9. • Optional conversion
• Mandatory conversion
• Accounted in Diluted
earnings per share
• NOT accounted in Diluted
earnings per share before
actual conversion
• Conversion signals growth
• Conversion signals trouble
EFIHello, this Efi P. We will be explaining to you with Paddy, what CoCos are. CoCos are not soft drinks, they are not fruits or vegetables. They actually belong to the capital structure of a corporation. Especially recently, they are very common in the financial sector.PADDY And I am Paddy H. and we will be explaining with Efi, CoCos. CoCos are no islands on the Caribbean, nor any cruise line or vacation airline. They have become in-vogue in the recapitalization of the financial institutions in Europe.The dialogue flows by alternating from one speaker to the other, unless otherwise marked by the blue arrows.
PADDYIn an earlier whiteboard video, I reframed the capital structure as an airplane seating arrangement. In the front (in business class) the bond holders are seated, so that they are close to the single front exit of the airplane.Then in the back (in coach class) we have stockholders who can get off last, in case of an emergency.And lastly, in the middle we have seats for hybrid structure holders.
EFINow I like to reframethe capital structure of a corporation, as a train with wagons. This train has only one exit door in the last wagon.Each wagon corresponds to an asset class from the capital structure. So, the bondholders sit in the last wagon, ready to jump first in case of an emergency and in the front wagon we have the equity holders.I like this metaphor because it is more European and it allows easily to add and rearrange wagons as needed.The bondholders, who brought their piggy banks, buy themselves tickets to travel in the last wagon. Paddy, we should emphasize the numbers of seats in each compartment.
PADDYI agree. In my airplane, the number of business class seats (bonds) compared to the number of coach seats (equity holders), typical for a financial institution, are 10 to 1. For every one seat in coach there are 10 seats in business class.
EFIIn my train too, normal In the financial sector, is 10 to 1.We are not considering normal, the Lehman Brothers train wreck during the subprime crisis, that reached a ratio of 35 to 1 (debt to equity ratio) during the peak of the crisis. Any ratios over 15 to 1, would make your airplane to nose dive and my train to accelerate dangerously speed because of the over-weight from the bondholders.
EFIWhen I think of any hybrid structure in the middle compartment, I am really thinking of some kind of cocoon that is potentially going to transform into a butterfly. So, the hybrid train compartment is packed with cocoon cargo. PADDYIn the middle class of either my airplane or your train, we have the hybrid structure holders seated. There can be preferred stockholders, convertible bondholders and our exotic sounding CoCo holders, an acronym for Contingent Convertibles. All of them cocooning and maybe ending up in further back in the plane or the train.
EFISo, there is a conversion possibility residing in the middle class or the middle train compartment. That conversion possibility, cocooning, can result in a movement from the middle towards the equity class.
PADDYAnd that will increase the seatings in the equity class and reduce any relative overweighting coming from the debt wagon. That will then reduce any speed acceleration or a nose-diving created from a very high debt to equity ratio.
EFILets zoom a little deeper into the hybrid area to understand how to differentiate among the various hybrids. For me there are three basic concepts for differentiating amongst hybrids.First, the nature of the conversionis it mandatory or is it optional?PADDYSecond, the accounting treatment- is the hybrid accounted for in the diluted earnings per share?or -is not before the actual conversion occurs?EFIThird, what does the actual conversion signal?- does it single growth?- does is it signal trouble? PADDYFor most hybrids, conversion is decided by the hybrid security holder. Usually to participate in the upside. So, basically the holder has the right… The issuer has sold this optionality.For CoCos, however there is no optionality. The conversion is mandatory if Core Tier 1 capital drops below the preset level. EFIMost convertibles are accounted in the calculations of diluted earnings per share.CoCos are not accounted for in the diluted earnings, before the actual conversion. PADDYThe mandatory CoCo conversion signals trouble with the business and the capital.Convertibles are converted, usually in a rosy corporate climate.
EFIIn 2009, Lloyds Capital issued over $12bil of CoCos with a 5% trigger.If Core Tier Capital 1 ratio dropped below the 5% trigger, the mandatory conversion would bring the ratio up to 6.5%. PADDYThe Lloyds CoCos were offered with roughly a 2% higher yield than comparable straight debt.
PADDYIn 2012, Barclays Capital issued $3bil of CoCos with a 7% trigger. EFIBarclay CoCos were offered with roughly a 1% higher yield than comparable straight debt.At the same time UBS also offered another $4bl with a 5% trigger.
EFIThis April, the Greek banks are discussing issuing a 5yr CoCo structure with a 5.125% trigger to be used in their recapitalization plan. PADDYThis Greek bank CoCo street talk has dragged as the recapitalization process is delayed further with the adjustments due to absorption of the Cyprus bank branches in Greece.
