The Securities Litigation Expert Blog

This post continues our series on insurance-liked securities ("ILS").

There has been a excessive amount of worry surrounding Deutsche Bank Contingent Convertible bonds ("CoCos") in the past week. (See our previous coverage here.)  As the weak sister in the European banking community, Deutsche Bank has been the focus of bond selling and consternation, as well it should be. The bank's stock is trading lower than during the Global Financial Crisis.

Chart 1: Deutsche Bank Stock Price Chart from 1999[1]

However, should anyone be surprised that Deutsche Bank's CoCo bonds have sold off? Absolutely not. Indeed, they have performed exactly as advertised.

So why the angst?

I believe it is another case of complexity risk. The CoCo bond structures are so complex that they have not been understood, even within the institutional investing community.

How could the sophisticated institutional investing community not understand a bond issuance? Days before the CoCo bond priced, Deutsche Bank issued a 44 page presentation to explain it's plans for strengthening it's balance sheet. I have extracted on page from that presentation below.

Chart 2: Deutsche Bank Explanation of "Comprehensively strengthening capital and leverage ratios for the longer-term"[2]

In order to understand this slide, you need to have facility with the following concepts:

• CET1 Capital;
• CRD4 Capital Ratio;
• G-SIB additional buffer;
• Conservation buffer;
• CET1 Minimum Ratio;
• CRD4 Adjusted Ratio;
• Pru Val;
• AT1;
• How these items will change between issuance and 2019

Luckily, Deutsche Bank provided some footnotes to help investors understand at these regulatory items, for example:[3]

Global systemically important banks buffer may vary between 1% and 3.5%… DB currently assessed in the 2% bucket. Alternatively, a buffer for macro-prudential and /or systemic risk of up to 5% can be set by EU member states. The higher of the G-SIB buffer and this systemic risk buffer is then applicable... (the 2019 Requirements) currently excludes the potential for a countercyclical buffer of up to 2.5%… (the Adjusted Ratio) comprises fully loaded CET1, plus all current eligible AT1 outstanding (under phase-in).

Trying to figure out EU member bank capital requirements may have led to investors taking their eye off the bond prospectus. The Deutsche Bank CoCo bond prospectus disclosed a number of red flags that should have put investors on notice about the speculative nature of the debt. Some of those include:[4]

• The bonds were rated below investment grade by S&P (BB), Moody's (Ba3), and Fitch (BB+) at issuance (P.1,7);
• The interest payments are made (or not made) at the complete discretion of Deutsche Bank and "depend on the Issuers Available Distributable Items ("ADI")… ADI means: the profit at the end of the financial year... any profits carried forward... minus any losses carried forward, and any profits which are non-distributable pursuant to applicable law". (P.8) Thus, any hit to profits, whether from an economic slowdown, loan loses, or settlement/litigation costs from regulators or others, would put the interest payments in jeopardy;
• Principal write-downs if Deutsche Bank's Tier 1 capital ratio fell to below 5.125% (P.11);
• A reduction in liquidity of the Notes from any event that could result in a write-down (P.11);
• Adverse price affects from changes in the Issuers Common Equity Tier 1 Capital Ratio (P.11);
• No scheduled maturity date for the Notes and redemption at the sole discretion of the Issuer (P.11);

Insurance, not Bonds

Deutsche Bank's investors seem to be upset that the CoCo bonds have declined in value.[5] They should not be. CoCo bonds are a form of insurance-linked security. By purchasing them, the bond holders have chosen to insure the bank's Tier 1 capital ratio.

Once this is understood, it becomes obvious how the bonds should trade. The principal is not the bond holders, it is the "insurers" (bond holders) reserves. If the insured event comes to be (Tier 1 capital declining below 5.125 percent), the reserves go to the insured.

An insurer would be willing to make this bet in perpetuity (while adjusting premiums along the way for changes in risk). The fact that CoCo holders are now complaining about their returns shows that they are not willing to make this bet over and over and that they didn't understand it to begin with.

