My wife and kids recently went on holiday for a few days to a static caravan site (we’re all in this together you know) somewhere in Sussex.
They brought me back a present of a stick of rock. Now I have not enjoyed the pleasure of such a treat for many a long year and I happily devoured it even though I knew it was going to rip the skin in the upper part of my mouth and cause me problems for days. Which got me thinking how strange it is that we enjoy things that are not good for us. Whether it be alcohol, cigarettes, fast cars, bungee jumping, drugs, or in my case sherbet pips (us analysts live on the wrong side of the tracks) many people regularly ingest, produce or take part in activities that may damage us either very quickly or very slowly — but invariably will damage us.
We are well aware of the risks but we continue anyway with a non-rational thought process of "it can’t happen to me" when we know deep down that it will happen to someone and there is no reason why it should not happen to us.
There have been a couple of examples of this kind of thought process in the capital markets recently. The first is with the product that was to be the all-new, all-singing, all-dancing answer to everybody’s prayers in giving excess yield to investors while providing banks with capital that can be adjusted to suit the underlying financial strength of the institution.
I refer of course to Cocos, a product which divides opinion more than Marmite. For some they are a wonderful opportunity to invest in paper that yields the equivalent of a high quality CCC corporate but issued by banks that have more core capital than ever before which have just gone through the disaster phase, are more tightly regulated and are now likely to be lower risk entities going forward (fingers crossed).
For others, Cocos have all of the upside of bonds with all of the downside of equities, which is not a great combination. In addition they are not eligible for inclusion in the leading bond indices and the rating agencies have made it clear that they would rather not assign a rating to these instruments because of the difficulty in assessing the potential loss. Plus of course that if an institution did appear to be in financial difficulty many investors would become forced sellers at exactly the worst time to sell.
Nonetheless the "Swiss finish" whereby the systematically important Swiss banks would have to hold 19% of total capital with a minimum of 10% of equity and the rest in Cocos looked like it could be the template for the future and when Credit Suisse issued earlier this year it looked like the brave new market could be on its way.
Since then regulation has rather dampened the prospects for the market but the proliferation of bond funds that were announced to take advantage of Cocos demonstrates a demand among the investor base.
Trigger-unhappy
However, the recent stress tests by the European Banking Authority inadvertently showed how Cocos could end up being quite dangerous for investors. The problem is not so much the structure of the product but the fact that while there is normally a trigger of tier one falling below a certain percentage there is another trigger point which is difficult to model.
As a reminder the Basel Committee published minimum guidelines which among other things stated Cocos "...must have a provision that requires such instruments, at the option of the relevant authority, to either be written off or converted into common equity upon the occurrence of the trigger event". The trigger event defined as "the earlier of: (1) a decision that a write-off, without which the firm would become non-viable, is necessary, as determined by the relevant authority..." Yes determined by the relevant authority.
Now look at the stress test results; 42 of the 91 banks would have a core capital ratio of less than 7% under the stressed scenario. Now imagine how the local regulators responsible for ensuring that the banks remain healthy would react to such figures. It is unlikely that they would wait until year end to examine the official tier one ratio as per the audited accounts to ensure that no breach has occurred for Cocos.
More likely they would be undertaking a stress test equivalent exercise on a regular basis. And they would probably be using a much higher level of stress to conclude whether or not the Cocos should convert. Or at least I would if I were a regulator, after all, why not sleep soundly at night and avoid a problem on your watch? Under this scenario half of the European banks could have seen their Cocos convert. That would leave an unpleasant taste in the mouth.
The other example is the continued bickering regarding the US debt ceiling. By the time you read this you will have eaten your fish and chips and I hope that the American politicians will have come to their senses and avoided a default.
I am sure they will because surely no one would be so stupid as to take all the negatives of a default without any of the positives (reduction in debt). But the stalemate has given the rating agencies plenty of excuses to downgrade the AAA rating of the US if they wish to do so. No one really knows what would happen in the event of a US default but I won’t be around next week to find out as I have decided to go for the traditional safe haven option. Well, actually it’s Milford Haven where my folks live but that’s close enough...
Gary Jenkins is head of fixed income at
Evolution Securities. All the opinions
expressed are those of the author as is his choice of holiday destination.