When billions of euros of the riskiest bank bonds vanish overnight at the whim of regulators, investors are entitled to wonder if the reams of detailed documentation for similar bonds at other banks are worth the paper they're written on.
Banks no longer go bankrupt, as the process has been renamed "resolution." But the collapse of the contingent convertible bonds at Spain's Banco Popular Español, from 100 cents on the euro at the end of March to zero on Wednesday, summons to mind Ernest Hemingway.
Asked how he went bankrupt, one his characters responded: "Two ways. Gradually, and then suddenly."
In one way the swift execution of Popular was a successful first test of Europe's new bank-failure regime, and the risky bonds that underlie it. Taxpayers didn't pay a penny, there was no contagion to other banks and Spain's sixth-largest bank opened its doors as usual on Wednesday morning.
In another way it was a complete flop, showing the perils to investors of relying on overengineered financial products. Popular was the first failure of a bank with contingent convertible bonds, supposed to provide a private-sector rescue by converting into equity when capital falls below a specified level (in Popular's case, one CoCo had a relatively high trigger at 7% of risk-weighted assets). The extra capital is meant to keep the bank functioning on its own, avoiding the need for painful bankruptcy or resolution procedures.
Instead of converting the EUR1.25 billion ($1.4 billion) of CoCos into shares, they were simply zeroed by the regulator, along with the shares, while another EUR1 billion of junior debt was turned into equity and sold for a symbolic EUR1 to Banco Santander. Conveniently, this extra capital exactly matched the regulator's new assessment of the shortfall, meaning senior debt and deposits were untouched.
The process suggests that investors might as well not bother reading the long and turgid CoCo prospectuses, and that time spent building complex models of the options embedded within a CoCo is wasted. If the regulator decides the bank is bust, the CoCo is worthless; the rest of the time it trades like normal junior debt.
CoCos are more like an insurance industry catastrophe bond linked to unpredictable hurricane damage than they are like ordinary corporate convertible bonds. Investors analyze the political and regulatory winds, but like weather forecasts, their reliability is limited. This unpredictability ought to make the bonds look more risky.
"They [CoCos] are priced way too tight," says Brad Golding, who runs a fund investing in bank bonds and stocks at hedge fund Christofferson Robb & Co. "How do you price the non-modellable risk of a regulator coming to your door the moment something looks weird?"
Popular suffered a disastrous bank run in its final days, even as it was trying to sell itself to bolster capital. A newly formed post-crisis regulator called the Single Resolution Board said those conditions forced it to act fast.
The rest of the CoCo sector was unperturbed by the Popular loss, to the surprise of those caught up in the brief panic a year ago around Deutsche Bank's CoCos.
One investor who lost money on Popular said everyone knew there were problems, but thought the bank would manage to raise capital. The lesson? "As soon as you get the first whiff of a problem you should get out as quickly as you can."
Part of the reason is that CoCos haven't worked. In a bank crisis a collapse in bond prices can be both an indicator of trouble and self-fulfilling, as it shows the bank cannot tap markets for more capital.
"When a bond really starts to trade down it's a signal to regulators that the market doesn't believe in that institution, and if the market doesn't believe in that institution, then it's not viable," said Piers Ronan, head of financial institutions debt syndicate at Credit Suisse.
This nasty cycle was one reason for the creation of CoCos, but they can provide such a thin sliver of new capital to a bank that they would make little difference.
CoCos are still one of the few places investors desperate for yield can find something -- but dramatically less than a year ago. One of Banco Bilbao Vizcaya Argentaria's CoCos yielded 16% last June, but now offers 6%, and many European CoCos yield 4% to 5%. With junk bonds yielding even less, this might attract some buyers. But the speed with which Popular's junior bonds went from the hospital to the graveyard should be a handy reminder of the risk these CoCos bring.
Write to James Mackintosh at James.Mackintosh@wsj.com
(END) Dow Jones Newswires
June 08, 2017 14:24 ET (18:24 GMT)