Time For Some Nice “Co-Co”

2011 February 21
by SJ Leeds

Before we get to the normal blog…our business school (McCombs) did a story for Valentine’s Day about couples that met at school.  I met Jenny at McCombs.  She was a student in an undergraduate class that I was teaching.  Okay, that’s not really true.  But, for a split second, all of the men thought that I was really cool and the women thought I was a pig.  (My guess is that the women still think I’m a pig.)  Jenny and I met in the MBA program.  You can read the story (and yes, see the picture) at this link.

For those young men who read the blog, this story and picture should teach you two important lessons:

1.     The time to get married is when you’re walking down the street and you can hear random people asking each other, “what the $&@* is she doing with him?”

2.     Just like companies issue stock when they believe that their stock price is inflated, you should sell yourself when you have a good head of hair.  Stock prices and hair count can decrease.

Now, on to less important matters, such as solving “too big to fail.”

This past week, Credit Suisse sold $6.2 billion of contingent convertible bonds (“Co-cos”) to two institutional investors.  A co-co is debt (a bond) that will convert into equity if certain contingencies arise.  For example, in the case of Credit Suisse’s co-cos, they will convert into equity if the bank’s capital ratios fall below 7% or if Swiss regulators say that the bank is in danger of insolvency.

If a bank has debt that will convert into equity (if bad things happen), the risk of insolvency (where liabilities are greater than assets – in other words, the equity is gone) is greatly diminished.  These bonds make it significantly less likely that a bank will fail.  Realize that most banks have equity capital of approximately 8%.  When loans aren’t paid back to the bank or the bank owns bad securities, the equity is diminished.  At some point, the banks are seized (or propped up by the government).  With contingent convertibles, this wouldn’t happen – the equity would be replenished by converting the debt into equity.

I believe that all US banks should be required to have co-cos equal to 8 – 10% of their assets.  This would be more than enough to replace the diminished equity of any bank (in all but the worst of catastrophes).

This is the solution to the “too big to fail” problem.  I love these securities.  Here’s what I love about them:

1.     They shift the risk of loss (bailouts) from the taxpayer to bondholders.  Taxpayers will no longer need to provide the implied (free) insurance.

2.     They allow the market to set the price of the risk that each bank has.

3.     This should even reduce (but not eliminate) the need for FDIC insurance (and the premiums that the banks pay).

4.     The banks are against it – so that tells me that it’s probably the right thing to do.

Some of the arguments that the banks make (against requiring the use of co-cos) include:

1.     Institutional investors will not buy these equities.

2.     The “trigger points” (such as capital dropping below a certain level) could destabilize banks – as everyone watches those specific levels.

Of course, the idea that there won’t be a market for these equities is hurt by the fact that CS just sold $6.2 billion of them.  Bankers need to remember…you were able to securitize mortgage debt from subprime borrowers and sell that crap to investors, so I’m confident that you could convince investors to buy debt that effectively insures your institutions.  After you do it, you can pat yourselves on the back and use the sale to justify your bonuses.  If, on the other hand, the market won’t buy your debt (that converts into equity only if bad things happen), what does that tell you?  (It would be like me trying to insure against hair loss.)   The reality is that the banks can sell this debt – they just might not like the price (i.e., the interest rate will reflect the risk).

My personal opinion is that the banks don’t like these securities for another reason.  If these securities provide a part of a bank’s capital, stockholders will have to price in the possibility that these contingencies could arise resulting in the current shareholders being diluted (by the conversion of the co-cos into equity).  Obviously, this decreases the value of the stock.  The banks would prefer to have the implied guarantee of their government – which is costless to them (and is a wealth transfer from taxpayers to shareholders).

The future of co-cos will be determined by whether regulators allow them to be counted as Tier 1 capital.   My hope is that this decision will be made by regulators, not lobbyists.


Please continue to forward this blog to others who may be interested.

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