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Bagehot is Rolling in His Grave over AT1s

Iris: Courage, old men! She, whom you see, is Lyssa (Madness), daughter of Night… Come then, unwed maid, child of black Night, harden your heart relentlessly, send forth frenzy upon this man, goad him wildly on his mad career. [H]e may learn to know how fiercely against him the wrath of Hera burns; otherwise, if he should escape punishment, the gods will become as nothing, while man's power will grow.

Lyssa: Of noble parents was I born, the daughter of Night, sprung from the blood of Uranus, (the Cosmos); and these prerogatives I hold, not to use them in anger against friends, nor do I have any joy in visiting the homes of men; … wherefore I counsel you, do not wish him dire mishaps.

Iris: Spare us your advice on Hera's and my schemes.

Lyssa: I seek to turn your steps into the best path instead of into this one of evil.

Iris: It was not to practice self-control that the wife of Zeus sent you here.

—Euripides, Heracles

Axiom Alternative Investments, largely a Société Générale alumnus operation, just launched a fund that targets contingent convertible bonds predominantly from large European banks. A dedicated coco fund is not new. However, I believe Axiom has a tactical edge over its competitors.

First, Axiom is a child of the great quant crisis of 2007-2008. Unlike many that have just barely survived, this one has thrived. Axiom’s AUM in January 2013 was €260 million. It is now €550 million. Experience costs blood and some get a taste for it and can’t look back. This is the key to their success. I should think they rather like sailing into the very heart of the storm, a son of Lyssa.

Second, Axiom Contingent Capital’s father is the bland and reactive bureaucrat called Basel III, an arranged suitor to his raging mom. Thematically, they believe in recovery and focus on bank debt. Strategically, they are financial engineers in the capable French style. Tactically, they report being on top of ever-changing banking regulations that allow them unique understanding of bank capital instruments hard to value or understood. They attempt to generate at some of their alpha by navigating the oceans of ink spilled on bank regulations in the last few years.

I have to admit this fund is an intriguing concept. Contingent convertibles, or CoCo/AT1s/AT2s, are both uncannily authentic and thoroughly synthetic. Authentic because European banks are and will be capital starved for years. Synthetic because contingent convertible bonds are new, not very bond-like, and can very easily blow a regiment of yield-chasers to bits. I presume that yield-chasers will find the most appeal in it.

At1s are the product of the regulator brain-trust, in response to a basic problem: Subordinated bank debt was not sufficiently loss-absorbing in 2008 and 2011. Shareholder or taxpayer money was used bail in or bail out banks but subordinated bondholders rarely had to bear any losses at all. AT1s are intended to replace traditional debt because default on legacy sub debt has meaningful and painful consequences. They make debt less of a bonding instrument.

AT1s don’t default. They convert. These new Additional Tier 1 and CoCo securities are CRR-compliant subordinated bonds intended to absorb losses when the bank’s capital falls below a predefined trigger level usually situated between 5.125% and 8%. While terms are bank-specific, in all cases losses are absorbed in two possible ways:

  • Principal write-down or conversion into shares if regulatory capital falls to a level considered critical by the regulator. This is subject to change in the future at the regulator’s discretion.

  • Risk of coupon suspension if the bank does not hold sufficient distributable reserves or no longer complies with the requirements established by the regulator.

Of course, few bond buyers in their right mind would think this an improvement on conventional sub debt, so the regulators instituted coercions to move money into these instruments. Namely, existing subordinated debt instruments will have reduced eligibility as regulatory capital during a grandfathering period ending in 2022. After 2022, non-compliant legacy instruments will become ineligible as bank regulatory capital. No more bank sub debt, hello CoCos.

It’s a key part of the larger Bank Recovery and Resolution Directive (BRRD) that entered into force on January 1, 2015. This directive creates a single rulebook for the resolution of banks in all EU member states. The new rules ensure banks’ shareholders and creditors pay their share of the costs of a bank wind-up through a “bail-in” mechanism.

Heaven forbid Europe actually considers letting an undercapitalized, poorly run, insolvent bank actually wind-up. Bagehot would be rolling in his grave. My Uncle Larry would be no doubt spitting venom from his grave. AT1s aren’t the New Age crap to sign up for. But the plan is to provide little alternative but to chase those yields.

Anyway, AT1 bond issuance as of December 2014 amounts to 100 billion euros. Due to the coercions, The AT1 market could be worth as much as 300 billion euros in the coming years as banks could issue AT1 instruments up to 2.5% of their risk-weighted assets.

In exchange for about 200 basis points over bank sub debt, you assume “trigger event” risk, which decomposes into:

  • Coupon cancellation risk: coupon payments on such instruments are entirely discretionary and may be cancelled by the issuer at any point, for any reason, and for any length of time.

  • Haircut risk: if a certain capital level is reached, these bonds are either converted into shares or partially or totally written down.

  • Principal payment risk: these are perpetual bonds that can only be redeemed at the issuer’s discretion on predefined call dates.

  • Capital structure inversion risk: contrary to classic capital hierarchy, investors in such instruments may suffer a capital loss, as subordinated creditors will be repaid after ordinary creditors and before shareholders.

I fail to see the dopeness here, and I have a pretty good eye for what is dope. Which to say I would expect more than a 2% complexity premium over conventional sub debt in exchange. At that spread level all I’m seeing are boys in grey uniforms running across an open field towards Union artillery, because they have no other viable alternatives. Or a fragment of some Greek tragedy. With perpetuals, there is a price where it could make sense. But with a perpetual AT1, well, the grave could be already dug and man still continues to hope.

Maybe our regulatory overlords living in the gated communities of Mt Olympus are just panicky. Or maybe they know something that we don’t know about how fragile the European banking system is. Or maybe if we mere mortals didn’t count out here in the low lands, they would become nothing.

I hope the first is the case. Either way, if you play with a cat, you must not mind her scratch.

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