April 8, 2011 Princeton Conference
in Honor of Burt Malkiel
Concocting CoCos
George M. von Furstenberg
Indiana University
For comments and related materials: vonfurst@indiana.edu
Writ Raghu Rajan 2010:
• If the govt. is likely to bail out SIFIs, the solution to the problem of
institutions becoming too SIF has to be found elsewhere than in
stiffening the backbone of regulators or limiting their discretion.
There are three possible solutions:
(1) Prevent institutions from becoming systemically important.
(2) Keep them from failing by creating additional private sector
buffers.
(3) Make it easier for the authorities to fail (resolve) them.
Focusing on (2), he proposed a double-trigger for Contingently
Convertible Debt Securities, cocos. The two events he required to
trigger conversion include the bank’s designated regulatory capital
ratio falling below a value that is set at or somewhat above the
regulatory minimum. This trigger is the identifying characteristic of
cocos and the only one that has been used in practice.
Macro-Prudential Triggers: A Critique
•
•
•
•
The likelihood that cocos with the single trigger just described will be converted is,
of course, much greater during a financial crisis than in normal and more
profitable times. Hence their conversion will have some countercyclical effect.
However, requiring conversions to wait until the entire banking system is in deep
trouble as judged, for instance, by the assessment of regulators based perhaps on
aggregate bank losses (Rajan) causes dangerous delay, and then a bunching of
conversions and a flood of newly-issued bank stocks, when the authorities finally
decide to pull the second trigger.
Ex ante, valuing cocos would become very difficult and involve speculations about
the behavior of regulators which Rajan, in dismissing the first option, otherwise
would not want to depend on.
Wanting to preserve “debt discipline” over management by preventing cocos
conversion except when the entire banking system is in trouble is dubious also
because denying cocos conversion to a SIFI, or to a number of financial institutions
that together constitute a SIFI, could bring on the very bankruptcies (and ensuing
externalities) against which cocos are designed to provide a measure of selfinsurance. In addition, cocos should take the form of long-term, not short-term
debt, so that mothballing cov-lite cocos debt may not do much for discipline.
COCOS
mandates??
Basel II
International
Standard
Basel III
International
Standard
SIFI-SWISS
(TBTF Comm
of Experts)
Progressive
Component
Add-on for
SIFIs not det.
6% Cocos
(Trigger 5%)
Buffer
(Countercyclical buffer
0 – 2.5%)
3% Cocos
(Trigger 7%)
Common
Equity: 5.5%
Conservation
Buffer 2.5%
Minimum
Source:
Tier 2: 4%
Addititonal
Tier 1: 2%
Tier 2: 2%
Addititonal
Tier 1: 1.5%
Minimum
Common Equity
(old definition):
Minimum
Common Equity
(new definition):
2%
4.5%
Patrick
Raaflaub
CEO
S.FINMA.S.A.
Chargeable on
min. from
cocos above:
3.5%
Minimum
Common Equity:
4.5%
Small Countries with “Too Big to Save” Banks “
Basel III
Bern
Swiss
SIFI Policy
Bern I“ Swiss SIFI Policy
Total Capital:
10.5%
19% w.
Countercyc.
10.5-13%
?
Common Eq. Min.: 7%
10%
The actual capital-ratio targets aimed at by financial institutions are the result of
optimizing capital ratios subject to constraints, such as the regulatory minima
set for such ratios, and the penalties for violating them.
When the regulatory minimum is increased, the excess of the actual over the
minimum capital ratio intended by financial institutions is reduced.
A crude way of supporting this statement is contrasting the positive level of
the capital ratio that is chosen when the minimum is zero, with equality of
the actual and required levels when the minimum capital ratio is 100% or 1.
Hence, at least in the relevant range, actual capital ratios will rise by less
than any increase in the minimum capital ratios. Even so, the actual Swiss
capital ratios, with the “Swiss finish”, are going to be far above those of Basel III.
If losses of tangible common equity of the banking system amount to ca. 3% of
total assets as later concluded, and the size of the tangible assets of the two
largest banks is 30% of GDP in the U.S. and 500% in Switzerland, it would take
0.009 (0.9%) of GDP to recapitalize the two in the US and 0.15 (15%) in
Switzerland. Because a Swiss TBTF back-stop is not very credible, Swiss capital
ratios need to be higher. Cocos are meant to make the additions less painful.
Critical Cocos
Specifications
• Trigger Definition and Level
(Staggering)(Book or market)
• Conversion Terms
(Formula or Market-Value)
• Relative Size of Issue
(Adequacy) (Mandates or
Market)
Coco-Sceptics: Dilution, no Market?
