Algebris Investments

Originally published in the July/August 2011 issue

The credit crisis and the subsequent sharp downturn in economic growth have presented economic policy makers and central bankers with an unparalleled series of challenges. They have sought to keep economic activity ticking over through quantitative easing and negative real interest rates in order to give heavily burdened borrowers the capacity to repay debt.

For commercial and investment banks, the need to shrink balance sheets and reduce leverage levels continues. The higher bank capital adequacy and liquidity demands of Basel III are also curbing balance sheets. In turn, subdued lending is leading to meagre economic growth.

One way out of this cul de sac and the downward spiral it may induce is to require banks to sell contingent debt that can be converted to equity when a regulator deems that a bank has insufficient capital. This debt would allow for a preplanned recapitalization in the event of a future financial crisis with private capital. These contingent convertibles, known as CoCos, are capital instruments that convert into equity when a pre-set trigger is hit.

Two hedge funds in London, The Children’s Investment Fund and Algebris Investments, whose 2006 launch by Eric Halet and Davide Serra drew backing from TCI, have been major investors in CoCos. This is still a very new market where total issuance currently amounts to around $25 billion, but the potential size could be many times that as banks rebuild their capital structures. Credit Suisse and Lloyds have been the biggest issuers of CoCos with multi-billion issuances this year and last. In early July, Allianz became the first insurer with a CoCo issue when it sold a €500 million tranche to Nippon Life.

Providing reserve capital
“It became increasingly obvious that moving towards the CoCos was a no brainer,” says Alessandro Lasagna, a director of Algebris. “It means banks had a reserve paid in capital as insurance. But the development of the CoCo market is still in its infancy.”

The Algebris Financial CoCo Fund launched in March 2011 and hasgrown assets under management to $270 million by mid-year. It is expecting further inflows with the launch of Delaware and Cayman feeder funds – the latter for pension fund allocations (made through the ERISA regime and requiring Securities and Exchange Commission registration) as well as non-taxable US money.

Because there hasn’t been enough CoCos issuance to satisfy the investor demand, only about 40% of the fund is invested in them. The rest of the fund is invested in old style hybrids. As issuance picks up, funds will be transitioned into freshly minted CoCos of which two or three new issues are expected to come to market in the final months of 2011.

The continued weakness in bank balance sheets, notably in Europe and the US, makes it probable that contingent capital instruments will play some role in helping to recapitalize these financial institutions. CoCos look attractive since they offer reserve capital representing additional prefunded equity in anticipation of a future crisis. As such, they provide a solution for the ‘Too Big to Fail’ dilemma attached to many banks and can help to limit future demands on public sector support. In turn, this could limit the fallout from a single bank failure and potentially reduce the follow-on failures that define a systemic crisis.

There is also an argument that CoCos can help change banks’ risky behavior. Since the instruments are automatically triggered when a capital ratio is breeched directors of financial firms have incentives to limit risk-taking behavior.

“If you are an equity investor and you have something that converts into equity, you’ve got to feel comfortable taking a position in that tranche of capital,” says Lasagna. “Speaking to regulators it was becoming more and more obvious that they wanted a piece of the capital structure that was loss absorbing. Hybrid instruments didn’t do this well enough.”

Basel III imperative
What is certain under Basel III is that banks must raise substantially more equity. Under Basel II European banks could run with reserves of 2% of common equity, a ratio that is to rise several-fold in coming years. What’s more, in Switzerland the regulator wants 10% equity and an additional buffer of CoCos in bank capital structures of up to 9%.

Take Credit Suisse. Having issued CHF8 billion in CoCos, it still needs to issue a further CHF20 billion to meet new capital reserve targets. Making the adjustment more difficult is that the change in the combined 10.5% common equity and Tier 1 capital requirements of the new Basel III regime (compared with 6% under Basel II) is combined with a mandatory capital conservation buffer of 2.5% and a further countercyclical buffer. The overall impact is substantial increase in capital reserves that means banks have to both deleverage and raise substantial additional equity capital.

The policy rationale for facilitating CoCos is straightforward. If banks shrink their balance sheet to reach the new capital reserves required under Basel III credit will contract until near the end of the decade. If banks don’t lend, economic growth will be sub-trend expansion and already pronounced levels of joblessness could increase further.

CoCos, on the other hand, are much better than equity for banks because they create an incentive for the directors to stay away from eroding the equity portion of the reserve structure. Keeping distance from the trigger point is the key to avoiding the dilution effect if losses strip away enough of the reserves for the conversion to kick in as the CoCos transform into common equity.

