NVCC Bonds: How Much Risk Would You Take for an 8% Yield?
We don’t normally lead a blog post with a full-length quote, but today’s topic calls for exactly that:
As to new financial instruments, experience establishes a firm rule . . . that financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design, one that owes its distinctive character to the aforementioned brevity of the financial memory. The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets. . . . All crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment.
– John Kenneth Galbraith, A Short History of Financial Euphoria
Galbraith wrote that back in 1990, a full decade prior to the Tech Bubble and nearly two decades prior to the Housing Bubble. And yet, here we sit, fully 26 years later, dealing with this (emphasis ours):
All regulatory capital must be able to absorb losses in a failed financial institution. During the recent crisis, however, this premise was challenged as certain non-common Tier 1 and Tier 2 capital instruments did not absorb losses for a number of foreign financial institutions that would have failed in the absence of government support. To address this, on January 13, 2011, the Basel Committee on Banking Supervision (BCBS) released the Minimum requirements to ensure loss absorbency at the point of non-viability (the “NVCC requirement”). These requirements augment the BCBS’ recently published revised capital standards, Basel III: A global framework for more resilient banks and banking systems (Basel III) to ensure that investors in non-common regulatory capital instruments bear losses before taxpayers where the government determines that it is the public interest to rescue a non-viable bank.
This Advisory outlines OSFI’s expectations in respect of the issuance of non-viability contingent capital (NVCC) by DTIs.
Long-time readers can imagine the absurdity threshold required to pry us from our cozy quantitative-and-evidentiary shell into the treacherously amorphous bounds of economic commentary.
Well, we’ve reached it, and here’s why.
Banks make money by taking your deposits and loaning against them. In fact, the law allows for banks to loan out a surprising amount of capital against your deposit, up to 90-95%, keeping only a 5-10% capital cushion. If we assume that banks do this many times over (they do!), and that they’re pretty terrible at risk assessment (they are!), then it’s possible that the amount they’re required to retain may be unsuitable in the event of a confluence of non-performing loans coupled with a bank run.
So, what then? Enter non-viability contingent capital instruments (NVCCs).
If I purchase an NVCC, I ultimately own a hybrid financing security that lives in the netherworld between debt (which has higher capital structure priority in the event of liquidation) and equity (which has lower priority). In essence, when a bank becomes troubled and its Tier 1 capital requirements are breached, those NVCC’s are converted to common shares.
The operative word is theoretically. To understand why, let’s do a little thought experiment. Imagine that a bank’s equity capitalization has dramatically and consistently shrunk over the last year, say because the loan book is chock full of energy and commodity related debt. And let’s further imagine that their last three financing rounds – raising $1.2 billion in capital – have been preferred NVCCs, which are automatically converted to common equity if bank capital falls below a certain threshold. If you owned a bunch of those NVCCs and you saw the preferred stock value dropping closer and closer to the conversion threshold, what might you do?
Yes, these NVCCs offered a high coupon rate in an ostensibly ZIRP environment, but ultimately you get what you pay for. A sophisticated investor, for example, might get to the point where he says “ENOUGH IS ENOUGH,” and shorts an amount of stock equal to the convertible value of his preferred shares. In doing so, he hedges away his individual future gains and losses. However, new to the overall market ledger is his equity short. This exerts downward pressure on the common shares, which triggers a potential feedback dynamic pulling both common shares and NVCCs toward the conversion threshold like a tractor beam.
Such is the potentially perverse, unintended consequence of a security whose original intent was to act as a capital buffer!
Matt Levine sums it up nicely when he says (emphasis ours):
…Here’s the thing. If you are buying something with an 8 percent coupon in a world of zero interest rates, and you somehow think it’s a risk-free bank deposit, I don’t want to hear about it. That’s not a thing. The coupon tells you the risk. If you bought it for the 8 percent coupon, you ipso facto knew it was risky…
Look, we understand the motivations (and yes, the benefits!) of profit seeking. But financial engineering ought to have the dual goals of providing a meaningful return within a context full disclosure and the opportunity for risk management.
It seems that investors in this case are either under informed of the risks, or are reaching for yield as if attempting to pick up nickels in front of a steamroller. In either case, there is a critical missing link; Either the understanding of risk or it’s appreciation is conspicuously absent from the full assessment.
And we fear that – whatever that missing link is – tragedy lurks.
Be careful out there.