• Oswald Grüner, CEO of UBS, (FT 03/03/2011) has said that a contingent
convertible is “a very dangerous instrument”. “As soon as you get near
these trigger levels – you do not have to hit them – what do you think
shareholders will do? They will get the hell out of that stock, so fast,
because you know it will halve in value if it is triggered.”
• Those negative views do not keep UBS from being a leading tout in the
cocos market, having worked on LBG’s November 2009 and Rabobank’s
March 2010 cocos, or cocos-like issues. Barclays Capital has suggested
that the reg.-driven cocos market, by 2018, could be huge (€700 billion).
• A supporting cast at UBS (CFO John Cryan) has faulted cocos mandates on
the grounds that there is “no natural universe of buyers for something that
is really quite an obscure and untried and untested instrument.” Cryan even
wondered “if ever one of these did trigger whether that would not cause a
systemic issue with that market.”
More cocos trashing: Charles A.E. Goodhart,
“The Squam Lake Report,” JEL, March 2011
49(1): 114-119
“Many, perhaps most, versions of CoCos, as defined
by their respective trigger mechanisms and
conversion terms, would not be effective, in some
cases positively dangerous. The version that would
be, in [his] view, socially best would impose such a
large dilution on existing shareholders that they
would have an incentive to issue new equity at the
first hint of trouble, rather than wait for the
conversion to be triggered.” P. 117
Goodhart, Central Banking Mag 21(1)
August 2010, p. 30 (29-33)
CoCos convertibility must be
triggered by falls in market, not in
accounting valuations, because
accounting values adjust too
slowly.
• Comment: Stock prices
become highly volatile in a
financial crisis and may deviate
from fundamental values for
flash-crash as well as extended
periods. Conversion and its
terms and consequences
become needlessly difficult to
gauge ex ante.
• Compromise: Stockholders by
majority vote and the Board of
Directors of financial
institutions should be able to
request an unscheduled
forward-looking and up-todate regulatory determination
of an institution’s capital ratio
to see whether the trigger
point has been reached. Such
a determination could also be
made a legal precondition
(and protection) for
conversion.
More Thrashing from Goodhart
The only [cash-flow] benefits that
cocos conversion brings is cessation
of interest payments.
A stronger mechanism would be to
require the authorities to ban all
dividend payments.
Comment: The second suggestion is
extraneous and can be adopted with
or without cocos. Basel III already
includes a reduction in the % of
earnings that may be paid on
dividends or sbb’s. The prohibition
would rise to 100% of earnings if
capital ratios cover less than 25% of
the sum of the compensation and
countercyclical buffers.
Response: By bringing regulatory
capital back up to adequate or wellcapitalized levels, cocos conversion
can lower collateral requirements
imposed on a financial institution,
raise the rating of its debt, and
increase borrowing capacity, for
instance on trade credit or CP, which
could bring in cash. The counterparty
risk on dealing with such an
institution would be reduced.
Micro- vs. Macro-Prudential
• Should conversion be
allowed only if an individual
bank and the whole financial system were in crisis?
• The CoCos pay-off function,
incurring a large loss when
all other assets are also
doing badly, is highly
unattractive.
• More problems: Contagion
from cocos conversion,
hedging through shorting,
death spirals?
• A financial crisis is marked
by idiosyncratic risk being
overshadowed by systemic
(highly correlated) risk.
• Surely the deadweight
losses of receivership, from
not having CoCos on the
balance sheet in a crisis, are
even less attractive.
• These concerns counsel
against setting the
conversion trigger by the
market value of equity.
Conversion Rates: At least two methods are
available.
1.
The number of shares obtained in the conversion is determined
so that their value at a “recent average price (as further specified)”
would be equal, at that price, to the face value of the cocos being
converted. Use of the “recent average price” may be qualified by the
phrase, “but not less than $x per share,” where x is a floor price. This
proviso is designed to limit dilution by placing an upper bound on the
number of shares to be issued in the conversion. Except when the floor
price is binding, the number of shares obtained from the conversion
thus is not known until the “recent average price” has been recorded.
The cocos-like tier 2 Buffer Capital Notes (BCNs) when to be
converted, “convert into Credit Suisse Group ordinary shares at their
prevailing market price over a 30-day period preceding the notice of
conversion, subject to a minimum price of USD 20” (Credit Suisse,
2011). On March 16, 2011, CS (ADR) was trading in the $41-$42 range
in New York.
The second, and ex ante calculable
conversion method, to be favored
2.
The second method focuses on the fair share (S) of new shares (NS),
SNS, in the total number of equity shares outstanding after conversion,
NS + ES, where ES is the number of existing shares prior to conversion.
