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Understanding CoCo Bonds: A New Source of Systemic Risk

Since the 2008 financial crisis, regulators, policymakers and the “too big to fail” (TBTF) banks around the world have been developing new ways to resolve insolvent TBTF banks without the need for taxpayer bailouts.  To this end, two broad categories for economic insolvency resolution have been developed: 1) systemically important financial institution (SIFI) living wills and 2) contingent convertible (CoCo) bonds.  The former is a regulatory resolution regime for insolvency while the latter is a contractual resolution regime for insolvency.  However, it is worthwhile to remember that both resolution regimes are untested and some key aspects of insolvency resolution are still not clearly defined, rendering the outcomes unpredictable.

In the case of CoCo bonds, it is designed as “going concern” capital, a financial buffer that can be activated to “bail-in” (instead of bailouts by taxpayers) before a firm becomes insolvent by the CoCo bond’s going concern trigger, a threshold that defines when a “going concern” (solvent) firm has become a “gone concern” (insolvent) firm.  However, while conceptually sound, the going concern trigger has not been quantitatively defined to be legally enforceable and defensible, hence exposing the activation (conversion) of CoCo bonds to legal uncertainties.  In fact, despite the original intention to eliminate the need for taxpayer bailouts, the lack of risk clarity and performance predictability of CoCo bonds could threaten to become a brand new source of systemic risk during the next financial crisis.

Yet, despite the structural deficiency in the design of going concern trigger, CoCo bond issuance in Europe during 2014 would likely reach record numbers around $100 billion.  In anticipation of a growing CoCo bond market, Bank of America Merrill Lynch recently launched the first CoCo bond index in the world and several asset managers are poised to switch their European high yield portfolios to CoCo bonds.

Mark White, a former assistant superintendent at Canada’s Office of the Superintendent of Financial Institutions, expressed his concern for CoCo bond’s going concern trigger in an article entitled “Going-Concern Triggers on CoCos Unrealistic, Says White” by on July 5, 2011.  He said in the article that “One big issue is whether the trigger and conversion mechanics can be set in advance so they will have the desired consequences – such as conversion at the right time and in a way that treats all stakeholders equitably.”

While $70 billions of CoCo bonds were issued from 2009 to June 2013 and $100 billions more are expected to be issued during 2014, a significant lingering concern of investors has indeed been the lack of clarity and predictability of going concern trigger that would trigger conversion of CoCo bonds at the right time and treat all stakeholders fairly.

The Financial Times echoed that concern about the underestimated riskiness of CoCo” bonds on January 28, 2014 as European banks were looking to issue record numbers of CoCo bonds during 2014 in order to meet the new capital requirements.  “The long-term risks are underpriced,” said Hans-Peter Lorenzen, senior credit strategist at Citi. “Coupon deferral is either at management or the regulator’s discretion – so as an investor you have very little clout.”

Hence, a legitimate question to ask, on the Eve of CoCo bond market taking off in Europe, is if credit rating agencies convey the right kinds of information to investors so that the issue of “conversion at the right time and in a way that treats all stakeholders equitably” raised by Mark White can be properly analyzed and addressed.   Unfortunately, the answer is no.  Here are some of my own observations on why rating agencies are not doing their jobs on rating CoCo bonds.

  1. Current analyses of risk profiles of CoCo bonds as going concern/gone concern capital are fundamentally flawed, especially for the risks associated with going concern trigger and conversion.  Corporate governance issues, such as contingent director fiduciary duties to CoCo bondholders and pre-conversion economic rights of CoCo bondholders that can significantly alter the dynamics of stakeholder conflicts before conversion, are completely absent in current analyses.
  2. Rating methodologies currently used to rate CoCo bonds are fundamentally flawed.  They do not convey any incremental information on going concern uncertainties, which is the main driver (instead of credit risk) for the risk of going concern trigger being activated for conversion.  Similarly, there is no incremental information on pre-conversion stakeholder conflicts in credit ratings.
  3. At present, bondholders in general and CoCo bondholders in particular do not have any economic rights to protect them against a host of economic risks (that are not protected by covenants), including shareholder expropriation of going concern value and credit valuation volatilities.  As such, CoCo bondholders are severely handicapped in the pre-conversion stakeholder conflicts.
  4. Stakeholder conflicts for maximizing their shares of the going concern value in economic insolvency resolution are not a binary or linear behavior.  They emerge as soon as the issuers start to show any signs of going concern uncertainties and usually intensify exponentially when the issuers have entered zone of insolvency prior to reaching the going concern trigger.  Unmitigated stakeholder conflicts can potentially prevent a CoCo bond from being triggered when the issuer needs the conversion the most.
  5. Economic insolvency resolution is distinctly different from bankruptcy resolution.  The former involves reallocation of going concern value among competing stakeholders (shareholders, bondholders, pensioners and employees) according to an economic order that should be based on the principle of fairness, while the latter involves recovery of liquidated assets by creditors as the only surviving stakeholder (all other stakeholders are presumed to be wiped out) according to a contractual order defined by bankruptcy priority and subordination.