Chart 3: Deutsche Bank 3.7% of 24, CoCo, and Common Equity Price Chart[6]

It appears likely that the complexities of CoCos blinded buyers to the fact that they were entering the insurance business, and that they didn't know how to do proper underwriting.

CoCo bonds are only suitable for those who have the ability to underwrite insurance on complex financial entities and who understand the shifting sands of European bank regulation.  (These two criteria probably eliminate the vast majority of CoCo owners.)

As most investors learn at some point: the market is an expensive place to get an education.

_________________

Notes:

[1]     Source: Bloomberg.

[2]     Deutsche Bank Investor Relations website; Available at: https://www.db.com/ir/en/images/Capital_increase_19_May_2014.pdf; Accessed February 15, 2016.

[3]     Id.

[4]     Deutsche Bank Undated Non-cumulative Fixed to Reset Rate Additional Tier 1 Notes of 2014 prospectus.

[5]     The Economist, Deutsche Bank's unappetising cocos, February 13, 2016; Available at: http://www.economist.com/news/finance-and-economics/21692933-investors-are-reassessing-yet-another-complicated-financial; Accessed February 16, 2016.

[6]     Source: Bloomberg.

 For information about insurance-linked securities expert Jack Duval, click here.

Guest Post by Len Santoro

Last year, European banks issued a record amount of a new type of high-risk bond meant to bolster each respective bank's Tier I capital in times of stress.  This year Deutsche Bank, which has been suffering through a lengthy restructuring and extreme litigation and settlement costs, may have to tap these bonds - wiping investors out.[1]

Deutsche Bank 6% Perpetual Contingent Convertible Bond Price Chart (Bloomberg)

These new bonds are called Contingent Convertible’s (“CoCo’s”).  They are a pre-funded source of capital meant to insure that the issuing bank maintains its Tier 1 Capital ratio if its other assets decline in value.

If a bank's assets suffer a catastrophic decline in value, the CoCo's are triggered and the capital gets transferred to the bank's balance sheet when it needs it the most, without having to go through a protracted and costly capital raise.

CoCo's can be considered a form of insurance-linked securities ("ILS") that insure against financial catastrophies (see our previous posts on ILS here and here).  CoCo's offer high yields, are highly complex, and can turn into equity or be written down to zero by the issuing banks at their discretion.

The creation and issuance of CoCo bonds goes back to the financial crisis of 2008-2009 which saw bank balance sheets destroyed by bad bets on sub-prime mortgages.  The international banking community, working through the Basel accords has been required to bolster its Tier 1 Capital.  CoCo bonds provide a buffer to an issuing bank's Tier 1 Capital.  Just like a catastrophe bond, if the issuing bank takes large losses to it's capital base, the CoCo bond gets written down for its owners and the assets are transfered to the issuer's balance sheet.

In this way, it can be thought of as insurance for the banks Tier 1 Capital ratio.

Tier 1 Capital

Tier 1 capital is comprised of common stock, retained earnings, some types of preferred stock, and certain hybrid securities such as trust preferred securities and now, CoCo’s.  It is used in the computation of a banks leverage ratio.  This ratio is calculated by dividing Tier 1 capital by total assets.

Since the global financial crisis, regulators have been working with banks to raise their Tier I capital (and thus lower their leverage).

Contingent Convertible as Tier I Capital

To qualify as Tier 1 capital, CoCo’s must meet a number of criteria, some of which include them being:

• Unsecured;
• Subordinated;
• Not convertible at the holders option;
• Having interest deferability where the profitability of the bank would not support payment.

Essentially, a CoCo is constructed to absorb losses when the bank's capital drops below certain regulatory levels.  Exactly how losses are absorbed varies by security and structure.

At issuance, CoCo’s are non-dilutive, debt servicing is subsidized by tax deductions, and, unlike traditional convertible securities, the issue is converted at the issuers discretion.  CoCo’s frequently do not have a maturity date and are typically callable every five years.  The other two key characteristics are the "trigger point" and the "lost absorption mechanism".

