What is going on with the bank stocks? Why are they suddenly falling everywhere, but especially in Europe? It all has its roots in a special type of chicken that is coming home to roost: the CoCo. If it sounds complicated, it's because it is. Very.
Back in 2014, when I wrote a piece on CoCos for a publication specialized in banking risk and regulation, I spoke with many experts and fund managers about these instruments, and they all agreed on one thing: they're beautiful, but risky. If you get into them, you'd better know what you're doing. The recent turmoil in European banking stocks shows that not every investor followed that advice.
Late on Monday, Germany's biggest bank, Deutsche Bank (DB), rushed to reassure investors about its hybrid debt instruments, after its stock collapsed to the lowest level since at least 1992, according to some estimates. (You can read the recent saga of these instruments from Deutsche Bank in an article by Carleton English)
It is the latest in a series of moves to try to calm market fears that have seen stocks in many sectors hammered, but does this mean we have seen the end of the weakness in European bank stocks? At Real Money, we have written extensively about the fears that have gripped investors, including the knock-on effect this has had on American banks.
It does look for now like investors are over-reacting: The issues that are currently at the center of their fears are by no means new.
Take for instance Deutsche Bank's hybrid instruments, which, according to some media reports, had sparked fears in the markets that the bank will have to resort to raising fresh capital. These are bonds whose coupon payments can be canceled and which can be converted to equity when the capital of the issuing bank falls below a certain level, and weak financial results from Deutsche Bank contributed to investors' fears that the moment when this might happen for the bank was approaching.
In a statement late last night, Deutsche Bank spelled out that it has more than enough funds to pay the coupons on the securities, known as Additional Tier 1 (AT1) instruments, contingent convertible bonds, or CoCos. It said payment capacity for this year is estimated at around 1.0 billion euros ($1.11 billion), which is "sufficient to pay AT1 coupons of approximately 0.35 billion euros on 20 April 2016."
"The estimated pro-forma 2017 payment capacity is approximately 4.3 billion euros before impact from 2016 operating results," it added.
The bank's disclosure seemed to have done the trick, at least temporarily: Deutsche Bank's shares were up 2.4% on the Frankfurt Stock Exchange in mid-morning in Europe, while Germany's DAX index was broadly flat and other European markets were slightly positive. The ADRs were up 0.6% in pre-market trading on the NYSE.
However, jitters about Additional Tier 1 instruments remain, and this is mainly because the securities have been poorly understood from the start. They are an extraordinarily complicated form of hybrid financing, lacking standardization (each security comes with its own characteristics), and therefore difficult to price.
Banks in Europe have been issuing them with a vengeance, especially after the European Parliament approved the Bank Recovery and Resolution Directive in April 2014. The purpose of the directive, together with the Basel III regulations and the Capital Requirements Directive IV that entered into force in 2013, was to protect taxpayers in the event a bank fails, by making shareholders and bondholders pay.
The hybrid instruments are a category of debt that ranks below senior bonds and, being convertible, they offer banks the ability to fill in the capital cushions required by regulators without diluting shareholders by issuing fresh equity capital. The regulators love them too, because it mean the banks' capital cushions are neatly covered.
A total of $450 billion in CoCos through 519 different issues had been launched between January 2009 and September 2015, according to a study by researchers affiliated with the Bank for International Settlements (BIS).
While the going was good (that is, as long as the Fed kept providing liquidity and stocks were hitting fresh highs) investors piled into CoCos, because they offered a much higher yield than safer alternatives.
What we are seeing now is the flip side of that coin: because the instruments are convertible, they are among the first to get hit heavily by the realization that high yield also means high risk.
No bank has so far defaulted on a coupon payment on a CoCo or been forced to convert one to equity, and for now, it doesn't look like either such event is close. However, the turmoil is a reminder to investors that if an instrument pays a high yield, it's because it carries a much higher risk.
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