Given the fundamental objective of CoCo bonds, which is to bail in at the right moment to preserve the going concern value of an economically insolvent issuer and redistribute it fairly among competing stakeholders, the issues mentioned above must be effectively addressed if CoCo bonds can be used effectively as a contractual resolution regime for economically insolvent issuers.  Otherwise potential economic costs of CoCo bonds would likely exceed the intended economic benefits.  Furthermore, the collective pre-conversion economic rights of CoCo bondholders must be urgently recognized, defined and addressed in order to protect them from suffering catastrophic losses during the next financial crisis.

My closing thoughts are that credit rating agencies will be unable to play an instrumental role in CoCo bond market, given that single dimensional credit ratings do not convey any incremental information on multidimensional going concern uncertainties and the pre-conversion stakeholder conflicts in allocation of going concern value.  Therefore, an alternative rating methodology is urgently needed to protect the economic interests of CoCo bondholders in a rapidly evolving CoCo bond market.

4 thoughts on “Understanding CoCo Bonds: A New Source of Systemic Risk”

  1. Bill Harrington

    Simon: One of many reasons that rating agencies cannot offer “any incremental information on multidimensional going concern uncertainties” is failure to assess evolving risks for an issuer under derivative contracts. Rather than evaluate derivative risk independently, rating agencies merely accept issuer summaries of derivative exposures at face value, which effectively doubles down on deficient issuer disclosures.

    1. Bill,

      As derivative contracts are mark-to-market, differences between face values and fair values during market uncertainties can create significant valuation volitilities that can drive a firm into insolvency (like Lehman). There are two issues at stake, real-time evaluation of derivative fair values and dynamic assessment of derivative countrparties’ insolvency risk. While I understand that rating agencies’ legal disclaimers continue to maintain that credit ratings capture only “credit risk” information, I wonder if regulators are having concerns about the points that you have raised.

  2. Stephan Krushev

    from your article I understand you propose to add more risk factors than just risk of default. What risk factors do you think of are most important?
    I would think of business risk (volatility of earnings) but it should be included in default risk.
    Incremental information- this could be caught by market volatility and volatility of volatility.
    A kind of internal political risk- how many senior managers have left/taken new positions within the company.
    Valuation volatilities (based on differences of market and model prices) as you mention.

    1. Hi Stephen,

      Apologize for the belated response.

      It isn’t about adding more risks to CoCo bond analyses, but credit rating methodology is not the right tool for rating CoCo bonds because of the following:

      1. The risks of CoCo activation are outside of the domain of default risks. In other words, liquidity risks are most likely the main drivers for CoCo activation. Since liquidity risks propagate much faster than default risks during a financial crisis, it is very likely that CoCo bonds would not be activated in time to provide bail-in capital because CoCo bonds’ credit ratings are based exclusively on default risks.

      2. Analysis of corporate governance risks (or internal political risks as you call it) should be a crucial factor in price discovery for CoCo bonds. Imagine you were a shareholder and you think the CoCo bond of your investee company is about to be triggered, what would you do? You would pressure the board of directors to take actions in favor of shareholders, including share buyback, excessive dividends, risky M&A, excessive leverage, etc. This is known as shareholder expropriation of creditor values in zone of insolvency.

      The CEO with a sizable stock option would have even more incentives to act before the activation of the CoCo bond. He could change the valuation methods of his bank’s portfolios, for example, or take more risky bets to increase his margin, etc.

      3. Under current corporate and securities laws, directors have no fiduciary duties to CoCo bondholders until the bank becomes bankrupt. This means CoCo bondholders would have no protection against shareholder expropriations because their contractual protection would activate only upon bankruptcy, and shareholder expropriations are pre-bankruptcy economic activities.

      I commented on Moody’s proposed CoCo bond rating methodology earlier this year. You can find it on Moody’s website or simply google it.

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