PrefBlog

Alan S. Blinder, the Gordon S. Rentschler Memorial Professor of Economics and Public Policy at Princeton University and former Vice-Chairman of the Fed’s Board of Governors, gave a wonderfully informative and chatty speech at the Federal Reserve Bank of Boston conference at Chatham, Massachussets, on October 23, 2009 titled
It’s Broke, Let’s Fix It: Rethinking Financial Regulation.

One quote I simply must highlight is:

After all, regulatory failure on a grand scale was one major cause of the mess.

However, at the moment I am more interested in his thoughts on Contingent Capital than anything else:

I myself am attracted to a particular idea for “contingent capital” suggested recently by the Squam Lake Working Group on Financial Regulation, an ad hoc panel of academic experts. Under the proposal, regulators would have the power, by declaring a systemic crisis, Their idea, which derives from Mark Flannery’s (2005) clever earlier proposal for “reverse convertible debentures,” is to require certain banks to issue a novel type of convertible bond. Conventional convertible debt gets exchanged for equity at the option of the bondholder; and because this option has value, convertible debt bears lower interest rates than ordinary debt. The proposed new form of convertible debt would reverse the optionality by giving it to the regulators instead.

Under the proposal, regulators would have the power, by declaring a systemic crisis, to force holders of these special convertibles (but not holders of other debt instruments) to convert to equity. As in many cases, one key question is price—specifically, how large an interest rate premium would investors demand to cover the risk that their bonds could be converted into equity against their will? If this premium proved to be very large, these new convertibles would be a very expensive form of “capital” that banks might shun, preferring ordinary equity instead. Only experience will tell. —thus giving banks more equity capital (and less debt) just when they need it most. Naturally, the existence of such an option would detract from the value of the bond and therefore would make the interest rate on reverse convertibles higher than on ordinary debt. Indeed, if the requirement was limited to TBTF institutions, as seems appropriate, that higher interest rate on a fraction of their debt would constitute a natural penalty cost for being TBTF. Furthermore, the spread on this new type of debt over regular debt could become a useful market indicator of the likelihood of a systemic crisis.

As in many cases, one key question is price—specifically, how large an interest rate premium would investors demand to cover the risk that their bonds could be converted into equity against their will? If this premium proved to be very large, these new convertibles would be a very expensive form of “capital” that banks might shun, preferring ordinary equity instead. Only experience will tell.

I have previously discussed the Squam Lake proposals, as well as the original Flannery paper; I think they need a little work. My major objections are that:

• It mixes book value with market value; theoretically suspect and leading in times of stress to unpredictable – probably procyclical – results, and
• by incorporating regulatory discretion into the conversion trigger, it unnecessarily introduces regulatory uncertainty into the evaluation of the investment, as well as encouraging regulatory capture and even corruption.

He breaks my heart by advocating credit ratings by government agencies:

But many observers think the fundamental problem lies deeper: with the issuer-pays model. As long as rating agencies are for-profit companies, paid by the issuers of the securities they rate, the agencies will have a natural tendency to try to please their customers—just as any business does. Unfortunately, the most obvious alternative, switching to an investors-pay model, is probably infeasible except in markets with very few investors. Otherwise, information flows too readily, and everyone wants to free ride. What to do? The way out of this dilemma, it seems to me, is to arrange for some sort of third-party payment. The government (e.g., the SEC) or an organized exchange or clearinghouse seem to be the natural alternative payers. In either case, they could raise the necessary funds by levying a user-fee on all issuers.

He also discusses the separation of prop trading from vanilla banking:

For example, the Group of Thirty (2009, p. 28)—hardly a bunch of wild-eyed radicals–recently concluded that, “Large, systemically important banking institutions should be restricted in undertaking proprietary activities that present particularly high risks…and large proprietary trading should be limited by strict capital and liquidity requirements.” That’s not quite a ban, but it’s getting close.

