Contingent Convertibles [CoCos]

The following sections are included:

• Acknowledgments
• Abstract
• Contents
• List of Tables
• About the Author

Reacting to the severe financial crisis of 2007–2009, contingent convertible debt securities, abbreviated CoCos or cocos, were introduced as a promising new instrument of financial reform. They were to reduce bank failures and thereby cushion the next financial crisis more reliably and automatically than existing subordinated debt. After a slow start in 2009 that almost stopped in 2010, their issuance has been growing progressively. However, a number of their design features and uses are still experimental. This makes it exciting to assist with their evaluation, development and acceptance in the public interest and from capital market perspectives…

The Basel Committee on Banking Supervision [BCBS], or “Basel Committee” according to its new charter (BCBS, 2013a), is the primary global standard-setter for the prudential regulation of banks and provides a forum for cooperation on banking supervisory matters. Since its establishment in 1974, the Basel Committee's mandate has been to strengthen the regulation, supervision and risk management practices of banks worldwide with the purpose of enhancing financial stability and contributing to “a level playing field” among internationally active banks. The current set of standards, first proposed in 2010–2011, is known as Basel III. The Committee's Secretariat is located in Basel, Switzerland, at the Bank for International Settlements [BIS]. The BIS is an International Financial Institution [IFI] founded in 1930. It now provides a coordination platform and technical support for central banks, and has regulatory and supervisory authority in drafting financial standards and regulations. Once finalized and adopted by the relevant committee such as the BCBS, these standards and regulations are proposed for adoption both by national regulators and for implementation by internationally-active financial institutions under their jurisdiction…

Contingent Convertible debt instruments are debt which comes with a contingent obligation to convert to common stock at a loss. This potentially costly obligation, to accept equity for more than it is worth when a designated trigger point for conversion has been reached, relegates cocos to the class of downside convertibles. Holders of Reverse Convertible Securities [RCS] and of catastrophe bonds and makers of Loss Equity Puts [LEP] share this downside exposure with investors in cocos: should bad things happen which they do not control, they lose…

When Systemically Important Financial Institutions [SIFIs], then called Too Big to Fail [TBTF], get into trouble as they periodically do, there are a number of ways to deal with them. Several of these approaches to problem resolution have been applied during the financial crisis of 2007–2009 with varying degrees of success to SIFIs and lesser institutions in the United States. Among the past resolutions scrutinized for clues to improved practices are those of the Investment Banks Bear Stearns, Lehman Brothers, and Merrill Lynch, and Savings Bank and S&L Association Holding Companies principally engaged in mortgage banking, Countrywide, Wachovia, and Washington Mutual.

For centuries most major economic crises in financially developed countries and principalities have been preceded and/or accompanied by financial crises—including waves of default and loss of capital—affecting banks and their counterparties. Over time, these crises and their disruption of financial intermediation and capital flows have spread far beyond their point of origin and afflicted entire regions, even the world economy. This has saddled policymakers with the task of guarding against and attempting to counteract financial crises of both foreign and domestic origin with the limited fiscal and monetary policy resources at their disposal. Cocos would be a useful addition to this arsenal because they could provide contingent capital infusions without undesirable side-effects or after-effects, although their sustainability through timely replacement after conversion remains a challenge. Continued issuance is likely to be least available for write-down-only cocos once they have left their holders badly burnt…

This part lays out specific rationales for having financial institutions choose to put cocos on their balance sheets by considering several alternatives. It also seeks to show how cocos must be designed and (not) regulated to live up to their promise…

Admati and Hellwig (2013) have recently published a much noted plea for higher CET1 requirements, pure and simple, and lambasted at every turn “the bankers” who chafe at raising them. My basic view is that the combination of capital and leverage requirements currently supposed to be phased in by 2019 (see Table 1) is about adequate. Their de facto implementation is already being moved up as banks compete in wanting to show that they already meet, or more than meet, the Basel III capital standards ‘fully loaded,’ i.e., at the final levels set for January 2019. The most that Admati and Hellwig (2013, p. 188) are willing to grant about cocos is that “they may be better at protecting the safety of the bank than simple debt.” But they see “no valid reason for non-equity alternatives to be considered instead of equity when using equity would be simpler and more effective in achieving the goals of a stable and healthy financial system.” They have not looked very hard to see any such reason; hence there is a challenge to demonstrate that cocos, which get just 2 out of almost 400 pages in their book, have some valuable features that distinguish them from common stock and make them suitable to be both part of and a supplement to the increased capital and leverage requirements ahead…