So far, CoCos have only been used by Swiss and British banks. The reason for this is tax treatment. Most national tax regimes don’t allow for CoCos’ interest coupons to be tax deductable. Instead, the coupons are considered dividends and taxed accordingly. This tax treatment means that banks might as well just issue equity to recapitalize and boost regulatory capital reserves.

In Switzerland and the UK, where the coupons are tax deductable, CoCos are thus cheaper than equity. But Algebris is optimistic that Italy and France will soon modify tax laws to make CoCos financially viable. The game changer for CoCos, of course, will be what happens in the US. Recent developments show that the US Treasury has warmed to the concept amid the debate about how much extra capital SIFIs (systemically important financial institutions) require and the size of potential CoCo buffers.

CoCos: a natural outgrowth
For Algebris, investing in CoCos is a natural outgrowth of its expertise in modelling and investing in financial services companies. Its core offering, the Algebris Global Financials Fund, also includes a UCITS-compliant version. Together with the Algebris Emerging Markets Financials Fund, the firm manages over $1.2 billion (see Fig.1).

“We know the balance sheet and the recapitalisation a bank has been through,” says Lasagna. “Investing in CoCos is like selling insurance after a storm when premiums have risen (see Fig.2). That is why we love them. The skill set to analyse these comes more from the equity perspective. In a specialised sector like banks it is necessary to understand what the real loss would need to be in order for it to trigger the dilution.”

At the moment, there are relatively few natural buyers for CoCos. Banks won’t invest in them, nor will insurers even though firms in both sectors have been buyers of hybrids. Fixed income funds generally can’t buy unrated entities and also would face the time consuming process of getting investor approval for prospectus changes. Pension funds may eventually emerge as buyers but only once the market is developed enough to offer meaningful liquidity.

In theory, investors in bank equity should be natural buyers since the value of the CoCo ought to be less volatile than the stock, while the coupon rate should well exceed any dividend.

Best returns in primary market
Algebris plays CoCos by going long and hedging the exposure. But Lasagna fully expects there is going to be lots of opportunity for shorting issues and doing relative value trades very soon. Right now the best returns come from buying issuance on the primary market. When Credit Suisse issued at 100 the next day the price rose to 102.5.

The limited liquidity of the few CoCos that have been issued makes trading them uneconomic (a round trip buy and sell transaction costs 50 basis points). But when some kind of exchange-listed product replaces the current over-the-counter market spreads should narrow. Unlike hybrids, which are complex and different from each other, CoCo issues are likely to have much more common features, thus making it easier to broker and trade the instruments more actively.

“These instruments are going to be more standardised and there will be more liquidity,” says Lasagna.

“When the price gets close to the trigger point (of the convertible) arbitrageurs are going to be coming in to arbitrage the equity to the bonds for the conversion. The arbs are natural buyers. If it converts you get the equity and that is liquid. What’s more, unless it is a Lehman-like blow-up, the owner of the CoCo is getting converted at the bottom of the cycle.”

This is shown by the operation of the Troubled Asset Relief Program. The US government recapped Citi at less than $1. The shares have subsequently rebounded to around $4 (before factoring in a reverse 10-for-1 share split). “Psychologically you are never going to buy shares at that point in time,” says Lasagna. “But getting converted, if you are an equity investor as we are, it is the best place to be as existing shareholders are diluted away.”

Conversions not expected
Yet the likelihood of getting converted from the few CoCos that have been issued looks remote.

With Credit Suisse, for example, the first trigger is at 7%. Currently the bank is running with common equity and Tier 1 capital of 10.5%. To get there the bank would have to lose around CHF16 billion or nearly triple its worst ever loss. The new CoCos will replace hybrid notes held by the bank’s two largest shareholders Qatar Holding LLC and The Olayan Group which signed up for issuance of CHF6 billion (with a coupon of around 9%). A further CHF2 billion got issued (with a coupon of 7 7/8) and was 11 times oversubscribed. Analysts estimate that Credit Suisse is obliged to issue an additional CHF20 billion of CoCos in coming years with a trigger threshold of 5% for the bank to meet its obligations to Swiss supervisors. In the event that the triggers were breached, holders of the Credit Suisse CoCos would dilute away the existing shareholders and emerge with 30% of the company.

Lasagna uses the analogy of a sky scraper to illustrate the change in the new capital structure (see Fig.3). “There were two floors of equity at the base, but now it is 10 floors of equity with another three floors of loss absorbing CoCos on top of that,” he says. “Not only are regulators happier, depositors are in a much better situation. There is a lot more loss absorbing stuff below than there was. It is a contingent pool that stops a bank from being dependent on issuing equity in the future.”

