It clearly has been a weekus horribilis, that I concede. However one aspect of the this week's financial market and banking volatility doesn't yet chime with me. In addition to all the other reasons for the sell off, CoCo securities have been identified as a big contributor to the carnage. Bloomberg ran a story yesterday entitled The Trouble with CoCos which suggests they didn't work so well. Part of the reason for this concern is they way they work... an issuer can take a holiday on interest payments under certain volatile conditions including facing financial stress.
The article rightly states that "in times of stress, uncertainty over the conditions that trigger conversions may add to the sense of alarm" and continues with a quote from John Mack (whom I admire as a leader) saying "The thought of DB missing a payment was absurd because the government will not let that happen". This may or may not be true. However CoCo's are after all capital security and they are functioning as promised on the tin - capital for banks will be riskier than senior debt. And do we really want to think buying a 6% security is back-stopped by the government (i.e., society)?
I thought those days were over anyway and expectations of government support served as the incentive to transfer these risks to the capital markets (read CoCo holders) who have pocketed coupons of some 8x the risk free rate for taking the risk. Yes, we are in a new world (actually, I recall some volatility of the Lloyd's capital notes too during the crisis almost immediately post new issue) but this is what we have bargained for... if you buy ILS securities for example linked to floods and they occur, their value will drop! Are Coco's for everybody... no. I am not even sure I would be happy with my insurer buying these for their fixed interest portfolios. But we have convinced ourselves government bailouts - no more. If so, some party steps in to take asset risk in banks and CoCos have been touted as part of the battery of tools banks have today to manage their growing capital needs. Another perspective on this debate can be found at http://www.bloombergview.com/articles/2016-02-12/the-trouble-with-cocos.
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