The Trigger Point

The trigger is the event that changes these securities from being contingent to certain.  Like ILS, CoCo triggers are very specific and are defined in the prospectus.  In practice, the trigger point is where the CoCo is partially or totally written down, or converted to stock.

Triggers can be formula- or regulatory-based and there are unique risks associated with each.  Formula-based triggers can be based on book or market value.  Book value triggers are less transparent and less timely.

Market value formula triggers have the advantage of being timely and transparent, however, they are subject to market pressures.

It's hard to imagine a situation where a trigger executed based on a regulator's decision would be preferred by the bondholder.

The Loss Absorption Mechanism

Loss absorption is simply the method through which management takes the bondholders investment.

There are two main methodologies for implementing this transfer of wealth.  One is through equity conversion and the other is through an outright principal write down of the bondholder's  investment.  Historically the loss absorption method has been evenly split between the two methods.

Equity Conversion

On the surface, equity conversion appears to be a preferential method for bondholders.  Having equity gives the bondholder some upside potential.  In addition, since equity conversion is dilutive, one can assume that management will be less motivated to implement the trigger.

However, the second part of the equity conversion method is the conversion price.  Depending on the issue, the conversion could be the market price at the time the trigger is breached or some other predetermined price.  Since a market price conversion would be dilutive, that is the most favorable to the CoCo investor.  A predetermined price conversion is less dilutive, and thus less attractive for bond investors.

Write-Downs

Some CoCo's give the issuer the ability to write-down the bonds to zero if certain triggers are met.  In this way, they are similar to Catastrophe Bonds that have been issued by reinsurers to protect issuers against severe weather events. 

The principal write-down security is most attractive to the issuer since it is not dilutive to current shareholders.  As with most bonds, what is favored by the issuer should be avoided by the bond investor.  The danger of buying a principal write down CoCo with a "high " trigger is that the company can obtain cheap capital when the bank is still well above insolvency, all at the bondholder’s expense.

As a general rule, market price equity conversion with low triggers is most attractive while principal write-down with high triggers are the least.  As with all fixed income investments, the bondholder must recognize that they and management are adversaries.

If a Coco bond write down is executed at a relatively high trigger point, it could be a windfall for the stockholders.  In such a case, there would be a transfer of wealth from the bondholders to the stock holders when the bank is still far from insolvency.

Suitability

CoCo’s have high complexity risk and are suitable only for the most sophisticated investors who are capable of understanding and evaluating their risks.  To fully evaluate the risks of a CoCo bond, an investor (or advisor) would need to understand at least the following factors:

• Bank capital requirements and potential changes to those requirements;
• The effect of the investment on an overall portfolio
• Currency risks
• The terms and provisions of the security
• How economic and interest changes might affect the security

In the Deutsche Bank deal mentioned above, the prospectus states:[4]

The Notes may not be a suitable investment for all investors.  Potential investors must determine the suitability (either alone or with the help of a financial adviser) of an investment in the Notes in light of their own circumstances.  In particular, each potential investor should:

• have sufficient knowledge and experience to make a meaningful evaluation of the Notes, the merits and risks of investing in the Notes...
• have access to, and knowledge of, appropriate analytic tools to evaluate, in the context of his/her particular financial situation, an investment in the notes...
• have sufficient financial resources and liquidity to bear all of the risks of an investment in the Notes, including the risk not to receive any return on investment or repayment of the invested amount...
• understand thoroughly the terms of the Notes and be familiar with the behavior of the financial markets; and
• be able to evaluate possible scenarios for econmic, interest rate and other factors that may affect his/her investment and his/her ability to bear the applicable risks.

Clearly, CoCo's are only appropriace for the most sophisticated market participants.  Furthermore, Deutsche Bank also attached a minimum lot size of the issue of $200,000, which demonstrates that it was not targeted for retail investors.[5]  (Most corporate bonds have $1,000 minimum lot sizes.)

In the current low interest rate environment, the mid-single digit percent yield on most CoCo’s is attractive[6].  However, chasing yield in CoCo bonds could end badly, especially for investors who did not understand what they were sold.

