Hot CoCos, For All the Wrong Reasons

What Is AT1 and Why Are European Banks Worried? [The Rude Awakening] March 23, 2023 [WEBSITE]( | [UNSUBSCRIBE]( Hot CoCos, For All the Wrong Reasons - When UBS took over Credit Suisse, the Swiss government marked CS’s AT1 capital to zero. - What are cocos and AT1 capital? And why did equity holders get paid out, but these bondholders didn’t? - What are the knock-on effects for European banks? [Over 62 And Collect Social Security? Take Action Immediately!]( [Click here to learn more]( [If you’re over the age of 62 and currently collect Social Security, you need to prepare now](. Because Biden has given our country the worst inflation in decades – and many warn things will only get worse from here. Worse yet, the Social Security check you receive now may not keep pace with inflation… [Which is why, if you don’t act now, you could fall behind in the months ahead](. Is your retirement at immediate risk? [Click here now to get the simple, step-by-step actions to survive inflation](. [Click Here To Learn More]( [Sean Ring] SEAN RING Happy Thursday from an overcast Asti. In today’s Morning Reckoning, hopefully coming into your mailboxes in a few hours, I write about my feelings concerning Credit Suisse’s demise. It was a fun trip down Memory Lane. But… there are some technical details that I couldn’t include there. So I’m going to do that here. Then, when you read the Morning Reckoning, it’ll make a bit more sense. In this Rude, I will define the Basel Accords, talk about a bank’s “cap stack,” and, ultimately, why there’s only one way to regulate banks. The Basel Accords Permit me to channel my inner Dickens (paraphrased from A Christmas Carol): Basel was dead: to begin with. There is no doubt whatever about that. The register of its burial was signed by the clergyman, the clerk, the undertaker, and the chief mourner. A screwed banker signed it. And a screwed banker’s name was good upon ’Change, for anything he chose to put his hand to. Old Basel was as dead as a door-nail. Ah, that felt good. The Basel Accords are the greatest example of bureaucratic “make-work” in human history. Since The Basel Committee on Banking Supervision (BCBS) was created in 1974, it has prevented absolutely zero of our myriad financial crises. The BCBS is a part of the Bank of International Settlements (BIS), the central banks’ central bank. Settlement risk was an afterthought in FX trading until the Bankhaus Herstatt debacle in 1974. Cutting to the chase, the bank failed to send its USDs to New York in exchange for the DEMs (Deutsche Marks - we didn’t have euros yet). As a result, many trades, along with the bank itself, failed. To fix this, the G-10 formed the BCBS. The BCBS sat around doing nothing until 1988. (For a time, there was talk of disbanding the BIS altogether.) But luckily for them, the US stock market crashed in October 1987. So the BCBS gained renewed vigor. The Basel Capital Accords (Basel I) were released in 1988 and concentrated on credit risk. Many in the international bureaucracy felt that credit risk, not market risk, caused the ‘87 Crash. In January 1996, following two consultative processes, the Committee issued the Market Risk Amendment to take effect at the end of 1997. In June 1999, the Committee proposed a new capital adequacy framework to replace the 1988 Accord. This led to releasing a revised capital framework in June 2004 called "Basel II." The revised framework comprised three pillars: - minimum capital requirements - supervisory review of an institution's capital adequacy and internal assessment process - effective use of disclosure as a lever to strengthen market discipline and encourage sound banking practices As we saw later in 2008, none of this guff worked. Basel III was birthed in 2010 after the abject failure of Basel II. Basel IV came into effect on January 1, 2023. You see the pattern: write rules; rules don’t work; take no responsibility; write new regulations. Now, let’s look at how that affects the banks. [Breaking: Did Biden Really Blow Up Nord Stream?!]