(UPDATES with more details in the 2nd and 15th paragraphs.)
By Sara Schaefer Munoz and Patricia Kowsmann
Of THE WALL STREET JOURNAL
LONDON (Dow Jones)--A new breed of debt that turns into equity when a bank hits trouble is becoming the instrument of choice for some Southern European governments as they prop up their ailing banks.
The instruments, known as "contingent convertibles," began to get attention following the financial crisis and have been issued by a few banks. "Co-cos," as they are called, are sold as interest-bearing debt that has to be paid back. But they convert to equity in the event that a bank's capital ratios fall below certain levels.
Now the governments of Spain and Portugal are seeing the virtues of this type of debt-namely, that they can use it to strengthen their weakest banks and avoid direct bailouts.
(This story and related background material will be available on The Wall Street Journal website, WSJ.com.)
The government in Spain last month said it will buy co-cos from banks, although it isn't clear yet which institutions will issue them. In Portugal, two major banks are expected to issue the instruments to meet European capital requirements. Because of accounting rules, the debt won't increase the governments' deficit as a direct injection of equity would, Spanish officials and analysts say. The approach also allows the banks to avoid partial state ownership that would come with an equity purchase, which could alienate private shareholders.
Purchases of co-cos are the latest effort among some European countries to dodge outright cash injections into banks, which would further stretch their budgets, and instead indirectly support their financial systems. Spain, for example, has used its guarantee of bank deposits to back troubled lenders. In Italy, the government has encouraged banks to use their holdings of government bonds to buy state-owned properties, which banks can then use to create asset-backed securities to serve as collateral for loans from the European Central Bank.
The co-cos help banks because they boost the capital ratios of those not healthy enough to attract private investment. Capital ratios are an important measure of financial health, and many European banks are racing to increase those ratios to comply with new European regulations by June.
Co-cos "are good for both government and banks," said Satish Pulle, a portfolio manager at Equity Credit Management Ltd., a fixed-income fund in London. "We would like to see more capital in these banks, and if co-cos get the job done faster, we prefer them."
But critics point out that the interest banks have to pay on the debt, which in Spain could be around 8%, can further crimp bank lending, even as restarting the flow of credit is a goal of the bank-support moves. Some also say the purchase of co-cos could be a way of postponing inevitable government losses.
Contingent convertibles first came on the scene to help protect banks from catastrophic losses. Once a bank hits trouble and begins burning through its financial buffers, it is hard to get investors to buy more equity to replenish what has been lost. The co-cos were designed to address that problem by automatically turning into equity once a bank's capital falls to a certain point.
Investors and banks have been skeptical about co-cos. One concern is that as the bonds reach their conversion point, equity investors could see that as a bad sign and flee, sending the bank into a downward spiral.
Nevertheless, some lenders, such as Lloyds Banking Group PLC (LYG, LLOY.LN) and Credit Suisse Group AG (CSGN.VX, CS), have issued large amounts of co-cos in the past several years.
The instruments got a boost in December when European banking regulators said they could count toward a bank's capital-ratio requirements. In some cases, they also count toward capital under so-called Basel III rules that will go into effect in coming years.
Spain, in a new round of bank reform, said last month that it would buy this debt from lenders as a way to prod consolidation and help banks boost capital levels. The banks' debt will be bought by the government's Fund for Orderly Bank Restructuring, or FROB. Details are still being finalized, but the idea is that the debt will convert to equity in the bank after a set period, about five years, or if the bank's capital levels fall below a certain point.
It is still too early to know which Spanish banks will use the co-cos or how much they will issue. Overall, the Spanish financial sector needs an additional EUR50 billion ($66 billion) to absorb problem loans, the country's finance minister has said.
"The objective of the reform is to increase the credibility, confidence and strength of the financial system, in order to be able to finance economic growth and job creation," said a spokeswoman from Spain's finance ministry.
Two of Portugal's largest banks, as well, are expected to issue co-cos to the government to meet European regulators' required capital levels by June. The funds will come from EUR12 billion set aside by Portugal to help banks as part of the country's EUR78 billion international bailout.
Banco Comercial Portugues SA (BCP.LB, BPCGF), which according to the latest official figures is facing a EUR1.725 billion shortfall, and Banco BPI SA (BPI.LB), with a EUR1.389 billion shortfall ahead of the June deadline, plan to issue co-cos in exchange for state aid to cover that shortfall, people familiar with the process said. Analysts estimate the issuance could happen in March or April.
Some analysts and economists say co-cos might allow the government to avoid a financial hit right now, but that governments may still be forced to take equity stakes in banks down the road if the banks' health doesn't improve.
"The premise with co-cos is that the banks need time to work these problems through," said Alastair Ryan, an analyst at UBS in London. "But some of these assets may be deteriorating faster than the cleanups anticipate."
-By Sara Schaefer Munoz and Patricia Kowsmann, The Wall Street Journal; 207-842-9218
(END) Dow Jones Newswires
February 12, 2012 16:23 ET (21:23 GMT)2012 Dow Jones & Company, Inc.
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