Reaching agreement on voluntary restructuring is much more costly and time consuming than converting bailinable debt into common stock. To illustrate the difficulties and losses that arise, the recent restructuring of a non-financial company, SolarWorld AG, can serve as a case in point that you do not have to be a financial company to benefit from having cocos on the balance sheet. Once Germany's largest solar producer, this public company has operations in a number of countries; it had even boasted of having America's largest and most advanced solar photovoltaic [PV] production facility (in Hillsboro, Oregon). Like most of its competitors, the company had been struggling with declining sales and with operating losses that escalated in 2013. Early in the year it started meetings with three groups of creditors holding promissory notes and loans, and two publicly traded bonds: (i) 7-year bonds or global notes totaling €400 million issued in January 21, 2010 at a fixed coupon rate of 6⅛%, and (ii) 5-year bonds totaling €150 million issued July 27, 2011 with a 6⅜% coupon. These two bonds could conceivably have been issued as cocos with a simple 10% leverage ratio trigger defined as book equity in percent of total balance-sheet assets. Such a trigger level would be very low for firms in most non-financial sectors; it was 27.5% (614.6/2,235.8 with data in millions of euros) for SolarWorld (2013, p. 40) as recently as January 1^st, 2012…

The question posed for this Part, “Why Cocos?,” demands an immediate summary of the answers. Within a year after cocos first appeared in the market, this short form for contingent convertible debt securities gained currency and attracted a fair amount of derision. As we have seen in the previous chapters of Part II, however, there are in fact several good reasons for the existence of high-trigger cocos. Adding such ‘recovery’ cocos to the financing mix appears superior to staying only with bailinable bonds and relying simply on more equity, or to counting on voluntary restructuring or Chapter 11 (of the US Bankruptcy Code) reorganization as an expeditious and low-cost way out…

The most critical variables for pricing the conversion risk premium in cocos are (i) the probability of conversion [π] in each year over the term of the bond and (ii) the recovery rate [ρ] obtained from the market value of the common equity received at conversion in relation to the face value of the bond cancelled at that time. To simplify the exposition, both π and ρ are taken to be constant over the term of the bond whose face value is normalized at 1. This principal amount will be repaid if the coco has not been converted into common stock by its maturity date [T]. The probability of the debt surviving to that date is (1 – π)^T. The ‘riskless’ rate r * that functions as the discount rate is deemed to be free of credit risk. It is entered as either 3% or 6% in the implicit basic equation for R below if the term to maturity is 5 years, and as either 4% or 7% if that term is 10 years. R is the annual rate of return required on cocos under risk neutrality, meaning it does not include a premium to compensate for risk aversion but only for losses expected in the event of conversion…

As previously deduced, the conversion risk premium on cocos can become steep when the recovery rate [ρ] is zero and the annual probability of conversion [π] is as high as 4%. Line 20a of Table 4 above shows, for instance, an expected value of that premium [R – r *] of 4.46% for ρ = 0 and π = 4%. This internally consistent inference from a pricing model must still be confronted with market data where the conversion risk premium is represented by Bloomberg estimates of G-spread and π is implied. It turns out that the average of the values of π in the last column of Table 7 that satisfy the basic equation with ρ = 0 and r * given by the yield curve on US Treasuries for the respective G-spread is 3.96% unweighted and 3.80% when weighted by the US dollar size of each of the 10 issues. Hence the value of π implied by actual data for the cocos issues of the 10 banks featured in Table 7 is roughly the same as the 4% value set for π in the model solution described at the beginning of this paragraph. For this reason, the average of the G-spreads in Table 7 is also expected to be close to the conversion risk premium of 4.46% deduced from the basic equation as described before. Even though this premium is not likely to be the only contributor to the G-spread, the actual average G-spread was lower than the average spread deduced from the model for the conversion risk premium alone. It was 4.18% unweighted and 4.01% weighted by size of issue compared with 4.46%. Hence there is rough—but meaningful—correspondence between actual data and model-based inferences.

