Category: Contingent Capital

The Globe and Mail interviewed Julia Dickson for today’s paper:

That is good – to focus on too big to fail and market discipline – but some of the suggestions for dealing with that are not appropriate, such as determining which institutions are systemic [too big to allow to fail] and trying to assess some sort of capital charge on them.

There are various reasons for that, but I think that designating institutions as systemic will lead them to take more risk, and I think that coming up with the capital charge would be hugely challenging.

Ms. Dickson’s opposition to Treasury’s proposal to designate systemically important institutions is well known, but the fact that “coming up with the capital charge would be hugely challenging” is hardly a reason to ignore the issue.

OSFI has already specified Operation Risk Requirements, which are included in risk weighted assets. One formulation considered acceptable is:

Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk,66 but excludes strategic and reputational risk.
…
Banks using the Basic Indicator Approach must hold capital for operational risk equal to the average over the previous three years of a fixed percentage (denoted alpha) of positive annual gross income. Figures for any year in which annual gross income is negative or zero should be excluded from both the numerator and denominator when calculating the average.68 The charge may be expressed as follows:
KBIA = [Σ(GI_1…n x α)]/n
Where
KBIA = the capital charge under the Basic Indicator Approach
GI = annual gross income, where positive, over the previous three years
n = number of the previous three years for which gross income is positive
α = 15%, which is set by the Committee, relating the industry wide level of required capital to the industry wide level of the indicator.

Gross Income is a better-than-random proxy for systemic importance and I thing many people will agree that a major part of the Credit Crunch was “inadequate or failed internal processes” related to risk control. If setting α to 15% has proved to be inadequate, try doubling it and see how the back-tests work out. That’s one way. I still prefer a progressive surcharge on Risk-Weighted Assets starting at, say, $250-billion.

We would be more in favour of promoting the idea of contingent capital internationally. So that’s where you have a big chunk of subordinated debt that converts into common equity if the government feels that it has to step in to protect an institution or inject money into the institution. So that’s the kind of position we’re taking internationally, and it’s a huge issue.

I guess if you quantify your proposal simply as a “big chunk of subordinated debt”, the challenge becomes less huge.

Of more interest is the proposed trigger: “if the government feel it has to step in”. The Squam Lake double trigger has attracted some support, but as noted in my commentary on the BoE Financial Stability Report, I feel that such a determination will amount to a death sentence for the affected bank and will therefore come too late to be of use … as well as putting a ridiculous amount of power in the hands of regulators. Let the trigger be the market price of the common; the market understands that, can hedge it and, most importantly, will have some certainty in time of stress.

Mark Flannery has published a paper with the captioned title dated 2009-10-6, which elaborates and defends his original idea for Contingent Capital that has been previously discussed on PrefBlog (he used to call them Reverse Convertible Debentures):

The financial crisis has clearly indicated that government regulators are reluctant to permit a large financial institution to fail. In order to minimize the transfer of future losses to taxpayers or to solvent banks, we need a system for assuring that large institutions always maintain sufficient capital. For a variety of reasons, supervisors find it difficult to require institutions to sell new shares after they have suffered losses. This paper describes and evaluates a new security, which converts from debt to equity automatically when the issuer’s equity ratio falls too low. “Contingent capital certificates” can greatly reduce the probability that a large financial firm will suffer losses in excess of its common equity, and will provide market discipline by forcing shareholders to internalize more of their assets’ poor outcomes.

Specifically:

• a. A large financial firm must maintain enough common equity that its default is very unlikely. This common equity can satisfy either of two requirements:
  • o Common equity with a market value exceeding 6% of some asset or risk aggregate. For simplicity, I’ll discuss the aggregate as the book value of on-book assets.
  • o Common equity with a market value exceeding 4% of total assets, provided it also has outstanding subordinated (CCC) debt that converts into shares if the firm’s equity market value falls below 4% of total assets. The subordinated debt must be at least 4% of total assets.
• b. The CCC will convert on the day after the issuer’s common shares’ market value falls below 4% of total assets.
• c. Enough CCC will convert to return the issuers’ common equity market value to 5% of its on-book total assets.
• d. The face value of converted debt will purchase a number of common shares implied by the market price of common equity on the day of the conversion.
• e. Converted CCC must be replaced in the capital structure promptly.

There are two problems with this proposal. First, there is a continued dependence upon official balance sheets which, however reflective they are of the truth, are subject to possible manipulation and will not be trusted in times of crisis. Second, the conversion of CCC into equity at contemporaneous market values has a destabilizing effect upon capital markets, brings with it the (admittedly slight) potential for death-spirals and (most importantly for some, anyway) leaves CCC holders immune to the potential for gaps in the market.