CoCo’s are only appropriate for investors who are comfortable speculating with their investments and who are prepared to see their CoCo investment wiped out if the bank issuers comes under stress.  As with all ILS, CoCo bonds should only be purchased in diversified pools and only represent a small portion of an investor’s diversified bond portfolio.

_________________

Notes:

[1]      John Glover, "Deutsche Bank's Woes Threaten CoCo Coupons, CreditSights Says", Bloomberg.  Available at:  http://www.bloomberg.com/news/articles/2016-02-08/deutsche-bank-s-woes-threaten-coco-coupons-creditsights-says; Accessed Tuesday, February 9, 2016.  For general background on CoCos, see:  John Glover, “Riskiest Bank Bond Sales Swell to Record in Europe”, Bloomberg, http://www.bloomberg.com/news/articles/2014-10-01/riskiest-coco-bonds-post-record-sales-in-europe-credit-markets (October 1, 2014)

[2]           FDIC, “Optional Regulatory Capital Worksheet”, https://www.fdic.gov/news/news/inactivefinancial/1998/fil9833b.pdf

[3]           Deutsche Bank Research, “Contingent Convertibles: Bank Bonds Take on a New Look”, May 23,2011, https://www.dbresearch.com/PROD/DBR_INTERNET_EN-PROD/PROD0000000000273597/Contingent+Convertibles%3A+Bank+bonds+take+on+a+new+.pdf

[4]           Deutsche Bank 6% Perpetual Contingent Convertible prospectus, 8.

[5]        . at 5.

[6]           These yields are approximately three to four full percentage points over senior bank note bonds.

 For information about insurance-linked securities expert Jack Duval, click here.

For our introduction to Insurance-Linked Securities ("ILS"), see this.  In this post, I examine very likely ways in which ILS could be highly correlated with other assets.

                                                   An F-1 tornado hits downtown Miami on May 12, 1997.  Photo:  USA Today.

Non-Correlation?

Insurance-linked securities are often touted as being non-correlated to traditional asset classes such as stocks and bonds. A recent research piece by Pioneer Investments listed the following 13-year correlations of ILS:[1]

• U.S. Equities: 0.2;
• Hedge Investments: 0.11;
• Commodities: 0.2;
• U.S. Aggregate Investment Grade Bonds: 0.19;
• U.S. High Yield Bonds: 0.28.

Pioneer concluded:

One of the most appealing aspects of ILS is its potential diversification properties. By definition, performance is driven by random meteorological or geophysical catastrophic events, which leads to a very low correlation to traditional financial market investments… We believe including ILS within a broader asset allocation can have powerful diversification benefits and total return potential.[2] 

While this may be true much of the time, it will certainly not always be the case. ILS investments must be vetted very closely for potential connections to the buyer and the economy in general.

Correlations

There are many scenarios in which ILS could be highly correlated to an investor’s total wealth[3] and for an institution, their other asset classes. I give examples of these correlations below.

Individual

Individual investors should not invest in ILS, nor pools of ILS, that insure perils they could experience themselves. An example would be a resident of South Florida owning ILS that insured risks such as: named storm, hurricane, wind, or water for South Florida. In such a scenario, the individual would be adding those risks to their portfolio when they were already exposed to them through their real estate holdings, businesses owned, and income steams.

This is a form of Company Town Risk, where many elements of an individual’s total wealth are connected to a common risk exposure. In our hypothetical scenario, the South Florida resident and business owner could have their total wealth wiped out by a category five hurricane that destroyed the individual’s office building and home. Their income would be stopped, they would be out of a home, and if they owned ILS with South Florida exposures, they could be severely haircut, if not entirely written down.

If the individual owned state or local municipal bonds, the impact could be even worse as their previously uncorrelated, safe, investments became correlated and unsafe at the worst time. 

If these scenarios seem far-fetched, consider Hurricane Patricia, which was the largest hurricane ever recorded in the western hemisphere. Patricia accelerated from a tropical storm into a category five hurricane in record time. Luckily, it made landfall near sparely-populated Manzanillo, Mexico, and then continued into the mountains of western Mexico where it quickly lost power.

