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Co-op-ting the bondholders

17 June 2013

I have mixed views about the Co-op rescue plan, partly perhaps because little detail has been provided; we may have to wait until October to get the full picture.

Of course it is to be welcomed that the ordinary customers are (setting aside sentimental attachment to the principles on which the Co-op was founded) unharmed, and that a survival plan has been identified in which Co-op will remain as an independent licence for FSCS purposes (in other words, that those who already have their £85,000 exposure in another bank won’t have to choose between loss of breakage funding costs and an increase in their single-obligor credit exposure, as was foisted upon some ING Direct customers).

But the idea of listing a minority holding of worthless shares, which are most unlikely to recover, sounds like a political gesture with significant nuisance value and administrative cost.

The essential question however is whether it is reasonable for the holders of instruments such as the perpetual subordinated bonds to take the hit. At first sight this is not as outrageous as asking depositors to do so, à la Cyprus: PSB holders were on notice from the rate alone that they had a greater exposure. But many will have bought these instruments in the Co-op on the basis of their conservative reputation, and on financial statements which may or may not have revealed the true state of the lending book and the other exposures that have led to the problem.

The question then boils down to this: if that disclosure was adequate for the PSB holders fully to understand the risks they were assuming, why was it not adequate for the financially sophisticated regulators to see that Project Verde was a non-starter at a far earlier stage – or even to have blocked the Britannia take-over? If the PSB holders had inadequate information and no say in the conduct of the business, it is rather odd to expect them to do the regulators’ job for them.

The fact is that banking really only works with smaller, simpler businesses with equally simple capital structure: no secured debt; senior debt provided pari passu by banks, institutions and depositors; and a large enough cushion of simple ordinary shares that carry full voting rights. That way shareholders can ensure the business is run for their benefit (and their capital can only be used in the business they bought into), and depositors can get their money back since the asset shrinkage on collapse is covered by the equity. PSBs, subordinated bonds, PIBS, Co-Cos etc are all illusions that distract from the brutal truth that our banks can’t generate enough real profit (after staff remuneration) to provide the proper return on correctly-priced equity and debt.

The related issue is discomfort with the arbitrariness of the deal. Rather than following strict winding up procedures in which equity is wiped out completely before subordinated debt, it would appear that this restructuring will leave some value with the parent, and once again shows that we are subject to the whim of politicians and regulators.

  1. Agree with much of what you say, but I think points about pricing deserve more emphasis. Holders of subordinated bonds have been getting an enhanced return – do we know that they were truly mispriced? I’m very sympathetic to investors who have been badly advised, but there are plenty of cases of investors expecting enhanced return without increased risk, or investors failing to perform their own due diligence. Completely unreasonable to ask that of ordinary depositors, but a reasonable expectation of bond investors. If they bought these relatively complex instruments simply because they thought Co-op was conservative, more fool them.

    I’m enjoying your posts on art and finance in equal measure, by the way, and liked your FT letter at the weekend.

  2. Thank you for your general remarks, and for this comment. I do agree that a 13% yield should have been a warning light: but isn’t this Schrödinger’s cat again? The bondholders couldn’t open the box, but the suspicion is (and I don’t have the inside story on this) that a regulator looking at the accounts properly would have realised that there was a catastrophic black hole already present, perhaps before the bondholder purchased the bonds: the eigenstate should have collapsed before. My real point however is that these bonds are never a good idea because hybrid instruments divorce risk from control.

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