Dr. Flannery cedes the first point regarding balance sheets:

Market values are forward-looking and quickly reflect changes in a firm’s condition, including off-book items, which GAAP equity measures might omit. In contrast, GAAP accounting emphasizes historical costs and provides managers with many options about when and how to recognize value changes. These options are manipulated most aggressively when the firm has problems – exactly when rapid re-capitalization is required to ameliorate those problems. A trigger based on GAAP equity value thus guarantees that the trigger will be tripped long after a financial firm enters distress, and perhaps long after it has become insolvent. (Recall how many troubled banks and holding companies during 2008 were “well capitalized” or “adequately capitalized” according to Basel’s book-valued calculations.) A trigger based on GAAP equity value thus guarantees that the trigger will be tripped long after a financial firm enters distress, and perhaps long after it has become insolvent. (Note how many troubled banks and holding companies during 2008 were “well capitalized” or “adequately capitalized” according to Basel’s book-valued calculations.)

I suggest that if the trigger is set according to a pre-determined equity price, then the potential for jiggery-pokery is reduced substantially as, for instance, bank management will have no incentive to manipulate the balance sheet, or to benefit from prior efforts at manipulation. It will be recalled that Citigroup’s problems first made the news due to its off balance sheet SIVs. It will also be recalled that banks have substantial nod-and-wink exposure to defaults experienced in their Money Market Funds that are not recognized until well after the fact.

Additionally, basing the trigger solely on the market price of the common has the great advantage of being separated from accounting and regulatory considerations – the redundancy is important! I suggest that such redundancy with respect to the leverage ratio vs. the BIS ratios is, essentially, what saved the North American banking system.

It is not clear why Dr. Flannery, having thrown out book value for the equity (numerator) part of the trigger, continues to believe in its adequacy for use in the assets (denominator) component.

With respect to the conversion price, Dr. Flannery states:

My proposal in Section 3 would convert CCC face value into shares at a rate implied by the contemporaneous share price. With a contemporaneous-market conversion price, CCC bonds have very low default risk. With a sufficiently high trigger value, the CCC investors will almost surely be fully repaid either in cash or in an equivalent value of shares. Relatively safe CCC bonds whose payoffs are divorced from share price fluctuations should trade at low coupon rates in liquid markets.

With all respect, I consider this to be a bug, not a feature. CCC bonds should have a higher default risk than other bonds – defining default to be a recovery of less than expected value – otherwise there is little incentive for buyers of such bonds to enforce market discipline. I suggest that CCC bondholders should be exposed to gap risk – if the equity trades on day 0 fractionally above the trigger price (however defined) and management makes announcements that evening that cause the stock to gap downwards overnight, I suggest that it is entirely appropriate for unhedged CCC bondholders to take a loss. Exposing equity but not CCC to gap risk will make it harder to recapitalize the bank through new equity issuance.

When discussing the Squam Lake commentary on this issue, Dr. Flannery asserts:

CCC bonds with a market-valued trigger and a fixed conversion price could effectively recapitalize over-leveraged firms. However, the fixed conversion price adds an element of equity risk and uncertainty to the CCC returns. A high conversion price might give shareholders an incentive to induce conversion as a means of selling equity cheaply. A low conversion price would make bondholders eager to bid down share prices (if possible) to trigger conversion. Such strategic considerations are unrelated to the firm’s credit condition and add nothing to the regulatory goal of stabilizing under-capitalized financial firms. Occam’s razor thus supports the separation of equity risk from credit risk in CCC, further abetting transparent solutions for troubled banks.

I do not find this argument convincing. If, as I have suggested, the trigger price is also the conversion price, then the statements A high conversion price might give shareholders an incentive to induce conversion as a means of selling equity cheaply. A low conversion price would make bondholders eager to bid down share prices (if possible) to trigger conversion. becomes not applicable.

Her Majesty’s Treasury has released a discussion document on the role of banks titled Risk, reward and responsibility: the financial sector and society, which discusses contingent capital among other things:

In the recent crisis existing subordinated debt and hybrid capital largely failed in its original objective of bearing losses. Going-concern capital instruments often failed to bear losses because banks felt unable to cancel coupon payments or not call at call-dates (even though it was more expensive to refinance), in part for fear of a negative investor reaction as well as due to the legal complexity of the instruments. Gone-concern capital such as Lower Tier 2 has often failed to bear losses in systemic banks as governments have been forced to step in to prevent insolvency in part to prevent further systemic impacts on debt-holders such as insurance companies. CRD 2, the first in a series of forthcoming packages amending the Capital Requirements Directive, sets out criteria for the eligibility of hybrid capital instruments as original own funds of credit institutions. It also provides a limit structure for the inclusion of hybrid capital instruments in own funds.

Box 3.D reviews academic proposals for Contingent Capital:

Debt-for-Equity Swap – Raviv (2004) [1]
The proposal is for debt that pays its holder a fixed income unless the value of the bank’s capital ratio falls below a predetermined threshold (based on a regulatory measurement). In this event, the debt is automatically converted to the bank’s common equity according to a predetermined conversion ratio (the principal amount may change upon conversion).

