Fear the wrath of COCO BONDS. [Spoiler alert: CoCos will make the 2007 financial collapse look like child’s play.]
I’ll try to explain the mechanics of CoCos in a moment. But, first, let’s talk about WHY CoCos exist.
Some clever human being invented a financial instrument for corporations called CoCo Bonds. Here’s MY interpretation of CoCo Bonds… A corporation is allowed to hide risk, since GAAP rules, (Generally Accepted Accounting Principles), do not require reporting of CoCo Bonds. Later, if a certain financial event occurs the corporation is allowed to CONVERT CoCo Bonds into their stock, (company shares), or to dip into investors’ and savers’ bank accounts to pull out their money, without their consent–called a bank “Bail-In”–and use their money to cover the bank losses. In that way, the loss is never actually reported and until the conversion event is triggered, the bank is able to meet Basel-3 capital ratio banking rules.
Lloyd’s bankers are credited with issuing the first CoCo Bond back in 2009 which, if the convertible feature had been triggered, allowed the bank to trigger a bail-in to cover its losses.1 [A Bail-In is the right given to a bank by government regulation to confiscate YOUR bank account savings to cover the banks losses. Canada and some European countries has this. USA is considering doing the same.]
These coco Bonds allow corporations to hide their massive obligations, their debts, their bad loans, their CDS’s (Collatoralized Debt Securities), by wrapping those “BAD” and high-risk financial instruments in the stealth protection provided by CoCo Bonds.
CoCo is the financial acronym for “Contingent Convertible” meaning that the financial instrument CONVERTS when a certain event takes place. The conversion may come from a debt into an equity, (stock) or, in the case of some banks, into a bail in. To make this a bit clearer, let’s look at a bank fictitiously named “Fat-Cat”.
Fat-Cat bank has been taking on high-risk loans, and investing in high-risk stocks in the stock market. Loans and stocks are now going sour. Fat-Cat realizes it is going to be in deep financial trouble. Fat-Cat bank puts up a CoCo Bond based on converting to a bank bail-in in the event the capital ratio falls below 5.125%, where 5.125% is the capital ratio required by “Basel-3” global banking guidelines. If Fat-Cat’s capital ratio drops below 5.125%, the CoCo Bond is permitted to “convert” and the bank allowed to take savers’ money in exchange for a piece of paper back to the account holders that says something the financial equivalent of “I.O.U.” or “You are now the proud owner of X number of shares in our failing bank.”
For companies, especially banks, this concept of CoCo Bonds allows for emboldening much more, and much more aggressive, risk taking, the very action that created the financial collapse of 2007. CoCo Bonds will make the financial collapse of 2007 look like child’s play.
The BIS Quarterly Review, September 2013, in an article titled, “CoCos: a primer”, authors, Avdjiev, Kartasheva, and Bogdanova explain that CoCos, “…are hybrid capital securities that absorb losses when the capital of the issuing bank falls below a certain level…CoCo issuance is primarily driven by their potential to satisfy regulatory capital requirements.” By the way, the BIS, an acryonum for Business of International Settlements, is the supreme commander bank overseer of all banks throughout the world. So this concept of CoCos is not a “surprise” to that grand lord of banks.
- “Regulators must act on coco bond risks” By Alberto Gallo. Ft.com. May 7, 2014.
NOTE: I am not a financial expert. Go talk to a certified Financial Planner or Analyst about your savings and investments and before you attempt any do-it-yourself investing. This is probably the best time to go talk to a qualified planner or analyst. Why? Because the markets and the investment tools and accompanying opportunities is becoming very complicated.