Why banks are going cuckoo over 'CoCos'

NEW YORK-- The global banking freak-out that has had lenders cut down to size in a matter of weeks has a lot of people talking about a yummy sounding financial instrument called "CoCos."

So what are CoCos and why are investors so afraid of them?

First, it's worth noting that U.S. banks — while plagued by fears of rising loan defaults and other costs tied to a slowing economy — are not exposed to CoCos. That has been the domain of European banks, which have been hit much harder than U.S. banks this year.

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Ironically, CoCos became popular with big banks as a way to protect against the cash-crunch that followed the last financial meltdown.

Short for "contingent convertible," CoCos are basically bonds that can convert into stock. In normal times, they work much like a normal convertible bond. But in times of trouble, bank CoCos can convert from bond to stock automatically when a bank's capital levels fall below a certain threshold.

This is supposed to help banks in two ways: First, it reduces their debt levels. Secondly, it gives them a capital infusion in the form of stock.

The problem is that investors are fleeing certain bank CoCos amid fears that they could lose a lot of money in an economic downturn. Even if the bonds don't convert to stock, banks can skip coupon payments in the case of trouble times.

How bad will it get for the banks?

Research company CreditSights recently questioned whether Deutsche Bank could face trouble paying its CoCo coupons next year amid a costly bank restructuring, uncertain legal costs and growing market turmoil.

"Our base case is that DB will find a way to pay," said CreditSights analyst Simon Adamson. "Although it remains vulnerable to significant unexpected losses this year."

Such fears prompted Deutsche Bank CEO John Cryan to counter with a surprise memo proclaiming a "rock-solid" balance sheet, and vowing to make coupon payments to investors who hold their Additional Tier 1 capital.

Other banks that rely heavily on CoCos include Switzerland's Credit Suisse, which has been the No. 1 issuer of CoCos since 2009, according to credit rating firm Moody's. In that time, Credit Suisse has issued $19.2 billion worth of CoCos, followed by Bank of China at $18.9 billion, UBS at $18.5 billion and the Agricultural Bank of China at $17.8 billion, Moody's said.

If fears of an economic slowdown crimp banks' earnings in the coming years, expect to see more CoCo investors run for the hills.

Follow USA TODAY reporter Kaja Whitehouse on Twitter: @kajawhitehouse