Contingent capital certificates – Flannery (2009) [2]

Similar to the above, contingent capital certificates are debt that pays a fixed payment to its holders but converts into common stock when triggered by some measure of crisis. In contrast to the above this would be a market-based measure, with conversion occurring if the issuer’s equity price fell below some pre-specified value. The converted debt would buy shares at the market price of common equity on the day of the conversion rather than at a predetermined price.

Capital Insurance – Kashyap, Rajan and Stein (2008) [3]

Under this proposal, the insurer would receive a premium for agreeing to provide an amount of capital to the bank in case of systemic crisis. The insurer would be required to hold the full insured amount, to be released back to the insurer once the policy matures. The policy would pay out upon the occurrence of a ‘banking systemic event’, for which the trigger would be some measure of aggregate write-offs of major financial institutions over a year-long period. Long-term policies would be hard to price and therefore a number of overlapping short-term policies maturing at different dates are proposed.

Tradable Insurance Credits – Caballero, Kurlat (2009) [4]

The central bank would issue tradable insurance credits, which would allow holders to attach a central bank guarantee to assets on their balance sheet during a systemic crisis. A threshold level or trigger for systemic panic would be determined by the central bank. An attached tradable insurance credit is simply a central bank backed Credit Default Swap (CDS).

1 Bank Stability and Market Discipline: Debt-for-Equity Swap versus Subordinated Notes. Raviv, Alon. 2004.

2 Contingent Tools Can Fill Capital Gaps, Mark Flannery, American Banker; 2009, Vol. 174 Issue 117.

3 Rethinking Capital Regulation Kashyap, Rajan, Stein, paper prepared for Federal Reserve Bank of Kansas City symposium on “Maintaining Stability in a Changing Financial System”, Jackson Hole, Wyoming, August, 2008

4 The “Surprising” Origin and Nature of Financial Crises: A Macroeconomic Policy Proposal, Ricardo J. Caballero and Pablo Kurlat, August 2009

As has been discussed on PrefBlog (as recently as last week), Flannery’s proposal makes most sense to me. The Capital Insurance proposal has been used in Canada, with the RBC CLOCS, but I am not convinced that such elements are reliable in terms of a crisis – to a large degree, this will simply shift the uncertainty and fear of a crisis onto the insurance providers.

Update, 2010-6-13: The Kashyap paper is available on-line.

The UK Financial Services Authority has announced release of a discussion paper, Strengthening Bank Capital Standards 3. Contingent Capital is now official (and stupid):

The CRD amendments impose a new limit structure on hybrid capital. These instruments will now be restricted to three buckets (15%, 35% and 50%) of total tier one capital after deductions. Hybrid capital instruments will be allocated to these buckets based on their characteristics.
…
The 50% bucket is limited to convertible instruments that convert either in emergency situations or at our initiative at any time based on our assessment of the financial and solvency situation of the firm. We also consider that issuers should have the ability to convert at any time, as elaborated by CEBS in CP27.
…
Instruments with a conversion feature in the 50% bucket would be converted into a fixed number of instruments, as determined at the date of issue. This predetermination would be based on the market value of the instruments at the issue date. The mechanism, as reflected in CEBS’s guidance, may reduce this predetermined number if the share price increases, but could not increase it if the share price falls.

In other words, Contingent Capital in the 50% bucket has no first-loss protection at all. I suppose that one might justify these instruments in terms of writing an option straddle (short call, short put) but how on earth will a bank be able to issue these so that they make sense for a wide range of investors?

The lower two buckets make more sense, dependent upon implementation:

Hybrids with going concern loss absorbency features (e.g. write-down or conversion) can be included up to 35% of tier one provided that they do not have an incentive to redeem.

Hybrids that have going concern loss absorbency features (e.g. write-down), but with a moderate incentive to redeem, such as a ‘step-up’ or principal stock settlement, can be included within the 15% bucket. Hybrid instruments issued via SPVs are also limited to this bucket.

However, the first-loss protection under the new regime is severely restricted:

Incentives to redeem: CEBS clarified the interpretation of a moderate incentive to redeem in its recently published guidance. We are proposing the following changes to our Handbook to reflect these clarifications:

• • no more than one step-up will be allowed during the life of a hybrid instrument;
• • the conversion ratio within a principal stock settlement mechanism will be restricted to 150% of the conversion ratio at the time of issue; and
• • instruments that include an incentive to redeem at the time of issue (e.g. a synthetic maturity) will remain within the 15% hybrid bucket allocated for such instruments even if such features remain unused.

They explain:

We consider that conversion should not be unlimited for the other buckets, because this would involve no burden sharing by the hybrid holders. So, a determination at the issue date of a maximum number of shares to be delivered that would be no more than 150% of the market value of the hybrid, based on the share price at the issue date, would be acceptable. This would limit dilution. Shares must be available to be issued, so sufficient extra shares must already have been authorised.

