European Banks Are In Love With The Coco

I hate to admit it, but…I’m in love with CoCo! I’m not talking about Ice T’s wife, the tasty wintertime beverage, or your lonely Aunt Irma’s favorite Shih Tzu. I’m talking about contingent convertible securities. High yield hand grenades with a stage name like CoCo so you won’t freak out when you hear about them.  

CoCos are a way to make banks safer so we can avoid another 2008. A CoCo has two parts, a triggering mechanism and a loss provision. As long as they are not triggered, the banks pay a yield in excess of their subordinated debt. That’s a fancy way of saying, they pay a lot, but if things go bad for the bank, you’re dunzo. What that pain will be is in the loss provision. What causes the pain, is the triggering mechanism.

The more mundane loss provision is the principal write down. So if one of these CoCos gets triggered, then instead of being worth, say $100, now it’s only worth $25. A 75% hit sounds like trouble. But the risk is totally assumed by the CoCo buyer. And CoCo buyers are restricted to non-Financial institutions just in case these CoCos started blowing up. The ECB didn’t want a bunch of blown up CoCos on banks’ balance sheets. So they pushed that risk over to suckers, I mean retail investors.

But the other loss provision is a conversion to common equity. Meaning, there could be a bunch of new shares issued by these banks. Who takes the hit there? You got it, shareholders. You didn’t think that risk was going to just disappear did you?

It’s like driving a convertible. Sure, it’s cool to look at and the ladies love it. Something about the way the wind whips through this beard has got ‘em going, What about Dave? But you hit that off ramp too quick and roll that bad boy, and it’s a tombstone with a hashtag, Beard Game Strong.

Again, none of this matters as long as the triggering mechanism, or what causes the pain, doesn’t go off. One triggering mechanism for these loans is the ratio of the banks market cap to its risk adjusted assets. In other words, it’s tied to the stock price. Which sets up the doomsday scenario for bank shareholders. The banks stock gets shorted, forcing prices down, pushing the stocks below the threshold, triggering the mechanism, setting off the loss provision, which adds more shares to the market, further diluting the price. Thanks for playing, kids!