SNS would be determined by just two comparable statistics that allow NS
to be expressed as b times ES. For instance, if the face value of cocos is
equal to 4% of total (not risk-weighted) assets as reported in a company’s
last Quarterly Report and the trigger level of the leverage ratio is 3% of
such assets, then NS=(4/3)ES if the cocos are converted all at once. Then
SNS = NS/(ES+NS) = 4/7, and the new shares account for a majority of
the total number of shares outstanding because the cocos conversion
contributed more to regulatory capital than the 3% that was left over.
On the other hand, if cocos amounted to only 2% of total assets so that
NS=(2/3)ES at the time of conversion, then the new shares would account
for 2/5 or 40% of the total number of shares outstanding after conversion.
By making the number of shares issued independent of their market value
at conversion in this way, downward stock-price spirals and the resulting
dilution of the value of the stakes of existing shareholders can be avoided.
Dilution through CoCos Conversion?
•
•
“The debt–overhang problem arises when even informed financiers refrain from
injecting additional equity since the proceeds of the investment are primarily
going to existing debt-holders rather than the new equity holders.” Brunnermeier,
FCIC Testimony Feb. 26-27, 2010. Here, by contrast, new shareholders share the
benefits from cocos conversion pro rata with existing shareholders. As a result, the
dilution of existing shareholders is fully compensated. Senior debt-holders see less
subordinated (cocos) debt and more common equity (from cocos conversion)
below them so that the new capital structure does not enhance the value of their
senior claim to that extent. Nevertheless, they too will share in the benefits that
result from the large reduction in PCA risk, followed by receivership and large
deadweight losses (of more than 30% of total assets in FDIC experience).
While it is true that any dollar contributed to a company that ultimately goes
bankrupt is a dollar contributed to its most senior claimants, the benefits of
bankruptcy avoided are shared by junior and senior debt claimants and
shareholders in line with their exposure to bankruptcy risk and its consequence of
destroying recovery value. The increase in the market value of the debt remaining
after cocos conversion, if charged against current earnings under MTM accounting
for liabilities, should be disallowed for reasons explained by Bishof and Ebert 2011.
Managing the Links between Financial Reporting and Regulatory Accounting
“Amortized cost remains relevant for debt instruments (both loans and
securities) not held for short-term profit-taking” (p. 170).
“Cumulative Gains and Losses due to Changes in Own Credit Risk –
if the fair-value option is applied for financial liabilities, all unrealized gains
and losses that have resulted from changes in the fair value of liabilities
that are due to changes in the bank’s own credit risk are derecognized from
tier 1 capital” (p. 171) under Basel III.”
Jannis Bischof and Michael Ebert, “The Mixed Accounting Model Under
IAS 39: Current Impact on Bank Balance Sheets and Future Developments,”
Journal of Financial Transformation , Cass-Capco Institute Paper Series on Risk
# 31, Part 2, March 2011, 165-172.
Deadweight Losses of Bankruptcy:
Lehman Brothers Holdings Inc.& Other Debtors
&Controlled Entities
Millions of
$
Date
Total Assets
Total Liabilities
Stockholders Equity
Total Liabilities and
Stockholders' Equity
Preferred Stock
Common Stock and
Addit. Paid-In Capital
Retained Earnings and
Other Stockholders' Eq.
Total Common Equity
Total Stockholders' Eq.
May 31 2008 Sept. 14 2008 Marc 31 2010
639,432
626,240
253,175
613,156
560,396
307,286
26,276
65,845
-54,111
639,432
626,240
253,175
6,993
13,077
11,035
2,382
47,431
26,162
16,901
19,283
26,276
5,337
52,768
65,845
-91,307
-65,145
-54,111
3.65 (Sept. 12)
0.1
36.81 (May
Stock Price ($) at Close 30)
Assumption:
(1) Market Value of Equity is
(2) Market Value of Equity Falls
Always Equal to its Book Value
Value
of Equity
1
Column:
No. of
Shares
2
to 0 Prior to Cocos Conversion
Value
Value
per Share of Equity
3
4
No. of
Value
Shares per Share
5
6
A. Existing Shareholders
Initially Very Well
700
Capitalized Level
After Deterioration
300
up to Trigger Point
Dilution upon
-(4/7)300
Pulling Trigger
Pro Rata Benefits from
(3/7)400
Cocos Debt Cancellat'n
Post-Conversion
300
Value
100
7
700
100
7
100
3
0
100
0
100
-1.7143
0
100
0
100
1.7143
100
1.7143
100
100
1.7143 (3/7)400
3
171.43
B. Value of Cocos Bonds or of New Shares from Cocos Conversion
Initial and Pre-Convers.