But there is a downside. Roping off “proprietary trading” from other, closely-related activities of banks is not as easy as it sounds. For example, banks buy and sell securities, foreign exchange, and other assets for their clients all the time. Often, such buying and selling is imperfectly synchronized or leaves banks with open positions for other reasons. Does that constitute “proprietary trading”? Furthermore, market-making has obvious synergies with dealing on behalf of clients. Do we want to label all such activities as “proprietary trading”? The point is: There is no bright line. That is why Adair Turner (2009), the chairman of Britain’s FSA, concluded that “we could not proceed by a binary legal distinction—banks can do this but not that—but had to focus on the scale of position-taking and the capital held against position-taking.”

I say – yes. we do want to label all such activities as “proprietary trading”; and the fact that there is no bright line is just something we’ll have to get used to. As previously urged on PrefBlog, I suggest that there be two regulatory regimes – for investment banks and vanilla banks, the former imposing relatively heavier capital charges on long term positions, the latter imposing relatively heavier charges on short term positions. It won’t be perfect, by any stretch of the imagination; but it will allow each type of institutions to make decisions on a tactical basis, according to their marginal value.

One of the things that brought down the investment banks was that they engaged in buy-and-hold strategies, which are more properly the province of vanilla banks, which have (or should have!) the expertise and controls in place to look beyond the next portfolio flip.

The papers of the Squam Lake Working Group , a very distinguished group of academics, are published by the Council on Foreign Relations (which seems rather strange, but there you go), who also publish the periodical Foreign Affairs, which I love but don’t have time to read any more.

The Squam Lake paper titled An Expedited Resolution Mechanism for Distressed Financial Firms: Regulatory Hybrid Securities is of great interest, albeit lamentably short on detail.

Most notably, they propose a double trigger for conversion:

A bank’s hybrid securities should convert from debt to equity only if two conditions are met. The first requirement is a declaration by regulators that the financial system is suffering from a systemic crisis. The second is a violation by the bank of covenants in the hybrid-security contract.

This double trigger is important for two reasons. First, debt is valuable in a bank’s capital structure because it provides an important disciplining force for management. The possibility that the hybrid security will conveniently morph from debt to equity whenever the bank suffers significant losses would undermine this productive discipline. If conversion is limited to only systemic crises, the hybrid security will provide the same benefit as debt in all but the most extreme periods.

Second, the bank-specific component of the trigger is also important. If conversion were triggered solely by the declaration of a systemic crisis, regulators would face enormous political pressure when deciding whether to make such a declaration. Replacing regulatory discretion with an objective criterion creates more problems because the aggregate data regulators might use for such a trigger are likely to be imprecise, subject to revisions, and measured with time lags. And, perhaps most important, if conversion depended on only a systemic trigger, even sound banks would be forced to convert in a crisis. This would dull the incentive for these banks to remain sound.

I don’t like the first trigger, the declaration by regulators that a systemic crisis exists. First, there is more than one regulator, which will lead, at the very least, to delays while simultaneous announcements are arranged and, at worst, to political kerfuffles regarding cross-border banks if there is no widespread agreement.

Secondly, it introduces an element of political uncertainty regarding conversion, which will lead to the political pressure they allude to in their discussion of the second trigger.

Thirdly, I just plain don’t trust the regulators.

It will be noted that the group skims rather lightly over the justification for the first trigger!

The group also suggests using Tier 1 Capital Ratios as a trigger:

What sort of covenant would make sense for the bank-specific trigger? One possibility, which we find appealing, would be based on the measures used to determine a bank’s capital adequacy, such as the ratio of Tier 1 capital to risk-adjusted assets.

I don’t like it, for reasons which have been discussed in my posts Contingent Capital: Reverse Convertible Debentures and Lloyds bank to Issue Contingent Capital with Tier 1 Ratio Trigger?. Tier 1 ratios are too easy for a bank and regulators to manipulate, do not measure the degree of investor confidence in an institution and do not provide a framework for market arbitrage. As a bank’s situation deteriorates, the price response of the hybrid should gradually become more-and-more equity-like, which suggests a market based approach rather than the binary now-it’s-debt-now-it’s-equity paradigm implied by an all-or-nothing conversion based on calculated figures. I have not seen anything yet to shake my belief that a fixed-rate conversion with a trigger based on the trading price of the common is the best solution.