( [Click here to learn more]( New evidence has just been released the all but PROVES a shocking truth… President Biden gave the green light to blow up Russia’s Nord Stream Pipeline! According to [this shocking new expose]( Crippling fuel shortages… widespread “Biden blackouts”… and energy bills rocketing to $1000… Are about to hit American shores as a result. [Click here to learn the TRUTH about Nord Stream and how it will impact YOU](. [Click Here To Learn More]( A Bank’s “Cap Stack” A bank's capital stack, or “cap stack,” differs from a regular company’s. Remember, your cash is your asset, but to a bank, that’s a demand deposit and, therefore, a liability. And your mortgage may be your most significant monthly payment. But to a bank, that’s likely its most important asset. What regulators make banks do is hold reserves against “risk-weighted assets.” Simply, a risk-weighted asset (RWA) measures the level of risk a bank's assets pose to its solvency. A bank’s cap stack looks like this: [SJN] Credit: [Pearson]( Common Equity Tier 1 capital is your common shares, retained earnings, and other comprehensive income. If you’re a perfect bank, your CET1 would be 12% (everything above the AT1 and Tier 2 capital). And here’s where the kerfuffle is. What about Credit Suisse’s AT1 sent shivers through the markets? Additional Tier 1 Capital: What are CoCos? To get their banks liquid again, the Europeans - who love bonds - came up with the idea of contingent convertible bonds (CoCos). It’s another idea only an academic can love. Here are three common types of CoCos: - Trigger CoCos: Trigger CoCos convert into equity when a specific trigger event occurs, such as the bank's capital ratio falling below a certain threshold. These trigger events are usually set by regulators and are designed to ensure that the bank maintains a certain capital adequacy level. - Mandatory CoCos: Mandatory CoCos have a fixed maturity date and convert into equity when this date is reached. They can also convert into equity if the bank's capital ratio falls below a certain threshold. Mandatory CoCos provide investors with more certainty about the timing of the conversion, but they may not be as effective at absorbing losses during times of financial stress. - Optional CoCos: Optional CoCos allow the bank to convert the bonds into equity under certain conditions. This gives the bank more flexibility in managing its capital structure but may also make the conversion less certain for investors. Credit Suisse issued a type of CoCo known as a “principal write-down” CoCo. That means the holder could lose their investment immediately, which is what happened to Credit Suisse CoCo holders. Writing Down the CoCos to Zero From [The Wall Street Journal]( (bolds mine): Late Sunday afternoon, UBS agreed to lift its offer and pay a little over $3 billion—less than half Credit Suisse’s market value on Friday. Crucially, Swiss regulators would write off $17 billion on the riskiest type of Credit Suisse bonds. The market for these bonds, commonly issued by European banks, was severely hit Monday. UBS would also get a more than $200 billion liquidity line from the central bank, and a government guarantee of over $9 billion against some potential losses. To get the deal done, the government waived antitrust laws on the grounds that financial stability was at stake. The upshot of all this is the following: - The Swiss government rewrote its rule book to get this deal done. - The Swiss regulators buried the CoCo holders with a write-off. - The CoCo bond market was hammered after this announcement. - Equity holders got something, though it was meager. - In an ordinary “order of liquidation,” bondholders get paid before equity holders. But because these were principal write-down CoCos, bondholders got nothing, while equity holders got something. That’s why the word “lawsuit” is being bandied about. - The backstop UBS was given to buy CS is nothing short of amazing. This deal may even work out for UBS in a few years. Honestly, if the Swiss are just making it up as they go, what hope do the rest of us have? The Only Way to Regulate Banks The Basel Accords are on the side of a milk carton. Nowhere to be seen. Credit Suisse wasn’t an unhealthy bank. It just made terrible decisions. The only way to regulate banks is to let them fail. Sure, the Swiss authorities thought a full-blown financial crisis would ensue, but truth be told, this should’ve happened years ago. That’s when bankruptcy would’ve been manageable. Silvergate, SIVB, Signature, and now CS. Different reasons for their bailouts, but it boils down to one thing: Boards that were about as useful as chocolate chastity belts. Wrap Up I’m sorry I got into the weeds a bit there. But there’s no other way of explaining the situation. If you have time, I hope you read the Morning Reckoning today. That will add more color to the story. All the best, [Sean Ring] Sean Ring Editor, Rude Awakening In Case You Missed It… Patriotism Doesn’t Pay, But Loyalty to The State Does [Sean Ring] SEAN RING Good morning from gorgeous Asti! While there’s still so much to write about the current market goings-on and the government machinations to contain it, Byron King once again wrote something too good to wait. Byron has written an excellent piece on Janet Yellen’s adherence to a dogma that has long been discredited. Thanks to that near-religious conviction, she’s been at or near the top of every financial disaster of this millennium. It’s long past time she should’ve retired. Read this piece from a Harvard grad who was there to see Yellen’s career in its embryonic stages. Not many people can lay claim to that. Byron can. See you tomorrow. All the best, [Sean Ring] Sean Ring Editor, Rude Awakening [Warning: Will “Bidenflation” Destroy Your Retirement?]