CoCo Consternation And Systemic Procyclicality

Karen Shaw Petrou’s memorandum to Federal Financial Analytics clients on CoCo consternation and systemic procyclicality.

TO: Federal Financial Analytics Clients
FROM: Karen Shaw Petrou
DATE: February 12, 2016

As bank stocks stumble and CDS spreads head into the abyss, the role of contingent convertible (CoCo) debt instruments warrants careful consideration. Their cataclysmic, downward price spiral is a reminder that market discipline is a ruthless task-master, especially when financial problems combine with policy incoherence. Without certainty about who loses what when, CoCos now and perhaps TLAC to come can turn into perfect procyclical storms, as I suggested to Bloomberg earlier this week. Without quick action to make bankruptcy and orderly liquidation not just theoretical, but also practicable interventions, all CoCos will do now and TLAC will do later is make financial markets still more volatile and the chances of taxpayer intervention still higher.

CoCo Consternation And Systemic Procyclicality

To be sure, CoCos aren’t TLAC, at least not the TLAC contemplated in the FRB’s bloody-minded proposal. CoCos in the Eurozone remind me a lot more of brokered deposits than TLAC in that they were sold to investors looking for more yield at banks investors knew to be higher risk in hopes that this risk would never be realized because governments would ride to the rescue (see, for example, John Mack’s comments that market fears about Deutsche Bank CoCos are overblown because the government wouldn’t let the bank miss a payment). The FDIC’s deal on brokered deposits is explicit while that for CoCos was implicit, but the market mechanics are the same: heads I win, tails you lose.

The reality of real CoCo risk only dawned on investors when Portugal last December closed a bank and failed to protect some CoCo bonds. Admittedly, the facts in this case were idiosyncratic and might not have been seen as an EU precedent, but that was before markets lost their nerve after New Year’s. A series of external phenomena – continued oil-price drops, negative rates in Japan and hints of them in the U.S. – put equity markets into flight that quickly translated into a debt rout. CoCo prices plummeted because investors feared that triggers could be reached or payments stopped, putting still more price pressure on CoCos and correlating these debt prices with equity to send market capitalization across the bigger banks into well below tangible-book value territory. To stem this disastrous tide, at least one big bank redeemed some senior debt (i.e, repurchased lower-yielding debt to pay high-cost CoCos) – in short, it borrowed from Peter to pay Paul, reducing its long-term debt-service capacity to avert continuation of the debt-equity price correlations that threatened the market confidence on which all banks so critically depend.

Will European regulators permit a debt buy-back at a bank already struggling with regulatory capital and liquidity? So far, one has. Like most regulators before it, this regulator has thus also borrowed from Peter – i.e., long-term market discipline – to pay Paul – the devil of systemic-size failures. This damned-if-you-do, damned-if-you-don’t decision may yet confront EU decision-makers, with their choice made still more difficult by the wholly-incomplete status of the European Stability Mechanism. Finance ministers today (or at least some of them) said they were sticking by the ESM and CoCo costs, but what EU finance ministers say and then what they do can all too often be all too different.

The U.S. situation is nowhere near so parlous and the FRB’s TLAC proposal demands debt significantly different than Eurozone CoCos. Still, CoCo’s lessons are critical. For TLAC to serve as a meaningful market discipline that does not wreak havoc on stressed banks at the worst possible moment, investors will need to know from the outset that they are at risk. We learned a lot from Fannie and Freddie, and one particularly costly lesson is that legal assertions on bond documents that the federal government doesn’t stand behind the obligation aren’t taken seriously by investors if they have any reason to hope for a rescue. With Fannie and Freddie, they got one – indeed, even the GSEs’ subordinated debt – the sort-of equivalent of TLAC was bailed out because Treasury Secretary Paulson so feared the consequences of anything but a total bail-out.

For TLAC to be truly loss-absorbing, the resolution protocol that makes use of it must be fully built-out and transparent. The EU has its problems with the ESM, but the U.S. also has an orderly-resolution system that’s more real on paper than in practice. We rightly want bankruptcy to work for big financial companies, but we know it can’t without statutory change Congress won’t craft. We know single-point-of-entry (SPOE) is the way to go both in bankruptcy and, should it be necessary, under an OLA intervention, but the FDIC to this day hasn’t gone beyond a 2013 concept release to lay out how SPOE would work. It’s suggested indirectly that it now knows that SPOE may also not work well for BHCs that need a multiple-point-of-entry (MPOE) approach, but understanding what this is for whom is still more vestigial.

As long as investors think TBTF, they will price TLAC up a bit, but TLAC won’t provide any more insight into bank risk than CoCos did until risk grows so great that investors come to grips with the prospect of a resolution without taxpayer bail-out. That’s the worst time for market discipline to come into play because market discipline under the combination of stress and shock will eviscerate the vulnerable and eat the young.