The authors discuss the conversion rate:

In addition to the triggers, this new instrument will have to specify the rate at which the debt converts into equity. The conversion rate might depend, for example, on the market value of equity or on the market value of both equity and the hybrid security. Conversions based on market values, however, can create opportunities for manipulation. Bondholders might try to push the stock price down by shorting the stock, for example, so they would receive a larger slice of the equity in the conversion. Using the average stock price over a longer period, such as the past twenty days, to measure the value of equity makes this manipulation more difficult, but it opens the door for another manipulation. If the stock price falls precipitously during a systemic crisis, management might intentionally violate the trigger and force conversion at a stale price that now looks good to the stockholders. Finally, in some circumstances, a conversion ratio that depends on the stock price can lead to a “death spiral,” in which the dilution of the existing stockholders’ claims that would occur in a conversion lowers the stock price, which leads to more dilution, which lowers the price even further.

An alternative approach is to convert each dollar of debt into a fixed quantity of equity shares, rather than a fixed value of equity. There are at least two advantages of such an approach. First, because the number of shares to be issued in a conversion is fixed, death spirals are not a problem. Second, although management might consider triggering conversion (for example, by acquiring a large number of risky assets) to avoid a required interest or principal payment on the debt, this would not be optimal unless the stock price were so low that the shares to be issued were worth less than the bond payment. Thus, management would want to intentionally induce conversion only when the bank is struggling. The advantages and disadvantages of different conversion schemes are complicated, however, and will require both further study and detailed input from the financial and regulatory community.

It seems that they believe that a problem with the conversion at a fixed rate is the potential for manipulation of the trigger terms by management. This would be avoided with a market-based trigger.

Mark J. Flannery Bank of America Eminent Scholar Chair of Finance at the University of Florida proposed Reverse Convertible Debentures in 2002 in his paper No Pain, No Gain? Effecting Market Discipline via “Reverse Convertible Debentures”:

The deadweight costs of financial distress limit many firms’ incentive to include a lot of (taxadvantaged) debt in their capital structures. It is therefore puzzling that firms do not make advance arrangements to re-capitalize themselves if large losses occur. Financial distress may be particularly important for large banking firms, which national supervisors are reluctant to let fail. The supervisors’ inclination to support large financial firms when they become troubled mitigates the ex ante incentives of market investors to discipline these firms. This paper proposes a new financial instrument that forestalls financial distress without distorting bank shareholders’ risk-taking incentives. “Reverse convertible debentures” (RCD) would automatically convert to common equity if a bank’s market capital ratio falls below some stated value. RCD provide a transparent mechanism for un-levering a firm if the need arises. Unlike conventional convertible bonds, RCD convert at the stock’s current market price, which forces shareholders to bear the full cost of their risk-taking decisions. Surprisingly, RCD investors are exposed to very limited credit risk under plausible conditions.

Of interest is the example of some Manny-Hanny bonds:

The case of Manufacturers Hanover (MH) in 1990 illustrates the problem. The bank had issued $85 million dollars worth of “mandatory preferred stock,” which was scheduled to convert to common shares in 1993. An earlier conversion would be triggered if MH’s share price closed below $16 for 12 out of 15 consecutive trading days (Hilder [1990]). Such forced conversion appeared possible in December 1990. In a letter to the Federal Reserve Bank of New York concerning the bank’s capital situation, MH’s CFO (Peter J. Tobin) expresses the bank’s extreme reluctance to permit conversion, or to issue new equity at current prices. At yearend 1990, MH’s book ratio of equity capital to total (on-book) assets was 5.57%, while its market equity ratio was 2.53%. The bank was also adamant in announcing that it would not omit its quarterly dividend. Despite the low market capital ratio, the Fed appeared unable to force MH to issue new equity. Chemical Bank acquired Manufacturers Hanover at the end of 1991.
…
When Manufacturers’ Hanover confronted a possible conversion of preferred stock in late 1990 (see footnote 6), they considered redeeming the issue using cash on hand. Such a “plan” only works if a supervisor will accept it. Under a market value trigger, such redemption would have to be financed by issuing equity; otherwise, the redemption would further lower the capital ratio. Another important feature of the MH convertible preferred issue was that the entire issue converted if common share prices were even $.01 too low over the specified time interval.

