CoCos – The Market Has No Memory – Again!

Blain’s Morning Porridge, 9th Nov 2023: CoCos – The Market Has No Memory – Again!

“Insanity is doing the same thing over and over again and expecting different results.”

UBS’s new $3.5 Bln ATI CoCo Bond was 10 times oversubscribed. It conclusively demonstrates the market not only has no memory, but very little understanding either. This is not a good time to be the very bottom of the bank subordination ladder.

The market has no memory. It’s one of my key market mantras! It’s great for bond market originators and other financial charlatans – you can earn fees selling the same bad deals tim and time again. It’s an absolute gift for financial commentators like myself: deals collapse for broadly the same reasons, companies fail, bonds default – it’s a just a matter of changing the names in the content. The reality is markets are fated to make the same mistakes again and again.

Welcome to yet another Groundhog Day in the Bank Capital Markets.

A number of years ago a very clever and highly experienced market participant commented: “in a low interest rate environment many investors might be tempted buy CoCos offering high headline returns. However they are complex and can be highly risky.” How right that observer was. It was the UK’s Financial Conduct Authority announcing a ban on retail investors participating in the market.

Move forward a decade. Yesterday UBS garnered a minor market triumph – building a book of over $36 bln for a two tranche 5-yr and 10-yr $3.5 bln issue of new AT1 CoCo bonds with a coupon of 9.25%. Such was the strength of demand for the issue – rated BB- by rating agencies – the initial price talk tumbled from a 10% plus coupon. Whoopee. Well done. But, I shall rain on that parade.

It’s a stunning success for a deal that flies in the face of rational investment. There are plenty of other, safer, more diverse, more conventionally structured deals out there, where the risks are clear and defined, yielding more than 10%. Call me for some examples.

“Nonsense, nothing to fear!” scream the Financial Institutions bankers, analysts and investors who are paid for their prowess in the dark arts of investing in banks. I guarantee I will receive emails and comments this morning telling me what a marvellous deal it was. Bollchocks. To my mind it’s the wrong deal at the wrong time. Let me explain:

Back in September I wrote about how UBS was sniffing out the market to issue new Contingent Capital Additional Tier 1 Debt (CoCos). Bank analysts reckoned UBS has to raise around $20bln of new AT1 Capital to cover the capital stretch caused by its emergency purchase of Credit Suisse after its’ domestic rival crashed in March this year. In any normal world, selling new CoCo Bonds should have been a problem because when it failed, the Swiss Regulator, FINMA, decided that $17 bln of Credit Suisse CoCos should be written down to Zero! Investors holding the bonds were shocked and are taking the regulator to court.

They had little right to be angry. If they had any ancestral knowledge of the history of AT1s they would have understood these were never designed to be bond investor friendly instruments. Back when they first emerged in the early 2010s I described them as the “bastard stepchildren of deranged regulators and desperate banks.” Contingent Capital was specifically designed to make sure bond holders (who had been bailed out whole during the post Lehman banking crisis) would suffer pain in any future banking crises! That is the only reason they are structured in complete contravention of every natural law of equity/debt subordination.

The bond risks were clear to investors – if they’d taken the time to do any due diligence. The right of the regulator to trigger Contingent Capital classes is enshrined in deal documentation and its DNA. Investors could have read a Credit Suisse AT1 prospectus. (I found one this morning and took 2 mins to scan the 150 page bond docs – you can find the link to it here, to find the relevant section on page 74, 7. Write Down Event.) Alternatively, you could simply pay a £10 per month subscription to the Morning Porridge, and I would have explained – as I have many times – the truths behind CoCo risks.

Remarkably, this morning Bloomberg carries a story that at least two institutional investors who saw their Credit Suisse Bonds written off to zero at the stroke of a regulators pen in March, were buyers of the new UBS deal yesterday. Really? What the **c* are these guys smoking and how much does it cost? Why? What makes the UBS deal better than the Credit Suisse ones?

I spoke to some “bank capital” experts yesterday. (BTW; I was head of the debt financial institutions groups at Bear Stearns and then HSBC a long, long time ago. I have a passing familiarity with the ways bonds, bank capital, and capital structure subordination are supposed to work. I also have nearly 40 years of watching banks wrecking themselves for a multiplicity of reasons.) I was assured the UBS deal is better because rather than these being “write off” bonds (where they are triggered into zero), these are “convertible” contingent securities – meaning the bonds are not written off, but converted into equity.