400
Value of Cocos
Transfer from Existing
(4/7)300
133-1/3
Shareholders' Dilution
Pro Rata Benefits from
(4/7)400
133-1/3
Cocos Debt Cancellat'n
Post-Conversion
400 133-1/3
Value
400
1.2857
0 133-1/3
1.7143 (4/7)400
3
0
133-1/3
1.7143
228.57 133-1/3
1.7143
C. Combined Value of all Equity and Cocos Debt Claims Outstanding
Initially
of which Equity
Equity after Conversion
1,100
700
100
700 233-1/3
7
3
1,100
700
100
400 233-1/3
7
1.7143
LOSS OF RISK CAPITAL (= EQUITY CAPITAL)
1.
The IMF’s Global Financial Stability Report (GFSR), April 2009, p. 36, estimates that by the end of
2008 the first two years of the 2007-2010 financial crisis had reduced the ratio of tangible common
equity (TCE), defined as total equity less preferred shares and intangible assets or as core tier 1
capital, to total tangible assets (TA) to 3.7%. In the United States. reported writedowns of $510 billion
exceeded capital of $391 billion raised during 2007-2008 by $119 billion. For 2009-2010, the IMF
expected writedowns of $550 billion to exceed net retained earnings of $300 billion by $250 billion. To
both raise the leverage ratio, TCE/TA, from a little over 3.7% to 4% and to keep it at 4% would require
an equity infusion of $275 billion in 2009-2010 according to this April 2009 estimate. The TA value for
the U.S. that is implicit in these calculations is $11,250 billion. All these and subsequent estimates for
the U.S. do not include the GSEs.
2.
[In the subsequent GFSR of November 2009, p. 15, the estimate of the capital infusion still required in
the U.S. from the middle of 2009 to reach a 4% leverage ratio by the end of 2010:Q4 was only $130
billion. Thus it is as if over half of the $275 billion capital injection previously estimated for 2009-2010
was made in the first half of 2009. Realistically, data and baseline revisions are also likely to have
played a part.]
3.
To raise the leverage ratio to the “well-capitalized” level of 6%, the “approximate leverage of U.S. banks
in the mid-1990s, prior to the buildup in leverage in the banking system that contributed to the crisis,”
would require a total equity infusion $500 billion according to the April 2009 IMF estimate.
4.
The two IMF estimates combined imply that the financial crisis required an additional equity cushion of
at least 275/11, 250 or 2.4%,and at most 500/11,250 or 4.4% for the crisis to be overcome by the
end of 2010.
Leverage Ratios for the 40 Largest U.S. Banking
Operations before the Crisis, June 30, 2005, and TARP
Top 3
Next 37
All 40
Tier 1 Capital ($ billions)
223
240
463
Total Assets, TA ($ billions)
3970
3162
7132
Total-Asset Weight
0.5567
0.4433
1
Aggregate Leverage Ratio %
5.62%
7.59%
6.49
Average Leverage Ratio %
5.66%
8.12%
7.94

0.51%
3.01%
2.96
115
74
189
2.29%
1.85%
2.09%
Standard Deviation
TARP Funding ($ billions)

as % of (1.082)^3 (TA),
to adjust to mid-2008
Sources: Calculated from (i) R. Alton Gilbert, Keep the Leverage Ratio for Large Banks to Limit the Competitive Effects of Implementing Basel II
Capital Requirements, Networks Financial Institute at Indiana State University, Policy Brief 2006-PB-01, January 2006, Table 5, and (ii) U.S.
Treasury Department, Office of Financial Stability, Troubled Asset Relief Program (TARP), Transaction Report for the Period Ending Feb 23, 2011.
How Big was the Hole?
Risk Capital Rebuilt 2009-2010
•
•
The Federal Reserve, in a March 18, 2011 press release announcing
completion of its Comprehensive Capital Analysis and Review of the capital
plans of the 19 largest U.S. bank holding companies reported that from the end
of 2008 through 2010, “common equity increased by more than 300 billion” at
these 19 companies. Considering that some of the smaller banks also issued
common equity in 2009-2010, the combined equity issue of approximately
$325 billion was quite enough to meet the IMF’s 4% leverage target set in April
2009 for the end of 2010 under the then-assumed (somewhat too high) writeoff and (if anything too low) retained-earnings conditions. The Fed appears to
have been satisfied that most of the 19 largest banks tested (one significant
exception was Bank of America) had reached a level of capitalization sufficient
to allow a resumption of (initially still modest) dividend payments or stock buybacks. The common equity raised has been sufficient to allow TARP funding to
be repaid by the end of 2010 by all of the 19 banks, except Ally Bank, the
inglorious successor to GMAC.
In sum, it appears that the recent financial crisis left a hole of 2.4% to 4.4% of total
assets, with additional indications pointing to 3% as the most representative round
number in this range. TARP funding (under CPP and TIP) provided an amount equal
to about 2% of total bank assets starting on 10/28/2008 and ending on 09/30/10.