( [Click here to learn more]( If you’re like most Americans, you’ve worked hard for decades to build your financial legacy. And now, as a result of Biden’s disastrous money printing policies, that’s all at risk. According to one top retirement expert, “Bidenflation” threatens to destroy your retirement and make your hard-earned savings worthless. That’s why you must take action right away to protect yourself… [Click here now to get the simple, step-by-step actions to survive “Bidenflation.”]( [Click Here To Learn More]( The Yellen Prophesies: Big Spending, Big Government, and Hitting the Economic Iceberg [Jim Rickards] BYRON KING “Old soldiers never die,” said Gen. Douglas MacArthur in his long-ago farewell address of April 1951. “They just fade away," he added with a note of deep sadness. I sure wish we could say that about Keynesian economists. That is, about economists who follow the doctrines and dogmas of John Maynard Keynes (1883 – 1946), a British economist whose main works were published in the 1920s and 30s and whose influence still steers the field of economics in the current world. Because not only do old Keynesians never seem to die, but neither do they even fade away. Indeed, on occasion, old Keynesians become Secretary of the Treasury, which is the case with Janet Yellen. Here’s why I bring it up… Ancient Texts Reveal the Future A while back I was organizing boxes in my basement. Inside one carton I found a collection of old Harvard student course catalogs from 1972 through 1978, the years when I studied geology there. [SJN] Inside these pages are the Yellen prophesies! BWK photo. Coincidentally, those mid-1970s years also cover a time when a much younger Janet Yellen was on the economics faculty at Harvard. [sjn] Janet Yellen, long ago, on faculty at Harvard. In 1971 Yellen earned a Ph.D. in economics from Yale University. Her thesis was entitled Employment, output and capital accumulation in an open economy: a disequilibrium approach, prepared under the supervision of Nobel laureates James Tobin and Joseph Stiglitz. Then with new her newly-issued New Haven degree in hand, Yellen migrated north to Cambridge and went on the payroll as an assistant professor of economics at Harvard, 1971–76. It’s fair to say that Yellen rubbed elbows with quite a distinguished group of Harvard colleagues, back then. While paging through the old tomes, I saw familiar names of long-ago professors from whom I took an economics course or two – Otto Eckstein, Kenneth Arrow, Robert Dorfman, and Wassily Leontief. And then there was Janet Yellen, Assistant Professor of Economics, with her bright, shining future still to come. In 1972 – 73, Yellen taught a course in “Aggregative Economic Policy.” This covered “Theories of national income determination, employment, interest, investment, money, and economic growth from Keynes to the present.” In 1973 – 74, Yellen taught that course again, with the same name except the course description changed to “Keynesian and post-Keynesian theories of national income determination, introduction to monetary theory, cyclical fluctuations and economic growth.” A year later, in 1975 after a leave of absence, Yellen taught courses entitled “Macroeconomic Theory” and “Economic Theory.” The first course covered “Keynesian and classical models of employment and income determination; theories of inflation, aggregate fluctuations, and growth; principles of stabilization policy; theories of consumption, investment and portfolio choice.” The second course in 1975 covered “Static Keynesian models and their classical antecedents; modern monetarist and post-Keynesian models; theories of consumption, investment, and portfolio behavior; theories of aggregate fluctuation and inflation; economic models and policy optimization.” Keynes, Keynes, Keynes Yes, it’s all quite a mouthful. And do you notice anything about Yellen’s choice of titles and subject matter? I mean, aside from