As far as the trigger goes, they’re obsessed with discretion:

For all hybrids, the trigger for the the write-down or conversion mechanism should, at the latest, be where a significant deterioration in the firms’ financial or solvency situation is reasonably foreseeable or on a breach of capital requirements. For the 50% hybrid bucket the trigger would be an emergency situation or the regulator’s discretion.

Q3: Trigger for activation of loss absorbency mechanism
– Do you agree that in order for the mechanism to be effective in supporting the firm’s core capital in times of stress that the trigger needs to be activated at the discretion of the firm?

I think discretion – whether on the part of the firm or of the regulator – is the last thing wanted in times of stress. In such times, investors want as little uncertainty as possible and the exercise of entirely reasonable discretion in a manner not guessed beforehand by the market can have severe consequences, as Deutsche Bank found out, as discussed on December 19, 2008.

The only trigger that makes any kind of sense to me is a decline in the price of the common. Everything else is too uncertain and too susceptible to manipulation.

Interestingly, the FSA estimates the incremental coupon on Innovative Tier 1 Capital:

The new innovative instruments will need to offer a higher return to investors to compensate for the increased risk inherent in the new instrument. It is impossible to quantify the precise increase in cost to firms of servicing such instruments. Consistent with the previous analysis, we have estimated an upper-bound for the differential in coupons between the legacy innovative instruments and the new innovative instruments of 4.7%.

Paul Tucker, Deputy Governor, Financial Stability at the Bank of England, has delivered a speech to the SUERF, CEPS & Belgian Financial Forum Conference: Crisis Management at the Cross‐Road, Brussels containing a rather surprising rationale for investment in Contingent Capital:

Almost no amount of capital is enough if things are bad enough. Which is why contingent capital might potentially be an important element in banks’ recovery plans, as the Governor set out recently in Edinburgh.

This would not be the kind of hybrid capital that mushroomed in the decade or so leading up to the crisis. The familiar types of subordinated debt can absorb losses only if a bank is put into liquidation, and so really has no place in regulatory capital requirements as we cannot rely on liquidation as the only resolution tool. It has been a faultline in the design of the financial system as a whole that banks issued securities that counted as capital for regulatory purposes, and on which they could therefore leverage up, but with institutional investors treating them as very low risk investments backing household pension and annuity savings.

By contrast, contingent capital would be debt that converted into common, loss-absorbing equity if a bank hit turbulence. It is, in effect, a form of catastrophe insurance provided by the private sector.

Why should long-term savings institutions and asset managers be prepared to provide such insurance? One possible reason is that if enough of them were to do so for enough banks, it might well help to protect the value of their investment portfolios more generally. If ever it needed to be demonstrated,the current crisis has surely put it beyond doubt – not only for our generation but for the next one too – that serious distress in the banking system deepens an economic downturn and so impairs pretty well all asset values. By taking a hit in one part of their portfolio by providing equity protection to banks, institutions might well be able to support the value of their investments more widely. And the trigger for conversion from debt into equity could be at a margin of comfort away from true catastrophe; say, a percentage point or so above the minimum regulatory capital ratio.

Of course, this would entail a structural shift over time in investment portfolios. But the system might be able to manage that adjustment. After all, it managed the all together less desirable adjustment to the development of the existing hybrid capital markets. But demand for contingent capital is, inevitably, uncertain at this stage. As are the terms on which it will be provided. We welcome the growing private sector focus on this.

That has to be the craziest rationale I’ve seen yet for investment.

Contingent Capital will succeed only if it designed so that its risk/reward profile makes it sufficently attractive that investors include it in their portfolio in order to make money – some investors, some of the time, for some purposes.

To suggest that it be held in order to make the bond allocation of the portfolio be more bond-like – which is what I think he’s saying – is ludicrous.

Assiduous Readers will by now be sick of hearing this, but I thoroughly dislike the idea of making the trigger dependent upon regulatory capital ratios; this makes the investor – and, to some extent, the bank – hostage to future unknown changes in regulation. It may also make the regulator hostage to the market, if they want to make a change but have to consider the effect on triggering conversion. Making the trigger dependent upon the price of the common – if the common declines by 50% from its price on the contingent capital’s issue date, for instance – will provide a market-based conversion trigger that can be hedged or synthesized on the options market in a familiar and reproducible manner.

… at least until the wind changes:

Bank of America Merrill Lynch (BAC.N) reversed its position for a second time on Wednesday to decide its bond indexes would not include new contingent capital securities, devised for UK bank Lloyds (LLOY.L).
On Tuesday the U.S. bank said it would include these new bonds in its benchmark indexes, but many investors objected.

“The preponderance of feedback that we have received from investors who are measured against our indices indicates that most do not view the new contingent capital securities as part of their investment universe,” Bank of America Merrill Lynch said in a research note.