A potential $1.0 trillion market
To date CoCos issuance has been limited. But Standard & Poor’s and Goldman Sachs have forecast that the market may be worth at least $1 trillion as all the old hybrid securities are replaced between now and 2019 (see Fig.4). The heavy over-subscription of the small portion of the Credit Suisse issuance that came to market showed the appetite for CoCos – a point that won’t have been missed by rivals who need enhanced capital buffers to backstop their own balance sheets to remain competitive in lending and structuring. But how quickly the market will ramp up is uncertain.

“It is anybody’s guess as to how many CoCo issues are going to come to market,” says Lasagna. “Basel III still needs to specify what will and won’t qualify and there are still some details missing. A lot of bonds that are being issued have a callable feature if they don’t qualify for Basel III meaning that if something doesn’t fit in Basel III the issuer will be able to recall it and issue Basel III-compliant instruments.”

On top of this uncertainty, is the lack of a cost advantage over issuing equity. Until the tax treatment changes, there will be no demand for CoCos that have an effective cost of capital of 8-9%. But if costs come in at 5-6% (after tax) issuance should get a spur. Overall, CoCos ought to benefit from regulators having an incentive to boost banks’ paid in capital reserves without draining further capacity from the financial system.

The CoCo fund Algebris runs is seeking to throw off a yield of 8-10% with some additional modest capital appreciation. This is less than the 15-20% return target of the Global Financials Fund. Around $450 million of the firm’s assets (of $1.4 billion) are in CoCos with around $180 million in the core financials fund. (Liquidity terms preclude the UCITS from any investment in CoCos.) Each of the four funds shares the same pool of research and portfolio managers, but uses different filters for investment bets. With the UCITS fund, for example, there are obvious concentration and leverage limits as well as a much lower propensity to invest in distressed securities.

Getting issuance
“We are small,” says Lasagna. “But we are very well-known to the banks because we do financials and we are very well-known to the structuring desks. The feed back we have is that if we have the cash they will give us the issuance. The structuring desks are all over the banks trying to issue them. If they can show that they have a natural buyer, then they will issue. We are not worried at all with respect to money coming in because we know we can deploy it. Actually the sooner we get money in the better the deals are we can get.”

Investors can generally choose from accumulation and distribution share classes. The latter is appealing to income seekers including endowments, pension funds and family offices which want to crystallise the income via the coupon paid. Around half of a recent issue by Rabobank is understood to have been placed with Asian private banks.

Many investors are expected to come from existing hybrids because they understand the de facto protection from dilution if the issue converts into equity. Investors with an equity bias are likely to be more drawn to CoCos than bond-focused investors.

“I think the capital markets desks of the investment banks are going to be looking to place big tranches with the existing equity investors,” says Lasagna.

“I think that is a very powerful marketing argument. Its sits on top of your equity, stops dilution and you get paid, say, 9% per year. Once a deal is structured with a lead investor, then the desk can go out to the market and give everyone else a discounted rate. That is the sweet spot where the structuring desks at investment banks want to be.”

Adding value through research
Algebris has two portfolio managers, two traders and six fully dedicated analysts following banks globally. Modelling balance sheets with proprietary analytics lets the team price about two-thirds of a balance sheet. The remainder is judged to depend on capital markets and government policies.

“With the experience we’ve got we can gauge what the probability of the losses could be,” says Lasagna. “The interaction between our experience analysing bank balance sheets and having someone for the past three and one-half years with an understanding of the credit side has been instrumental in running the CoCo fund. By putting the credit specialists and the bank specialists together we really can get a very good idea of the probability or not of conversion.”

The key for any CoCo to get traction with a broad range of investors is simplicity. What made the Credit Suisse issue desirable is that the trigger of conversion was so far out the money that investors focused mainly on the income stream. As the market gets bigger, the simplicity hypothesis looks certain to be tested as new issuers come to market with products that convert into equity, but may also give investors a warrant to, in effect, double up potential returns.

Algebris is mindful, Lasagna says, of stripping away unnecessary complexity whether with CoCos or other products. With UCITS funds, he notes that there is an important difference between having an investment hypothesis and wrapping it into something that investors will buy.

“A lot of people don’t understand the necessity of making these funds as plain vanilla simple as long only products from an administration and execution point of view,” Lasagna says. “If you get that wrong you are narrowing down the number of investors who can buy it.”