Are CoCos Nuts?

I was going to write about peer-to-peer loans this week, but instead I am going to concentrate on another new type of investment that offers high headline rates of interest.  They are known as CoCos and this week the Financial Conduct Authority used a new tool in its armoury to effectively ban their sale to retail investors.

The ban states that contingent convertible instruments, to give CoCos their full name, are ‘risky and highly complex instruments’. And indeed they are and I certainly welcome this pre-emptive ban. If a product can’t reasonably be understood by a private retail investor or, frankly, those advising them then clearly trading in it should be restricted to those with far more experience.

But I thought I’d give you a bit of insight into what they are and why they exist. And it’s not a story about financial recklessness, quite the opposite. They are a tool intended to aid financial stability – although with billions now in existence, that has yet to be tested.

One of the great realisations of the recent crisis was that some financial institutions were ‘too big to fail’. In other words, they had become so large and so complex that if they became troubled, that trouble would quickly spread to other financial institutions and threaten the whole financial system. I have written in previous blogs about a ‘network effect’ and this made the financial sector especially vulnerable.

And the poster child of this problem was an investment bank called Lehman Bros. When it failed in 2008 it set off waves of destructive ripples through the balance sheets of other financial institutions that were more severe than regulators in the States or elsewhere expected.

They had hoped that through a process known as ‘resolution’, the bankruptcy of Lehman could actually be orderly and give confidence to the rest of the market. And it’s true to say with other failing banks this did work, such as Washington Mutual. But with Lehman, which had a large and highly leveraged international operation, it patently did not.

And that realisation meant that regulators around the world knew that, given the resolution process was so inadequate, that they would have to keep their major financial institutions alive – even if that meant providing them with vast tax payer funded loans.

Now you don’t need me to tell you how unpopular those bailouts were and remain. And institutions, such as the Bank of England have been looking at ways ever since to improve that process of resolution so that if a bank gets into trouble it can be resolved in a more orderly fashion – and without resorting to the national purse.

To do that it wants to insure that, not only do banks have sufficient capital as a buffer against losses, but also that those who provide that capital via loans (bonds) and equity (shares) know that if that buffer gets depleted they are first in line to meet those losses – not depositors, not those who have lent the bank money that is secured against an asset for example and not tax payers.

So how do CoCos make this process more orderly? Well, the buffer I mentioned above is officially known as Tier 1 capital and a loan to a bank that helps meet this buffer has very little protection in the event that a bank needs to use the loan to meet losses.

What then normally happens is that there is a long drawn out process where the lenders meet with the bank to see how much of their money they will get back and only when it becomes clear it will be very little will lenders reluctantly accept shares in the bank as compensation for losing the value of their loans – known as a debt for equity swap.

Now, long drawn out processes are not good for market confidence or stability. Investors like certainty and this is why the Bank of England has championed the development of CoCos, because they have this whole process already built in.

If you own a CoCo loan with a bank, you already know that if the Tier 1 capital is threatened your loan will be converted to shares in the bank. The Lloyds Bank CoCos convert if the Tier 1 capital falls to 5%. And from the Bank of England’s perspective, they have control over this simplified process as they are responsible for announcing the conversion has been triggered.

It also ensures that at exactly the time that a troubled bank needs the benefit of swapping a loan for shares it is able to do so. You could call it repayment insurance for the original loan.

One of the proponents for these types of convertible loans or bonds is Andrew Haldane, the Executive Director for Financial Stablility at the Bank of England. He laid out the case for their use in banking and other areas in a speech titled ‘Debt Hangover’ in 2010.

I got to hear him speak on the more recent topic of ‘This Market’s Nut’s’ at Camp Alphaville, which I mentioned in my last blog. He was one of several speakers on the topic and it was not his choice of title, but there was clearly awareness that all this liquidity central banks have created, coupled with a low interest rate environment have led to a chase for high interest rate investments – whatever the risk profile.

And I suspect this is also in part where this ban has come from. Not only do the Bank of England and the FCA want to avoid poorly informed investors holding such products at this time, but if the Bank of England ever pulls the conversion trigger on one of these loans they do not want to be dealing with a bunch of retail investors claiming they never understood the risks.

Far better to be dealing with experienced investors, used to valuing other complicated hybrid investments such as convertible bonds – my own specialist area for several years.

And even where investments are allowed it’s important to know their limitations or know someone who does. And this whole series of blogs is designed to help you do that. It’s so easy to get over confident as I have mentioned before.

My wife and I still have the emotional scars from the time, given a background in art, I offered to apply her makeup for her. I was hoping for the subtle look of Coco Chanel, but she got the more distinct appearance of Coco the Clown. The pictures are here.

But that’s enough cocos for one day!

Please remember:

• past performance is no guide or guarantee of future returns;
• the value of stock market investments can rise and fall over time,  so it is quite possible to get back less than what you put in, depending upon timing