The Association of British Insurers (ABI) said on Tuesday its members were against including these new securities in bond indexes.
…
BofA Merrill Lynch had originally planned not to include the new bonds in its indexes, but then changed its mind on Tuesday.

“We have decided to evaluate the new securities on their own merits and will revert to our original decision to exclude them from the indexes,” Merrill’s research note said.

The note also said the bank would review all bank Tier 1 debt – the lowest ranking bank bond that has equity-like features – currently in the index to determine if there are, in fact, other securities that should be removed from the index.
…
No decision has been made yet for the iBoxx indexes, a leading benchmark in the investment grade arena, said Markit, which runs the indexes.

Markit’s oversight committee, made up of asset managers, regulators and consultants, is expected to meet next Tuesday to discuss a recommendation on this issue, Markit said.

Barclays Capital has already decided that contigent capital securities that are convertible to equity will not be eligible for broad-based investment-grade Barclays Capital bond indexes such as the Global Aggregate, Sterling Aggregate and US Aggregate indexes.

The new securities would also not be eligible for the bank’s high-yield benchmark indexes, but might be eligible for Barclays Capital Convertible Bond indexes, provided they meet inclusion rules, Barclays said.

I reported last week that UK authorities were promoting inclusion with the presumed purpose of widening the investor pool.

Two amusing things about this article are, firstly: “We have decided to evaluate the new securities on their own merits” which the smiley-boys at Merrill consider to be worthy of note, and secondly, that the stated reasons for exclusion have nothing whatsoever to do with whether these notes are bonds are not.

Can the issuer avoid bankruptcy while being a day late or a dollar short in their payments? No? Then it isn’t a bond.

Update: For all that, the issue is popular:

Lloyds Banking Group said yesterday that it may increase its capital-raising by £1.5 billion to £22.5 billion because of a clamour by investors to take up its offer to swap debt into equity.

Shares in the beleaguered banking group rose 5 per cent to 89¼p on the latest positive signal from the bank.

Investors are flocking to take up Lloyds’ offer to convert their tier 1 and tier 2 debt into new “contingent capital” because it will guarantee them an income of possibly 10 per cent or more in an annual coupon.

Standard and Poor’s has noted Contingent Capital Is Not A Panacea For Banks, Says Report:

There are certain practical difficulties, however.

The first is whether contingent capital securities will convert into capital early enough to help the bank. For contingent capital securities to prove effective as a buffer for senior bondholders, the conversion triggers need to be set at appropriate levels. However, this is difficult to determine
before a crisis hits.

The second is that contingent capital securities may not be sufficiently attractive to investors at a price that is also attractive to the issuing banks. The level of investor demand for contingent capital securities is unclear, given the difficulty that investors may face in pricing the potential conversion risks. Therefore, it is too early to gauge how this market will develop.
…
One big question for the development of the contingent capital market will be how the conversion trigger levels are set. Given that bank capital ratios are typically not strictly comparable, we expect that any specific ratio (such as a 5% Core Tier 1, for example) could mean different things to different issuers. In our capital analysis, we take account of how likely the conversion would be to happen in a time of stress, and this depends on what type of financial stress scenario the trigger ratio would represent. Published capital ratios can be lagging indicators of financial strength, and also can be calculated more conservatively by one bank than another. It may take some time for the contingent capital market to develop norms for trigger levels, and it may be complicated to compare these across banks.

For these instruments to be effective in a time of stress, the conversion will also need to happen quickly. This raises several questions:

• •How frequently will the trigger ratio will monitored?
• •Will the status of this ratio always be publicly disclosed?
• •Is there an appropriate process in place to enforce the conversion quickly?

I continue to suggest that the three closing questions are answered readily by ignoring the manipulable and variable capital ratios, and instead making the conversion trigger the breaching of a floor price by the common, with the the conversion price equal to that floor price.

Possibly the most bizarre form of contingent capital I’ve yet seen is the Deutsche Bank Contingent Capital Trust V Trust Preferred Securities, which begin their lives as Upper Tier 2 Sub-debt with a cumulative coupon, but convert to Tier 1 Innovative Capital with a non-cumulative coupon at the whim of the issuer – with no step up, no penalty, no conditions.

Update: More commentary from Tracy Alloway at FTAlphaville.

One thing that has irritated me for a long time has been the inclusion of Innovative Tier 1 Capital (IT1C) in the major bond indices. Those things aren’t even bonds! IT1C is simply preferred shares dressed up as bonds – this doesn’t degrade their utility as an investment vehicle and can make them quite attractive for non-taxable portfolios … but it doesn’t make them bonds.

However, Scotia stuck them in the index when the DEX indices were still the Scotia Capital indices, which I always presumed was just a way to make them easier to sell. There is never any shortage of pig-ignorant portfolio managers who neither know nor care about the specific risks of particular investments; the dirty part about this is that since institutional clients generally know even less and benchmark against “the index”, portfolio managers must make the choice: not buy them, and risk underperforming for 9 years out of ten; or buy them and pretend that, yes, they really are bonds.