The recovery rate was previously treated as a control variable. Given the expected stock price in the event of conversion, the replacement or recovery rate could be set by choosing a conversion price that would yield it. For instance, if the estimated market price in the event of conversion [MP_c] is projected to be $8 per share, setting a conversion price of $10 would imply an 80% recovery rate provided the estimate of MP_c had already taken this target value of ρ—and what it implies for the number of shares outstanding after conversion—into account. It was argued that such a recovery rate would provide the right incentives for both cocos holders and pre-existing shareholders to be vigilant. The latter would be hurt by the de-capitalization that led to conversion and any associated stock price decline, but not by conversion itself so long as the recovery rate for cocos holders is less than 100%. There are indications from the first of the two cases that follow that the actual recovery rate to be expected has not gotten even close to 80%. This means that of all the bad consequences pre-existing shareholders may face when the capital ratio of their bank has declined to the trigger point, conversion of minimal-replacement cocos may be by far the sweetest for them while being unduly harmful to (usually institutional) cocos holders and their institutional counterparties. If there is a tendency in the finance sector to build up tail risk by favoring investment strategies that promise to generate high yields much of the time while courting a low risk of incurring disastrous losses on rare occasions, here is a good example of this destructive tendency.

So far we have considered write-down-only cocos and cocos which convert into common shares when triggered. The former type of cocos provide for an extreme form of private-sector debt-holder involvement in loss absorption outside bankruptcy known as bail-in. Writing off the cocos debt of a concern that remains in operation subordinates the claims of cocos holders to those of existing shareholders when a contingency event has occurred. Upon conversion, cocos holders lose their entire investment while shareholders gain from the debt relief. The same debt cancellation is also provided by cocos that convert into common stock, but cocos holders do not lose everything because the recovery rate from the common shares cannot (yet) be down to zero outside of bankruptcy when the cocos are accurately triggered. What cocos holders do not lose from conversion, pre-existing shareholders cannot gain. Whether cocos convert into common shares or not does not affect how much the book value of equity is raised by conversion, but only how that elevated book value—and hence ownership and control—are shared between pre-existing shareholders and new shareholders from conversion…

Some of the most questionable uses of cocos have been made in the recapitalization programs of leading banks in the Iberian Peninsula.

For their treatment under the corporation and business income tax, it matters in several ways whether hybrids, such as cocos, are classified as predominantly debt-like or equity-like. Dividends and capital gains are taxed at preferential rates in some countries, and some countries do not tax capital gains at all. In the United States, for instance, the federal tax rate on qualified dividends and realized long-term capital gains that are paid to fully taxable recipients is capped at 20%. This rate is only about half as large as the maximum individual income tax rate of 39.6% for 2013…

Cocos can enter into credit ratings in at least two ways. They can be rated essentially like other subordinated debt on the likelihood that they will survive until their first call date (if undated) or maturity (if dated), that interest will be paid in full in a timely manner, and taking into consideration what the recovery rate would be should they be converted into equity rather than just written off. Secondly, as FitchRatings noted in a brief report on “Bank Contingent Capital to Rise,” dated May 28, 2013: Cocos with a high capital ratio trigger are particularly relevant in stress tests and recovery planning as their writeoff or equity conversion, once a pre-determined trigger is breached, is designed to absorb losses on a “going concern” basis before fundamental viability is threatened. In recognition of this, we assign such instruments either 50% or 100% equity credit in our bank capital analysis [that feeds into the firm's rating], broadly depending on coupon flexibility…

This chapter will document the development of the capital and instrument requirements proposed under Basel III and how they have affected design, volume of issuance, and regulatory uses of cocos. To deduce the outlook for cocos from their regulatory treatment to date, it will present excerpts from key documents released by the Basel Committee on Banking Supervision [BCBS] and the European Banking Authority [EBA]. These documents in turn provided the foundation for the Capital Requirements Regulation [CRR-IV] issued in Europe in 2013 and the “final rule” adopted by bank regulators in the United States in the same year. Both of these regulations, also excerpted here, aim to implement Basel III in their respective countries or zones. Starting with the global regulatory framework first proposed in BCBS (2010 and 2011c) “for more resilient banks and banking systems,” the Chapter will focus on how regulations pertaining to the role of cocos in meeting capital requirements have evolved from the time they were first proposed to when they were adopted with variations by both the European Union and the United States…

On New Year's Day, 2014, the New York Times carried a story that wondered why “Ski Helmet Use Isn’t Reducing Brain Injuries.” Such helmets have been getting ever better in shock absorbtion, but the rate of serious head injury has reportedly not declined; only lesser injuries like scalp lacerations, have been reduced. We may similarly ask ourselves why it is that capital has become ever more loss absorbing, yet the rate of financial crises has not declined. Perhaps it will turn out that excessive risk taking is hard to restrain when managers have no intention to help in doing so and are inclined to rate regulations by their nuisance value rather than by any stabilization benefits. Greater capital buffers might just stimulate higher risk taking, and the eventual damage could be just as great as before…

The following sections are included:

• References
• Index