Markets

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

European regulators dreamed up a new type of bond after the 2008 financial crisis to prevent another financial meltdown: contingent convertible debt, which would get wiped out before a big bank became insolvent.

Banks have sold hundreds of billions of dollars of this debt in recent years to bolster their capital, and regulators have declared the financial system safer.

Massive Growth
There's been tremendous growth in the pool of contingent convertible debt outstanding
Source: Bloomberg

There’s just one problem: No one really knows how this debt will work. Until now, perhaps. In theory, these so-called CoCos allow a bank to suspend interest payments when it runs into trouble, force losses onto bondholders or even convert the debt into equity. 

While no bank has ever triggered the break-glass-in-case-of-emergency features, Banco Popular is getting pretty close to being the first. The Spanish bank has been a train wreck for years, but now its situation appears dire. Its shares have plunged. Its leadership has been seeking a buyer. Some are whispering about the political implications of a government bailout, or another loan from the European Central Bank.

Plunging Prices
Banco Popular's equity value has evaporated as its outlook deteriorates
Source: Bloomberg

Banco Popular's issues stem from its insurmountable pool of nonperforming loans, which have eaten into its capital buffers. And yet regulators haven’t instructed it to stop paying out on its 1.25 billion euros of CoCos, even though they have broad discretion to do so and the bank is clearly teetering on the brink of insolvency.

There are some legitimate arguments for why Banco Popular has enough capital to keep paying out on these notes. But this is a fuzzy area, with vast leeway for interpretation. And policy makers have broad discretion. It's clear that debt traders are planning for the worst, with the lender's 500 million euros of 11.5 percent notes trading at 53 euro cents, down from 102.7 euro cents at the end of March.

Off a Cliff
Banco Popular's contingent convertible bonds have plunged as investors gird for the worst
Source: Bloomberg

This raises a lot of questions for a $181 billion pool of contingent convertible debt globally, which offers big coupons but is sort of the mystery meat of financial markets. If Banco Popular doesn’t qualify as a troubled bank in need of some capital support, it’s unclear what circumstances would be appropriate for regulators to step in and prompt a bail-in, foisting losses on CoCo investors.

There is much gray area when it comes to deciding when a bank ought to stop paying on these notes. As Bloomberg Intelligence's John Giordano and Jonathan Tyce wrote Tuesday, valuing the risk and value in these notes "is more art than science."

This is especially true now, as members of the European Commission consider some changes to the rules overseeing this debt to give greater priority to some of these bondholders in an insolvency. Regulators rethought some of their rules after the scare over Deutsche Bank AG's contingent convertible  bonds last year, when that bank approached the threshold for how much capital it needed to have, raising questions about whether it would keep paying on its debt.

Deutsche Bank was more of a systemic concern, given its size and scope in global financial markets. Banco Popular doesn’t pose a clear threat to the broader financial system as illustrated by the lack of a sell-off in the broader contingent-convertible market in response to the lender's difficulties.

In some ways, this makes it almost more surprising that regulators haven't stepped in already. Their apparent reluctance to trigger a bail-in raises questions about how effective this $181 billion buffer really is. Banco Popular's woes are idiosyncratic, but it holds some valuable lessons for how these contingent convertible bonds will -- or perhaps more likely, won't work -- in a downturn.

-- With assistance from Lionel Laurent

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net