/publ/qtrpdf/r_qt1309f.pdf
[11] This quote and the following are found on page 12 of: http://media.mofo.com/files/Uploads/Images/FAQs-Contingent-Capital.pdf
[12] The planned disposal of Hua Xia Bank, for up to €3.7 billion, is part of a strategy to narrow Deutsche Bank’s focus and sell assets to shore up capital buffers. This restrucuring program also includes parting company with Deutsche Postbank AG, the Bonn-based retail lender.
[13] Personally, my gut tells me that whenever executives begin making strong and unconditional statements about financial health… followed by politicians telling investors “Not to worry”… I am far too strongly reminded of George McGovern’s statement following the emergence of doubts about his selection of a V.P. running mate for the 1972 Presidential Election (Sen. Thomas Eagleton): McGovern stated publicly that he would back Eagleton “1000 percent!” Alas, far too soon thereafter, McGovern asked Eagleton to resign his candidacy. (Kennedy in-law, Sargent Shriver, replaced him on the Democratic ticket).
[14] From Sparknotes: http://www.sparknotes.com/lit/alice/canalysis.html
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