I have previously pointed out that the lack of first-loss protection means that the Lloyds notes are not bonds. They may have merit as investments, certainly, but they are not bond investments.

Now Duncan Kerr of eFinancial News reports that UK government and regulatory authorities are teaming up to pull exactly the same trick with ludicrous index inclusions in a column titled Investor threat remains to Lloyds’ contingent capital plans:

Some of the UK’s biggest fixed-income investors are already frustrated about Lloyds’ lack of clarity over its plans, and some are even threatening to block the inclusion of the new capital securities on widely-used bond indices.

The UK Treasury and Financial Services Authority have been pushing hard for Lloyds’ new contingent capital bonds to be included on the main indices, which would make them more attractive to fixed-income investors.
…
However, according to analysts some of the UK’s biggest bond investors are arguing that the new securities should not be classed as debt and therefore cannot be included on the main traded indices, which could severely dent investor demand.
…
>“The Treasury and FSA have been pushing very hard for contingent capital to be in the indices, clearly because it is more attractive when it is part of a tradable index. And if it is more attractive, the more is sold to investors and the less the Treasury will have to buy of this new instrument,” the [anonymous] banks analyst said.

One factor exacerbating this crisis has been the lack of trust in the authorities: when the BoE lent money on good collateral to Northern Rock, they felt they should do so covertly, in contrast to prior practice … doubtless feeling that their word that the instution was solvent but illiquid would be doubted. How much of the current crisis would have been averted if a man with the gravitas of J.P.Morgan had simply asked his right man “Are they solvent?” and reliquified freely on an affirmative answer, as happened in the Panic of 1907? The reliquification and word of J.P.Morgan that it was indeed reliquification was good enough to stem the panic … but nowadays, that sort of statement from the authorities is regarded as just another lie. Well done with the record of integrity, guys!

And now we have the UK authorities trying to pretend that these notes are actual bonds and should be in the bond indices, right up there with 10-year Gilts. It’s a disgrace.

And so the seeds of the next disaster are sown: we’ve seen what happens when the myth that Money Market Funds are risk-free gets punctured, even by just a little bit … should the authorities be successful in weaving the myth that Contingent Capital = Bonds, we will learn the effect of an overnight drop in bond funds due to mandatory conversion to over-priced common.

I can only hope that the structure of the Lloyds Contingent Capital notes (now referred to as “CoCos” by the ultracool). It really does not require a lot of thought to arrive at the conclusion that these are bad investments at any rate of interest that may be of interest to the issuer; that they do not go very far towards meeting policy objectives; and that they are strongly procyclical.

Prior posts in the series about these notes are:

• Lloyds Issues Contingent Capital
• Contingent Capital and the RBC CLOCs
• Lloyds Bank to Issue Contingent Capital with a Tier 1 Ratio Trigger?

… while Contingent Capital has been discussed in the posts:

• Contingent Capital: Blinder Supports Squam Lake Model
• Contingent Capital: Squam Lake Working Group
• Contingent Capital: Reverse Convertible Debentures
• OSFI Joins Contingent Capital Bandwagon
• Tarullo Confronts ‘Too Big to Fail’
• Dudley of FRBNY Supports Contingent Capital
• HM Treasury Responds to Turner Report
• Treasury Announces Bank Capitalization Wish-List

Gee … I’ll have to think about adding a category!

There are two elements of a contingent capital deal that are of interest:

• The conversion trigger, and
• The conversion price

In the Lloyds deal, the conversion is triggered when the “published core tier 1 capital ratio falls below 5 per cent“. Commentators have been breathlessly announcing that in order to reach this level “loan losses in 2009 and 2010 would have to be about 50 billion pounds”.

I won’t take issue with this statement but it should be fairly obvious that this is not the only way in which conversion can be triggered. Other pathways are:

• A deliberate increase in Risk-Weighted Assets, and
• Changes in the regulatory regime

From an investment perspective, changes in the regulatory regime must be considered a random variable. At time of conversion, under the terms of the issue, it is the published Tier 1 Ratio that is used – not the Tier 1 Ratio computed in accordance with procedures in place at time of issue. Thus, investors are being asked to buy into a regulatory regime that may have completely changed in effect prior to maturity of their investment. How is anybody supposed to price that? The risk of regulatory change will add significantly to the coupon required by a rational investor, increasing the expense to the issuer and – potentially – leading to political pressure on the regulators to take or refrain from action for the convenience of one side or the other.

Investment isn’t some kind of new age cooperative game. An investor must consider the issuers to be his enemies, eager to take action to compromise his interests. This is particularly true for bond investors, who have no role in the selection of management.

From a public policy perspective, the trigger-point of 5% Tier 1 Ratio is unsatisfactory. What if regulatory changes make 6% the mandatory level? The issuer could then be in a position where it was wound down due to insufficient capital – or forced to issue equity at fire-sale prices – without the conversion being triggered.

