Contingent Convertible Debt? A Quick Primer For Finance Jocks.
Just a quick addition to my comments so far this week:
Just when you thought it was safe, out pops another miserable acronym. Finance is awash with silly names and jargon – those lawyers must be paid huge fees to think this stuff up.
Today’s hot new acronym is ‘Co-Co’, as in contingent convertible bonds, is becoming all the rage in banking discussion circles.
Just what are these ‘co-co’s’?
They are a new breed of bond a bank can issue that acts like a true bond during normal economic times, but which can be triggered into pure equity when a bank’s capital is under stress. This may seem arcane, but I think the idea has some merit, and may even help reduce the need for future bail out cash from taxpayers when were we to experience another banking implosion.
There have always been convertible bonds: they are structured such that an investor can convert an investment from debt to equity under certain favorable conditions. This mechanism is biased to favor the investors and induce them to participate in a company’s stock growth by allowing them to covert debt into stock at a predetermined price. This gives a bond investor a share in the equity gain a growing company may experience, yet protects them from any downside risk: if the company’s stock price drops the bondholder simply doesn’t convert and thus protects the investment. If the stock price rises the bondholder converts into equity and shares in the gains. This structure is why many start-up companies find themselves funded through convertible bonds rather than straight equity.
So traditional convertibles have been designed to favor the bondholders. Not so with ‘co-co’s’.
Essentially a co-co bond acts as if it were a form of regular long term debt until the terms of its trigger mechanism move it from one slot on the balance sheet to another. This move is a key one: creditors, like normal bondholders, do not anticipate losing their investment when a bank’s capital is stressed by things like loan losses. Those losses are absorbed first by the shareholders through their loss of the capital they have invested in the bank. When that capital is exhausted the bank is insolvent and goes into bankruptcy – unless it is too big to fail of course, in which case taxpayers bail it out. Notice that in this process the bond holders are treated as if they were ‘normal’ creditors. Their investment is at risk and may be subject to a ‘haircut’, but they have legally accepted rights in bankruptcy that they can enforce in court and thus have the ability to gum up the works and prevent a quick resolution of the bank’s problems.
This legal standing appears benign, and in non-financial companies it usually is dealt with in bankruptcy court, but in a bank the option of a lengthy legal battle flies in the face of the public interest which is to protect the banking system from a knock-on run on healthy banks. So regulators are often forced to protect bondholders as well as depositors in a bank insolvency through the need for expeditious action. This is nonsense since the purpose of the public safety net is to protect depositors not large scale and sophisticated investors. More to the point, bondholders are often negligent in taking preemptive action when they see a bank entering into profit difficulties: they know their debt is protected so they tend to avoid getting involved in pressuring bank management to act more forcibly. Plus many big banks are bondholders in other financial institutions so they are reluctant to boss around their fellow bankers. Even worse: some large banks, Goldman Sachs is particularly prone to this, hedge their bond positions by taking out credit default swaps. This means that they will be paid back their investment via the CDS insurance regardless of whether the bank has the resources to pay them or not. Following this thought further: if a bank like Goldman holds a CDS for the full value of its investment it will more than likely receive more money back were it to allow the bank to cave in, than were it to renegotiate the terms of its loan in an attempt to keep the bank afloat. Clearly this creates a huge conflict of interest and potentially a motive for anti-social behavior.
So bondholders often represent a roadblock to keeping a bank afloat because they have no economic interest in renegotiating its debts – those CDS’s may cover them anyway. Then, after the bank goes under, they are often swept up in the warm embrace of the public safety net even though theat safety net was never designed to protect them. This is a classic case of the ‘rent seeking’ I have been going on about lately.
This new concept of a co-co ends this ability to rent seek by forcing the bondholders to confront the looming loss of their investment. They will have the option to force management’s earlier action, and thereby try to rescue the bank and their investment, or they will see their bondholder status converted into pure equity where the bankruptcy process is harsh. Either way the public gains: the bondholders are forced to be active investors, or they stand to lose their privileged position in the winding up process and are no longer able to be scooped up in protective net the taxpayers provide to depositors. This makes for cheaper bail outs in future.
The bank benefits also by having an emergency cushion of equity that will kick in just at the moment when it is highly unlikely the bank can raise fresh equity from new investors.
The idea of a co-co style bond is still very new, and is subject to much debate. But if it acts in the way I have just described, it will be another brick in the wall as we rebuild a better regulatory system and safer banks.
