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CoCo Bonds

In Le Gardien on November 17, 2009 at 12:08 AM

“You are what you eat,” so goes the old nutrition adage.

That thought in mind, Le Gardien represents a new thread provided here, one whereby the freshest products being offered in the financial planetary landscape will be explored and/or at least made known a little more so in fuller, adequate lighting.

That said, Lloyds Banking Group of London is issuing one of the newest products on the market as of this quarter. Financial Times of London reported a headline on November 5 reading, “Stability concerns over CoCo bonds,” and a second article scrolling, “UK experiment raises prospect of new asset class.”

Rent losses have been mounting for banks since the U.S. sub-prime housing collapse in 2006, imploding exotic debt contracts arranged by interconnected counterparties dispersed around the world over.

Many have written on the subject.

For an overview, read about the evolution of the once-popularized bundled mortgage-backed securities market here. Also available is a more general history provided by Niall Ferguson, British financial economic historian, here.

Llyods apparently is moving ahead as the first investment house boldly willing to introduce the new product friendishly titled the “CoCo bond.” Her groping is essentially being characterized as an effort to find a viable replacement/substitute for once lucrative CDOs, SIVs, Hybrids, and the like.

From the jist of the article as written, CoCo bonds are a new, unexplored breed of swappable financial engineering. Standing for “contingent convertible” instruments, these are irregular bonds that are transitional, capital contingent and debt-to-equity convertible in nature; in a sense, complicated; in a sense, sophisticated.

In these stylized bonds, there, by method, typically exists what is referred to in the industry as a “trigger” mechanism, i.e., an event in which a change in contractual terms occurs. Counterparties involved in the contract at that point, post-trigger instance, are then subjected to a newly enforceable, binding agreement.

For example, if say a financial institution experiences a drop in capital level below a certain pre-specified level, say 10 percent, in this case the hypothetical “trigger event,” what happens is that immediately the terms of the contract are enforced into effect in one-for-one manner, swapping the debt-ownership interest, in the form of ownership of that bond, into equity-ownership interest, in the form of stock ownership in the same company.

The idea, things turn for the worse with a financial institution, then at some pre-specified trigger threshold, the bank is instantly re-capitalized by the contract.

Members of the Financial Services Authority (FSA), the SEC-equivalent overseas in the U.K., have mixed hopes for this new instrument. In short, it has not weathered any business cyle, it is young, and there exists no long historical stress-testable data.

Will CoCo represent the next Vioxx?

All one can say at this point, firmly, is that CoCo bonds are new, complex and being eaten away at by financial beings the likes of Lloyds Banking Group.

Skilled and skeptical papers are taking note, so stay tuned.

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