her extensive use of deep-insider academic jargon that almost no mere mortal can begin to fathom. Exactly: everything is all about Keynes! In essence, back when Yellen was fresh out of Yale she taught party-line, orthodox Keynesian economics. And what was that? Well, Keynesian economists believe that private sector economic decisions often lead to what they perceive as “inefficient” macroeconomic outcomes. That is, an economy typically just does not do what central bankers and government planners want it to do. And this lack of efficiency is a very bad thing in their collective mind. When viewed through a Keynesian economic prism, people don’t behave properly. Their cumulative, micro-economic sins all add up to grave policy faults and macro-inefficiencies. Thus, according to Keynes and his acolytes, something must happen to correct the problems. And what might that be? The standard Keynesian policy solution to economic inefficiency is that government takes active measures via a (supposedly) wise and knowledgeable central bank, one filled with people who hold PhDs in economics from top-notch universities. Because they know stuff. These central bankers act in tandem with fiscal policy emanating from a (supposedly) all-seeing, all-knowing government, one filled with well-intended political actors. And politicians know stuff, too. Well, that’s what they tell you, anyhow. Under Keynesian theory, between those wise bankers and politicians at the helm, the overall economic ship will sail much better. To continue the nautical metaphor, a well-guided economic ship will hit no icebergs. Or that’s the idea. Indeed, the Keynesian goal is “stabilize output,” especially over and around business cycles. In other words, the Keynesian approach is intended to smooth out the economic bumps. Or from a more political angle, it eliminates those pesky recessions that lead to large-scale business failures and unemployment. No Roaring 1920s; no Great Depressions of the 1930s. That’s the lure. Cynics might call this an “economics-lite” version of a 1920s/30s-era Soviet Five-Year Plan, in which the central state controls the money supply and directs investment to virtuous ends that the commissars discern. Because that planned Soviet model was Keynes’s intellectual competition back then; or the economic counter-model. In the 1920s/30s, the world was evolving out of both the Great War (aka World War I), as well as the Bolshevik Revolution. The Anglo-Saxon model – meaning primarily what was happening in Britain and the U.S. – competed for world intellectual acceptance with the Lenin-Stalin model in the Soviet Union, based on Karl Marx and his book, Das Kapital, published in 1867 as a critique of proto-capitalism. So as you may have discerned from this timeline, much of what passes for modern economics – certainly Keynesianism – is rooted in century-old thinking that formed as a counterpart to even older, Marxian ideas from 150 years ago. That is, Keynesianism involved government control but through the more benign approach of a so-called “mixed economy.” The private sector must jump through myriad policy hoops created by government and its legions of Very Smart People, the ones with those PhDs in economics. And again, the desired end-state in all of this is to avoid recessions. I won’t belabor the preceding points; people write long books about Keynesianism, versus, say, Soviet central planning, let alone the far more free-market-focused “Austrian” school of economics. Of course, smart people also argue over the merits of recessions. Because one way or another, recessions happen. Economies undergo periodic, and sometimes major contractions that tend to clean out the accumulated muck of malinvestment and poor spending decisions. And of course, people argue over whether or not it’s truly possible to control business cycles. There’s all of this, and much more to discuss about Keynesianism; and really, at the end of the day how much government control do people really want in life, right? But for now, let’s return to Harvard and Janet Yellen. Because by 1976, and despite her Stakhanovite focus on instructing Keynes to eager, impressionable students, young Yellen was denied tenure by the cognizant faculty committee. She received her walking papers. Ms. Yellen packed her bags and went on to another series of jobs over subsequent years, back and forth between government and academia. In the late 1970s and 80s, Yellen’s employment ranged from staff work at the Federal Reserve, to an appointment as a professor at Berkeley; not shabby at all. In the 1990s she found a gig with