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By Ronald Fink
The Dubai financial crisis represents an odd test case for the use of contingent convertible securities to recapitalize big banks that run into trouble.
The U.K. government has required Lloyd's Bank to issue so-called "CoCo" bonds that convert to equity if its Tier One regulatory capital falls below 5 percent of assets. The idea has also been embraced by Federal Reserve officials who see such securities as part of a potential solution for U.S. banks that are too big to fail.
But the bonds that the financially beleaguered investment arm of Dubai has issued are also a form of contingent convertible. While the indentures of Dubai World's bonds say interest payments are required under English law, the adjudication of any dispute will take place under Islamic law, whose antipathy to usury is traditionally reflected in not recognizing failure to pay interest as a default. That would effectively turn the debt into equity.
"In a strange way the Dubai Islamic bonds may become a test case for this cockamamie CoCo proposal of distinguishing between debt and equity," David Kotok, chairman and chief investment officer of Cumberland Advisors, explained in a Q&A posted on the website, the Institutional Risk Analyst, on Monday.
To further complicate matters, Kotok said, investors have reason to worry that loans extended to Dubai World by Western banks have similar terms. And he argued that this is the real basis for the seemingly outsized reaction last Friday to a potential failure to make interest payments on a mere $59 billion in outstanding bonds (not including the debt kept off of Dubai World's balance sheet).
In Kotok's view, investors are only taking into account the Islamic bonds that have been issued. And he noted that the amount of bank loans extended in this form won't be known until reporting banks have to disclose their exposure.
"That is why I think there is a possible contagion risk," Kotok said. "This problem potentially is much larger than a single payment on a $3.5 billion item," referring to the amount of interest immediately due.
Of course, if Dubai's oil-rich neighbor, Abu Dhabi, makes bondholders and banks whole, the crisis may be averted and the distinction between debt and equity rendered moot. But in that case, regulators' expectations that CoCos will limit taxpayers' exposure to bank losses elsewhere may have been shown to be misplaced.
As Kotok put it, "If the trigger is some book value/regulatory capital measure," as is the case in the CoCos issued by Lloyd's and envisaged for U.S. banks in recent speeches by Fed officials, "then I don't think it has a prayer of being effective, because politics will come into play."
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