Los Angeles is only about 1,700 miles north of Manzanillo and San Diego is closer. If Hurricane Patricia had made landfall in Los Angeles, it could have knocked out America’s biggest port for a month or more. The damage to Los Angeles and San Diego infrastructure could have been enormous. If airports, bridges and other utilities were shut down for prolonged periods, they would lack the revenue to meet debt payments.  This would certainly result in sharp markdowns to local and state municipal bonds as well as possible defaults.

The national economy could be negatively affected as well with a few points of GDP being shaved off due to bottlenecks and idled workers.

Institutions

Institutional investors face similar issues. For instance, a large university in the south- or mid-west would have the same Company Town Risks described above. An F-5 tornado that hit a large metropolitan area where a university was located could cause high levels of property destruction and prolonged interruption of services.  The impact would likely be negative in a number of areas: university revenues would decline, as would the prices of any debt they had issued (raising the costs of financing), and any local ILS exposures would likely take an extreme, if not complete, write-down.

While there would almost certainly be insurance on university property, any ILS they owned would serve to limit those coverages. Indeed, an endowment that owned ILS that insured local tornado risks would merely be paying the university insurance proceeds from its own pockets.

In effect, the university would have paid for insurance coverage and then added the exact same risk back through the ILS.

This scenario holds true for all institutional investors, especially those running pensions or other asset pools for individuals in one geographically concentrated area.

Complexity Risk

ILS have a Byzantine complexity that only adds to their risk. Compounding this is the fact that most money managers are not insurance or underwriting experts. This implies that even the most sophisticated institutional investors will have to rely on third parties to vet and select ILS for them. Outsourcing understanding and due diligence is a risk that is uncompensated and frequently ends badly. Many institutional money managers discovered this the hard way after relying on the ratings agencies to understand and evaluate CDOs for them.  

As has been well documented, the rating agencies didn't know what they were doing, but the institutions took the loss.

I have discussed in a previously published white paper how investment complexity is a discrete risk factor. In subsequent posts I will discuss how complexity risk manifests itself in ILS and how they are only suitable in highly diversified investment vehicles, for very small percentages of a portfolio, and where a complete loss would be acceptable.

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Notes: 

[1]      Insurance-Linked Securities: A Primer; Pioneer Investments; 2015; 4. Available at: http://us.pioneerinvestments.com/misc/pdfs/brochures/ils_primer.pdf;jsessionid=3469F67B1699177CBEDA86053B26AE10.atg01-prd-atg1?adtrack=ria_ils_pdf_primer; Accessed November 8, 2015.

[2]       Id. at 3-4.

[3]       For an explanation of Total Wealth, see our “Company Town Investing” white paper, available at: http://blog.accelerant.biz/blog/company-town-investing-white-paper.

For information about insurance-linked securities expert Jack Duval, click here.

This is the first blog post in a series exploring the risks and suitability of insurance-linked securities ("ILS") for retail and institutional investors.

              Hurricane Patricia as seen from space.  Photo: The Telegraph.

Insurance-linked Securities (“ILS”) are high yield debt instruments used to transfer specific risks from an insurance or reinsurance company to the debt holders.  In effect, they allow the debt holder to act as a reinsurer for the ILS issuer.  ILS are a significant development because they allow insurers to fund specific risks directly from the capital markets.

Some of the risks insured (called perils) include:

• Hurricane/Wind
• Earthquake
• Severe Thunderstorm
• Winter Storm
• Cyclone
• Typhoon
• Volcanic Eruption
• Meteoric Impact
• Lottery Jackpot
• Health Claims
• Extreme Mortality

The most unique trait of ILS is that they usually have a binary payoff structure that hinges on a pre-defined trigger.  If the trigger is not reached, the ILS performs like a traditional bond, providing interest payments and then the return of principal at the maturity date.  If a trigger is reached, then the ILS performs like a bond from a distressed company.  Interest payments may be stopped and the principal amount paid back may be severely haircut or written down completely.

