A new study, “Agency Costs of a Bail-In,” points to a new “in-vogue” investment, “CoCo bonds,” or Contingent Convertible bonds, being marketed to institutions and high net worth individuals that, while appealing to yield hungry investors, might be masking risk – particularly if a bank were to fall prey to another financial crisis.

CoCo bonds

Issues with the CoCo bonds

The report, from Kenjiro Hori and Jorge Martin Ceron of the Birkebeck University in London, considers two issues with the CoCo bonds: wealth transfer and value destruction associated with an equity conversion or a write down.  Certain bonds, when converted under certain conditions, could lead to the bond holder left with equity in a bank, for instance, that had very little if any tangible value.

The paper calls the CoCo bonds “an intricate product which is becoming in vogue in a low yielding environment, as investors rush into high yield instruments, and banks take advantage of it by issuing a “cheap” (relative to the cost of equity of the banks) equity-like instruments that helps bolstering the capital and leverage ratios,” meeting Basel three regulations.

“However, the lack of standardisation4 and its complex nature means that its impact on banks’ behaviour is not yet well understood,” the report said. Like many unregulated SWAPs insurance contracts, the bonds are written using obfuscating language that often can be interpreted to have multiple meanings.

CoCo bonds problems related to wealth-transfer

The first problem, the report points out, is related to wealth-transfer.  This is where the bond holders have an incentive to take on riskier projects because of the long option position held by them, and “sold” by the guarantors – the government in the government bail-out case and the bondholders in the bail-in cases.  As in an options volatility play familiar to many hedge fund traders, higher volatility of the projects’ values means higher option value, leading to wealth being transferred from the guarantors to the equity holders. In a bailout situation this has hidden issues.

The second issue the report covers is the problem of value destruction. This is where in a falling solvency scenario the bond holders are tempted to “gamble-for-ressurection”, i.e. sacrifice value for higher volatility. The report authors considered the unintended consequences and read the fine print to determine bondholders should not bear losses until equity holders have been wiped out.

The report cites the example of Banca Monte dei Paschi di Siena SpA (BIT:BMPS) in 2013, the world’s oldest surviving bank was bailed out by the Italian government in 2013 due to, among a horrid of issue, their failed investment in BTPs (Italian Sovereign Bonds) in 2010.  This example, according to the authors, was a “gamble-for-resurrection” that did not pay off.”

The report concludes that while new financial regulation has been “articulated to dampen moral hazard and minimize the chances of another financial crisis,” the reality is the regulator is “swapping” bail-out for bail-in, which “is in essence a replacement of moral hazard with agency costs.”