Monday, February 13, 2012

Since investors won't, governments step up to buy Eurozone bank CoCo bonds

A Wall Street Journal article confirmed this blog's prediction that based on the current lack of disclosure investors would have no interest in buying contingent convertible bonds issued by Eurozone banks.

Since investors won't buy these bonds because they cannot assess the risk of the banks, naturally, governments are stepping up and saying they will buy the bonds.


To keep up the pretense that the banks are adequately capitalized when using highly manipulated bank capital ratios.

Each CoCo bond purchased is a waste of resources that should instead be directed towards policies that will encourage economic growth.

As this blog has thoroughly documented, bank solvency is a function of the market value of the bank's assets and the book value of its liabilities.  Banks are insolvent when market value of the assets is less than the book value of the liabilities.  No amount of denial by governments is going to change this fact.

More importantly, market participants simply do not care about an easily manipulated accounting construct.

  • Depositors care about whether or not the government or an entity backing the government will make good on the deposit guarantee.  

  • Unsecured debt investors care about if the implicit guarantee will continue to be made explicit as it has been throughout this financial crisis.

  • All market participants care about liquidity and whether the central bank will continue to provide unlimited liquidity against good assets.

The only market participants who care about capital are policymakers who have chosen the failed Japanese model for handling a solvency crisis.

A new breed of bank debt that turns into equity if a lender hits trouble is becoming the instrument of choice for some Southern European governments as they prop up their ailing banks. 
The instruments, known as "contingent convertibles," began to get attention following the financial crisis and have been issued by a few banks. "Co-cos," as they are called, are sold as interest-bearing debt that has to be paid back. But they convert to equity in the event that a bank's capital ratios fall below certain levels. 
Now the governments of Spain and Portugal are seeing the virtues of this type of debt—namely, that they can use it to strengthen their weakest banks and avoid direct bailouts.
Governments buying these bonds do not strengthen a bank.  Depositors already think the government protects them against loss.  Unsecured debt holders see CoCos as once again making the implicit guarantee of their investment explicit -- Cocos are junior to the unsecured debt holders and act to shield the unsecured debt holders from losses.

Please remember, no market participant knows what the true losses are that are hidden on and off the balance sheets of the banks.  As a result, unsecured debt holders don't know if the CoCo bonds fully insulated them from these losses or whether the losses could still wipe-out their position.
The government in Spain last month said it will buy co-cos from banks, although it isn't clear yet which institutions will issue them. In Portugal, two major banks are expected to issue the instruments to meet European capital requirements. 
Because of accounting rules, the debt won't increase the governments' deficit as a direct injection of equity would, Spanish officials and analysts say. The approach also allows the banks to avoid partial state ownership that would come with an equity purchase, which could alienate private shareholders.
Oh, so under CoCos, the taxpayers once again gets the risk and does not get adequately compensated.
Purchases of co-cos are the latest effort among some European countries to dodge outright cash injections into banks, which would further stretch their budgets, and instead indirectly support their financial systems. 
Spain, for example, has used its guarantee of bank deposits to back troubled lenders. 
In Italy, the government has encouraged banks to use their holdings of government bonds to buy state-owned properties, which banks can then use to create asset-backed securities to serve as collateral for loans from the European Central Bank. 
The co-cos help banks because they boost the capital ratios of those not healthy enough to attract private investment. Capital ratios are an important measure of financial health, and many European banks are racing to increase those ratios to comply with new European regulations by June...
Banks that cannot attract private investment for their equity also cannot attract private investment for CoCos.

Capital ratios in the absence of ultra transparency are not an important measure of financial health.    The focus on capital ratios is a symptom of the failed Japanese model for handling a solvency crisis.
Contingent convertibles first came on the scene to help protect banks from catastrophic losses. 
Once a bank hits trouble and begins burning through its financial buffers, it is hard to get investors to buy more equity to replenish what has been lost. The co-cos were designed to address that problem by automatically turning into equity once a bank's capital falls to a certain point. 
Investors and banks have been skeptical about co-cos. One concern is that as the bonds reach their conversion point, equity investors could see that as a bad sign and flee, sending the bank into a downward spiral....
It is hard to get investors to buy more equity in the absence of ultra transparency.  When investors cannot independently assess the risk of the bank for themselves and they know the bank has hidden on and off balance sheet losses, investors simply do not invest.

The question is when will governments realize that governments should never be an investor in a bank and instead will require the banks to provide ultra transparency?

With ultra transparency, the investors could figure out what the losses are and which banks have a franchise that is capable of generating future earnings.  Investors will invest where the ability to generate future earnings exists.

The banks that cannot attract additional capital after they provide ultra transparency should be closed.
The instruments got a boost in December when European banking regulators said they could count toward a bank's capital-ratio requirements. In some cases, they also count toward capital under so-called Basel III rules that will go into effect in coming years.
Further confirmation that policymakers are focused on the easily manipulated meaningless capital ratio that is a symptom of the choice of the failed Japanese model for handling a solvency crisis.
Spain, in a new round of bank reform, said last month that it would buy this debt from lenders as a way to prod consolidation and help banks boost capital levels. The banks' debt will be bought by the government's Fund for Orderly Bank Restructuring, or FROB. 
Details are still being finalized, but the idea is that the debt will convert to equity in the bank after a set period, about five years, or if the bank's capital levels fall below a certain point. 
It is still too early to know which Spanish banks will use the co-cos or how much they will issue. Overall, the Spanish financial sector needs an additional €50 billion ($66 billion) to absorb problem loans, the country's finance minister has said. 
"The objective of the reform is to increase the credibility, confidence and strength of the financial system, in order to be able to finance economic growth and job creation," said a spokeswoman from Spain's finance ministry....
Buying CoCos does not do this.  It simply reduces the amount of resources available to Spain to address economic growth.

As this blog has documented, banks can be insolvent and still support economic growth and job creation (just look at the US Savings and Loans in the 1980s).

Spain would be better off if it simply required its banks to provide ultra transparency, recognize their losses today and let the banks rebuild their book capital through the retention of future earnings and equity issuance.
Some analysts and economists say co-cos might allow the government to avoid a financial hit right now, but that governments may still be forced to take equity stakes in banks down the road if the banks' health doesn't improve. 
"The premise with co-cos is that the banks need time to work these problems through," said Alastair Ryan, an analyst at UBS in London. "But some of these assets may be deteriorating faster than the cleanups anticipate."
Banks do in fact need time to work through their bad debt.

Under the Swedish model, the impact on the real economy of working through the bad debt is minimized.  Banks take their losses today and then rebuild their book capital.

Under the failed Japanese model, the impact on the real economy of working through the bad debt is maximized.  Until the losses are realized, prices in the real economy are distorted.  For example, it is easier for an underwater  borrower to get credit to support a zombie loan than it is for a new borrower.

Under the failed Japanse model, banks absorb their losses only as fast as they can generate the earnings to absorb the losses.  This stretches out the process of dealing with a solvency crisis and damaging the real economy for decades!

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