This binary payoff structure makes an ILS a speculative investment.[1]

Life Insurance Swap Example

The easiest way to understand ILS may be to think about them in terms that most people are familiar with, term life insurance.  Term life insurance policies can be thought of as very simple swap agreements.  The buyer of the policy pays a fixed rate payment every year for the term of the policy (let’s assume a 20 year fixed term policy).  The insurance carrier pays the policy owner a variable rate each year.  The determinant of the variable rate is whether or not the insured person is living.  If she is, the variable rate is zero, if she is not, the variable payment is the policy’s face value.

With ILS, the roles are reversed.  The insurance (or reinsurance) company becomes the buyer of the insurance and the ILS holder is the seller of the insurance.  The insurance company pays the fixed payment to the ILS holder (the premium payments, or interest) and receives back a variable payment determined by the occurrence of a trigger event.

Chart 1.  The Swap Structures of Term Life Insurance and ILS

Differences Between ILS and Traditional Bonds

The comparison of ILS and term life insurance is true in spirit, but leaves out one important detail, the existence of an intermediary between the ILS holder and the ILS issuer.  In the case of life insurance, the premium payments by the policy owner go into the insurance carrier’s general account where they are conservatively invested in order to meet future claims.

With ILS, the entire insured amount is held as collateral by a third-party trustee.  In effect, the insurance proceeds have been paid upfront and are being held in escrow.  If there is no triggering event, the proceeds revert back to the ILS holder, just like a typical bond returns the principal amount invested at maturity.  If there is a triggering event, the proceeds are delivered to the issuer (although sometimes after a delay of up to 36 months).

Collateralized Risk

Even though they are frequently called “bonds”, most ILS are not structured as typical fixed income securities.  A typical bond transaction is motivated by an entity that wants to raise money for its operations but does not want to sell an equity interest in itself.  In most cases, the entity will borrow money from lenders in exchange for interest at a specified rate and the promise to pay back the amount borrowed at a specified time.

The raison d’etre of a bond transaction is that the issuer will get the use of the proceeds until the bond matures, at which time the principal has to be repaid.  ILS do not work in this manner.  Indeed, in most cases, the issuer will never get the use of any of the proceeds.

Instead of going to the issuer, the proceeds from an ILS are usually held in a trust account and typically invested in risk-free assets such as U.S. Treasury bills or money market funds.

The issuer does make payments which flow through to the noteholders (as does the investment yield on the assets held in the trust account).  However, these payments are not interest payments as with traditional bonds.  They are insurance (or reinsurance) premium payments.

In this way, the buyer of an ILS is in effect an insurer.  If the insured event never happens, the insurance premiums are kept by the ILS buyer and no payments are made to the issuer of the ILS.  At the end of the contract term the principal held in trust is returned back to the ILS holders.  However, if an insured event trigger is reached, the premium payments can stop and the principal held in trust is (partially or completely) transferred to the issuer as a loss payment.  In this case, the note holders would receive back the remaining principal or nothing.[2]

This transaction structure is visualized below using the Everglades Re Ltd. Catastrophe Bond as an example.

Chart 2.  Everglades Re Ltd. Transaction Structure[3]

ILS have a high degree of complexity risk, are speculative, and have a very real possibility of going to zero.  They should only be recommended (and purchased) in contemplation of a complete loss.

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Notes:

[1]                 “Speculative” is a term of art on Wall Street and is typically reserved for investments which have a high probability of becoming worthless.  Long stock options are a good example of speculative investments.  If they are out of the money at expiration (the stock is below the call price), they become worthless and the entire premium paid is lost.

[2]                 As will be discussed more below, it is not uncommon for the maturity date on many transactions to be extended by periods up to 36 months to allow for loss development and reporting.  These extensions do not apply to the risk period.

[3]                 Everglades Re Ltd deal structure was obtained from Standard & Poor’s RatingsDirect research.  Available at: https://www.citizensfla.com/bnc_meet/docs/551/02f_presale_s_p_everglades_re_ltd_report.pdf; Accessed October 25, 2015.

For information about insurance-linked securities expert Jack Duval, click here.