Triggers based on regulatory ratios mix market value considerations with book value considerations. While not necessarily a deal-killer all by itself, such mixtures require close inspection.

The other problem with the Lloyds issue is the conversion price – put management, the FSA and the EU together in the same room and you know that something ridiculous will emerge! The conversion price is, basically, equal to the price at time of issue.

What this means is that conversion may be triggered at some point in the future due to unfortunate results, but that the price is based on today’s price. In other words, holders of these notes have no first-loss protection on losses experienced between issue date and conversion date. And without first-loss protection … they’re not even bonds. They are merely equities with a limited upside. Sounds like a really, really good deal, eh?

It is the interaction between the two vital elements of the issue terms that introduces the greatest danger. Let us assume that – some time after issue, but well before maturity – we enter normal banking times in which management is free, subject to normal regulatory requirements, to make its own decisions regarding risk and leverage.

Management works for the shareholders, so what is the optimal course of action to take on their behalf? I suggest that it is optimal to lever up the company with as much risk as possible to a level slightly above the conversion trigger. If things work out well … then pre-existing shareholders get to claim all the rewards, paying the contingent capital noteholders their coupon. If things work out badly … well, pre-existing shareholders lose money, sure, but they get to share these losses with the contingent capital holders.

The risk/reward outlook for the existing shareholders has become skewed – precisely the thing that the regulators are telling us they’re oh-so-worried about! This asymmetric risk/return is a source of systemic instability.

As has been previously argued, I support a model for contingent capital in which:

• The conversion trigger is a decline of the common stock to a value below X, where X is less than the issue date price
• The conversion price is X

Such a model

• provides noteholders with first-loss protection
• is unambiguous (uncertainty in times of crisis can be rather disturbing!)
• allows the market to work out prices using extant option pricing models, without incorporating regulatory uncertainty, and
• simply formalizes “normal coercive” exchange offers such as that of Citigroup

I suggest that a good place to start thinking about the value of X is:

• half the issue-date price for issues to be considered Tier 1 (e.g., preferred shares and Innovative Tier 1 Capital)
• one-quarter the issue-date price for issues to be considered Tier 2 (e.g., subordinated debt).

Update, 2015-4-12: Lloyds ECNs at centre of legal dispute:

Lloyds Banking Group has won permission from the City regulator for a controversial plan to redeem some of its high-yield convertible bonds, although it has suspended the redemption until the courts clarify the law.

The bank’s “enhanced capital notes” were issued in the teeth of the financial crisis, switching investors, many of them pensioners, from preference shares and permanent interest-bearing shares in a bid to improve its capital base.

The notes would convert to equity if Lloyds’ core tier one capital ratio fell below 5pc, although this threshold turned out to be too low to count under the European Banking Authority’s rules on convertible capital.

While the Prudential Regulation Authority has agreed that, from the point of view of Lloyds’ financial strength, the bonds can be redeemed at par, the matter will now go to court for a “declaratory judgement” on whether a redemption would breach bondholders’ contractual rights.

Redeeming the bonds would strip investors of generous interest payments. The bonds have until recently traded above their par value as they offered annual payments as high as 16.125pc, making them particularly attractive as interest rates on other savings products have dwindled.

However, Lloyds said in December that it would seek permission to redeem the bonds at par value, following the Bank of England’s stress tests that did not take the bonds into account when measuring the bank’s capital strength.
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Lloyds intends to call in 23 tranches of bonds, worth a total of almost £860m, that were issued in 2009 and 2010.

It has been rumoured for a while and now it’s official – Lloyds is issuing contingent capital:

Lloyds Banking Group plc (‘Lloyds Banking Group’) today announces proposals intended to meet its current and long-term capital requirements which, if approved by shareholders, will mean that the Group will not participate in the Government Asset Protection Scheme (‘GAPS’).

• Fully underwritten Proposals to generate at least £21 billion of core capital1, comprising:
  • £13.5 billion rights issue. HM Treasury, advised by UKFI, has undertaken to subscribe in full for its 43 per cent entitlement
  • Exchange Offers to generate at least £7.5 billion of contingent core tier 1 and/or core tier 1 capital (core tier 1 capital capped at £1.5 billion)
• High quality, robust and efficient capital structure:
  • Immediate 230bps increase in core tier 1 capital ratio from 6.3 per cent to 8.6 per cent2
  • Significant contingent core tier 1 capital – equates to additional core tier 1 capital of 1.6 per cent3 if the Group’s published core tier 1 capital ratio falls below 5 per cent
  • Reinforces the Group’s capital ratios in stress conditions and meets FSA’s stress test
  • Higher quality capital compared to GAPS where capital benefit reduces over time

The exchange offer is a way of addressing the burden-sharing demanded by the EC.