In reality, that’s not much better than a choice between being shot or hung.

If a bank finds itself in such a deep crisis the regulator triggers it’s CoCos – its effectively dead in the water and the equity will be close to zero. The investor will have the joy of receiving equity in a broken bank. What is the equity in a failed bank worth? Oh. Zero. But at least the subordination ladder looks intact – the expectation that the first line against losses is equity.

As I wrote in September:  “the fundamental truth of the Contingent Capital AT1 market is these instruments have all the upside of bonds, and the downside of equity: meaning you will never get more than the coupon in returns and if it goes badly wrong you lose ahead of equity holders – putting AT1 holders in the deepest bilges of the subordination ladder.”

Do you really want to be taking deeply subordinated equity downside risk to European banks at the moment? Perhaps the stock might make sense – UBS is close to high this decade, bur the dividend yield is 2.2%! If bond yields are about to rally as central banks ease, then maybe 9.25% makes some kind of trading sense. But, the global economy faces recessionary and even stagflationary risks.

At present there are significant risks hovering over the whole bank sector. Corporate and consumer defaults and losses are set to rise. Although banks have significantly de-risked themselves – now they largely originate risk to sell to the asset management sector in the form of corporate bonds and packaged consumer receivables – they are still very vulnerable to economic forces. As credit card, auto-loans and mortgage defaults rise, bank provisions and hence their need for bank capital will rise.

In times of crises, bank can dip into their reserves – which, as we discovered from the collapse of regional banks in the US earlier this year, comprise government bonds deeply discounted from where purchased because of the rapid rise in interest rates. If banks are forced to absorb the unrealised notional losses on hold-to-maturity bond portfolios, they quantum of losses will swift swamp their entire capital reserves.

Not that I want to sound bearish… but I reckon the efforts of European banks – UBS is not the only one that’s been scrabbling to issue new AT1 debt – to raise capital is because they are following one of my key banking mantras: Raise Capital When You Can, Not When You Need To. Banks can sense where the economy is going from the metrics on their loan books – they know winter is coming.

I’d be very interested in what the readership thinks about CoCo AT1s:

Back in January I wrote:

“CoCos are what they are.. But I do care if folk don’t perceive the risks. AT1s/CoCos remain far more equity like than debt-like. The risks are largely equity risks – that a sudden liquidity event hitting a bank, triggering a run or collapse in the ability of the bank to fund itself, could very quickly consume capital or cause regulators to declare it “non-viable” triggering a write down of the AT1 (or conversion into worthless equity).

Such a liquidity event may come from cybercrime, fraud, bond losses, or conventional sources such as increasing loan delinquency – which is likely to happen if rates are rising. Or it may come from a major fund going bust on the back of some event, trigger a systemic hit on its lenders’ balance sheets.

There are multiple reasons why things could still go to rack-shit in a heartbeat across the banking industry. The threat may be less than in 2007/08, but it’s not negligible. You need to understand the capital structure, the risks it covers, and the ability of the bank to manage these risks. And all banks are different..

And never forget, when an investment bank tells you complex financial instruments are cheap and you should buy them, you first thought should be how long and wrong they are…”

Back then a reader commented:

“I think you do a disservice to CoCos. …. they offer equity-type returns with less volatility than the underlying equity and significantly greater downside protection against all but the most extreme events, they represent a desirable alternative for equity investors as well as being worthy of a place in credit portfolios. Check out the performance of CoCos versus the underlying equities and you can see that it’s a sector worth looking at. Moreover, because so many people fail to understand the product, they often offer excellent value, especially after broad-based risk-off episodes.”

Go ask the holders of the Credit Suisse bond just how excellent their value was…

Five Things To Read This Morning

FT                    Softbank paid $1.5 bln to WeWork Lenders days before bankruptcy

WSJ                 Fed’s Neel Kashkari Not Convinced Rate Hikes Are Over

Times              Andrew Bailey: It’s too early for BoE to talk about interest rate cuts

BBerg              EV Market’s Surge Toward $57 Trillion Sparks Global Flashpoints

Project Syndicate        An Industrial Strategy For Europe

Out of time, and back to whatever…

Bill Blain

Market Strategist and Author of the Morning Porridge