Cocos channel revenue for securities finance

Are cocos a coconut plant or a "very dangerous" financial instrument? In actual fact, contingent convertible capital bonds (dubbed cocos) are one of the central banker’s favored tools to help recapitalize banks under stress. We will look at their impact on securities financing given that convertible bonds stimulate borrowing demand.

Cocos can be viewed as a kind of reverse convertible bond. Regular convertible bonds pay a yield and offer a cheap way to own equity if a company is doing well. The coco offers an even better interest rate, but a savage downside whereby debt turns to (falling in price) equity should the bank’s capital slide below its regulatory minimum. Oswald Grubel, the UBS boss thinks they are “very dangerous,” but seems to be in the minority with the Bank of England and the Swiss equivalent very much in favor. The BofE even think bonus payments to staff should include cocos.

With Sir John Vickers recommending that “too big to fail” banks hold a tier 1 capital ratio of 10% there is renewed focus on the tools that can help banks to raise ‘contingent’ capital to meet this. Credit Suisse recently issued USD 2 billion of “Tier 2 BCN” cocos (meaning buffer capital notes) and the issue was 11 times oversubscribed. Lloyds Banking Group has issued a version as have Rabobank (with a different type of contingency). Here are some of the issues:

How big will this market become?

Barclays suggest USD 700 million. Goldman Sachs is far more expressive saying that covering 4-8% of risk weighted assets (RWAs – an indicator of potential unexpected loss) of the top 50 global banks would lead to USD 1-2 trillion of cocos in issue. This would make it bigger than the global convertible bond market.
What is the effect on the securities finance market if either of these predictions was right?

I have heard tales of equity finance desk heads being pulled into rooms to hear that their revenue expectations have just been adjusted upwards thanks to the “home run” that cocos present. However, unlike normal convertible bonds, there will be no need to short sell the underlying equity until such time as the bank in question is approaching the event that would trigger the contingency. So, far from providing a smooth layer of perma borrowing seen with traditional convertible bonds, coco could induce owners to suddenly add themselves to the list of other short sellers queuing up to borrow a shrinking pool of shares if a bank is in major trouble. This sounds like a headache for a prime broker but a chance for higher fees from a lending perspective. The case in point is the stock on loan in Credit Suisse – it did not increase upon the issue of their coco, whereas it almost always spikes upwards when a plain convertible is issued.

Perhaps Custodians will hold back shares in anticipation of this? Of course, holders of the cocos could instead just sell their bonds. The other hedge is to buy way out of the money put options but who will be offering these? Liquidity seems unlikely in the size required.

Why do banks like issuing them?

Previously, rights issues were the tool of choice but these immediately dilute existing shareholders, whereas cocos are debt instruments that only dilute shareholders once the ship is on the rocks. They are cheaper to issue than equity (being ranked senior) and the assumption is that the interest payments are tax deductible. However, I’m not going to wade into the debate over whether or not they potentially dilute earnings per share.
Who will buy them?

John Vickers discusses the uncertainties around cocos, one of which surrounds who can buy them. The usual buyers of bank debt – pension funds and insurance companies – may not be allowed to own such funky instruments according to their mandate. Hedge funds may be the biggest takers since they really understand how to value and hedge instruments that contain embedded options such as cocos. Not surprisingly, a financials focused hedge fund, Algebris has already launched a cocos only fund.

What is certain is that we have a whole new slew of financial jargon to deal with. Impress your friends at dinner parties by telling them what your CET is, the size of your BCN, and that your RWA is so impressive that you don’t need any cocos.