Offering documents seem to be available, but are not accessible since the world’s regulators are protecting investors from news and foreign prospectuses are, generally, better protected than the Necronomicon. It is not clear – it never is – whether this protection is explicit, or whether they’ve introduced such a conflicting snarl of regulation that the issuers simply throw up their hands and refuse to take the chance.

However, it appears that there is a single conversion trigger based on published Tier 1 Capital Ratios, which I think is thoroughly insane. What happens if the rules for calculation of this ratio change? They’re supposed to change! Treasury and BIS are working feverishly to change them! Does Lloyds have to maintain a calculation of ratios under today’s rules? In that case, not only is there huge expense and confusion, but unintended effects when the trigger occurs under one set of rules but not another. If the rules do change in the interim, then investors are being asked to buy into a blind pool, which will make the securities even more risky than intended.

Update: The cool way to refer to this structure is CoCo:

Contingent convertible bonds differ from traditional equity-linked notes, which can be handed over for stock when a share rises to a pre-agreed “strike price.” CoCos became popular in the U.S. in 2006 as issuers took advantage of accounting rules to sell securities that could only be swapped for stock after the shares passed a threshold above the conversion price and stayed there for a set length of time.

To reach the trigger for the CoCo notes to convert after a 13.5 billion-pound rights issue, loan losses in 2009 and 2010 would have to be about 50 billion pounds, according to [Evolution Strategies’ head Gary] Jenkins.

The CoCo notes were rated at BB by Fitch Ratings today, two steps below investment grade, while Moody’s Investors Service rates the securities at an equivalent Ba2.

Update: Neil Unmack points out that this is a coercive exchange:

However, contingent capital is untested. It is not clear what price investors will demand to hold debt that carries a risk of turning into equity if things go wrong. The proposed exchange could also be problematic. Many fixed income investors aren’t allowed to buy equity-linked debt.

As a result, Lloyds is paying up to get investors on board. They get to switch out of their existing debt into the new contingent capital at par, and get a coupon that is up to 2.5 percent higher than the one they’re getting at the moment. For investors who bought the debt below par — some Lloyds bonds traded as low as 15 percent of face value last March — this means a healthy pay day.

The sweeter coupon alone probably wouldn’t clinch it. Many investors would rather stick with what they have rather than accept an untested instrument which may trade poorly and could be forcibly converted into shares at a later date.

Enter the European Commission, with which Lloyds has been negotiating over state aid. The Commission is compelling Lloyds to cut off coupon payments for up to two years on bonds where it has the right to defer interest. This should help investors with any lingering doubts to make up their minds.

A healthy appetite for the bonds will be a boon for Lloyds, but it doesn’t necessarily mean contingent capital will catch on. For one, it is very expensive: Lloyds is paying interest of up to 16 percent on its bonds. Not every bank will want to pay that.
…
Still, not every bank is in as dire a situation as Lloyds. Without mafia-style coercion, these kind of large-scale debt exchanges will be harder to pull off.

And S&P took action:

Standard & Poor’s Ratings Services said today that it affirmed its ‘A/A-1′ long- and short-term counterparty credit ratings on Lloyds Banking Group PLC (Lloyds) and its subsidiaries. The outlook remains stable. At the same time, with the exception of issues from Lloyds’ insurance subsidiaries, we lowered our ratings on hybrids with discretionary coupons to ‘CC’ from the current range of ‘B’ to ‘CCC+’. Furthermore, with the exception of issues from Lloyds’ insurance subsidiaries, we raised the ratings on hybrids without optional deferral clauses to ‘BB-‘ from ‘B-‘ in the case of holding company issues, and ‘BB’ from ‘B’ in the case of bank issues.

So the senior’s at “A” and the CoCo’s at “BB”. Six notches!

Update: Bloomberg’s John Glover notes:

Lloyds will stop making discretionary interest payments on the existing notes and won’t exercise options to redeem the debt early for two years starting Jan. 31, the bank said, citing this as a condition laid down by the European Commission. Lloyds will decide whether to call the old bonds on a purely economic basis after the two years are up, it said.
…
The price at which Lloyds’ new contingent capital bonds will convert into equity will be the greater of the volume- weighted average price in the five trading days from Nov. 11 to Nov. 17, or a calculation based on 90 percent of the stock’s closing price on Nov. 17 multiplied by a factor.

Update, 2009-11-5: Hat tip to the Fixed Income Investor website of the UK, whose post regarding Lloyds Preference Shares linked to the Non-US Exchange Offering Memorandum.

Update, 2009-11-6: The Economist observes:

“When banks get into problems, it is usually not just a marginal 1-2% addition to capital that they need,” says Elisabeth Rudman of Moody’s, a rating agency.

That could make things worse, not better. With previous hybrid instruments, banks were reluctant to halt interest payments and did all they could to buy back bonds on specified dates for fear of showing weakness to markets. Converting the new debt could also slam confidence without raising a big enough slug of equity capital to restore it. That may encourage banks to hoard capital rather than breach the trigger-point.