the Clinton administration, and some years later, under President Obama, rose to become Vice-Chair of the Fed, 2010 – 14, and Fed Chairwoman, 2014 – 18. Note that those years – the 2010s – with Yellen near or at the top of the Fed were also a time of long-term, historically-low interest rates, and in fact negative real rates when inflation is counted. [SJN] It’s not inaccurate to say that the low interest rates of the 2010s were a backdoor central bank subsidy to the broader bank sector. The macro-idea was for the Fed to help recapitalize the banking sector in the wake of the 2008-09 global financial crash. But at the same time, this low-interest subsidy came out of the collective hide of savers and investors who muddled along with next to no return on their socked-away cash. Some commentators have calculated a $4 trillion cost to all of this, taken from savers and handed to bankers. And if you dust for fingerprints during that decade-long spree of government subsidy, you will absolutely find those of Janet Yellen. Her Keynesian upbringing was on display throughout that episode. Yellen’s central bank approach dramatically reshaped the economy in a low-interest environment, and a certain class of people made one heck of a lot of money. With this in mind, it appears that across her career Ms. Yellen’s inner Keynesian instinct has always been at the forefront. She literally talked her book in the 1970s at Harvard, and even today still deeply believes the Keynesian dogma that central bank monetary tinkering can successfully manage a vast economy. To keep with nautical analogies, Yellen believes that Keynesian economics will steer the proverbial ship through the field of economic icebergs. Another angle of the Yellen-Keynes approach is that if the economy doesn’t respond as intended, then there just wasn’t enough government oversight and central bank tinkering. Recently, we saw more of that Yellen Keynesianism on display when she simply and summarily overrode the law and rules that govern federal deposit insurance on bank accounts, in the matter of Silicon Valley Bank (SVB). No doubt, you’ve followed the tale. The Federal Deposit Insurance Corporation (FDIC) will backstop a maximum of $250,000 per account holder at any given bank. But at the ill-fated SVB, about 97% of total holdings exceeded that number, a factor of about 33 to 1. Another way to say it is that the depositor base included a large number of cash-rich, if not well-off people and businesses. Unilaterally, Yellen and her associates within the Biden Treasury Department rewrote the FDIC rules to “insure” every dollar claimed against every deposit in SVB. Yellen removed the limits, and no depositor lost a dime. And then Yellen rigged the FDIC fund to tap a new assessment onto other banks out across the country, where the solvent ones – and their customers, like you perhaps – would pick up the slack for the insolvent SVB. When asked about it, Yellen replied that the idea was to save “systemically important” banks. Oh, now she tells us. Except that SVB was not previously considered critical, not before a bunch of well-connected people stood to lose some serious money. But hey, with Yellen at the helm, the ship made a quick course change, and the depositors got their money back, with no issues. Even more recently, Yellen testified to the U.S. Senate that she would make those “systemically important” calls when, where, and how she determined. Anymore, it’s all up to her and her government staff. So now, under the ministration of Janet Yellen, the entire banking system has reached a point of profound contradictions. Among those is an FDIC with rules on the books about insurance limits, but the rules don’t apply when Yellen thinks differently. Another way to say it is that we now live in an era of intellectual chaos within the field of economics writ large, and banking more specifically. “Buy rumors, sell news,” goes the old saying. And the news is that America’s economic system has just hit one of the biggest icebergs in the sea, with Janet Yellen at the helm. Sad to say, her Keynesianism never faded away before we reached this awful point. Oh, and if you want a more direct takeaway, buy gold. That’s all for now. Thank you for subscribing and reading. All the best, [Byron W. King] Byron W. King [Paradigm]( ☰ ⊗ [ARCHIVE]( [ABOUT]( [Contact Us]( © 2023 Paradigm Press, LLC. 808 Saint Paul Street, Baltimore MD 21202. By submitting your email address, you consent to Paradigm Press, LLC. delivering daily email issues and advertisements. 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