Flannery proposes the following design parameters for RCD:

RCD would have the following broad design features:

• 1. They automatically convert into common equity if the issuer’s capital ratio falls below a pre-specified value.
• 2. Unless converted into shares, RCD receive tax-deductible interest payments and are subordinated to all other debt obligations.
• 3. The critical capital ratio is measured in terms of outstanding equity’s market value. (See Section III.)
• 4. The conversion price is the current share price. Unlike traditional convertible bonds, one dollar of debentures (in current market value) would generally convert into one dollar’s worth of common stock.
• 5. RCD incorporate no options for either investors or shareholders: conversion occurs automatically when the trigger is tripped.
• 6. When debentures convert, the firm must promptly sell new RCD to replace the converted ones.

An example of RCD conversion is provided:

The bank in Figure 1 starts out at t = 0 with a minimally acceptable 8% capital ratio, backed by RCD equal to an additional 5% of total assets. With ten shares (“N”) outstanding, the initial share price (“PS”) is $0.80. By t = ½, the bank’s asset value has fallen to $97, leaving equity at $5.00 and the share price at $0.50. The bank is now under-capitalized ($5/$97 = 5.15% < 8%). Required capital is $7.76 (= 8% of $97). The balance sheet for t = 1 shows that $2.76 of RCD converted into equity to restore capital to 8% of assets. Given that PS = $0.50 at t = ½, RCD investors receive 5.52 shares in return for their $2.76 of bond claims. These investors lose no principal value when their debentures convert: they can sell their converted shares at $0.50 each and use the proceeds to re-purchase $2.76 worth of bonds. The initial shareholders lose the option to continue operating with low equity, because they must share the firm’s future cash flows with converted bondholders.

The critical part of this structure is that the triggering capital ratio values outstanding equity at market prices, rather than book. Additionally, not all – not necessarily even all of one issue – gets converted. Flannery suggests that issues be converted in the order of their issuance; first-in-first-out.

A substantial part of the paper consists of a defense of this market value feature, which I shall not reproduce here.

Flannery repeatedly touts a feature of the plan that I consider a bug:

Triggered by a frequently-evaluated ratio of equity’s market value to assets, RCD could be nearly riskless to the initial investors, while transmitting the full effect of poor investment outcomes to the shareholders who control the firm.

I don’t like the feature. I believe that a fixed-price conversion with a fixed-price trigger will aid in the analysis of this type of issue and make it easier for banks to sell equity above the trigger point – which is desirable! It is much better if the troubled bank can sell new equity to the public at a given price than to have the RCDs convert – Flannery worries about a requirement that the banks replace converted RCDs in short order, which is avoided if the trigger is avoided. If new equity prospects are not aware of their possible dilution if bad times become even worse, they will be less eager to buy.

Additionally, I am not enamoured of the use of regulatory asset weightings as a component of the trigger point. The last two years have made it very clear that there is a very wide range of values that may be assigned to illiquid assets; honest people can legitimately disagree, sometimes by amounts that are very material.

Market trust in the quality of the banks’ mark-to-market of its assets will be reflected, at least to some degree, by the Price/Book ratio. So let’s re-work Flannery’s Table 1 for two banks; both with the same initial capitalization; both of which mark down their assets by the same amount; but one of which maintains its Price/Book ratio (investors trust bank management) while the other’s P/B ratio declines (investors don’t trust bank management, or for some other reason believe that the end of the write-downs is yet to come).

Note that Flannery’s specification for the Market Ratio:

The market value equity ratio is the market value of common stock divided by the sum of (the book value of total liabilities plus the market value of common stock).

This is basically the same as Flannery’s example; however, he uses a constant P/B ratio of 1.0 to derive a Market Ratio of 8%. In addition, I will assume that the regulatory requirement for the Market Ratio is 10% – the two banks started with a cushion.

Disaster strikes at time t=0.5, when asset values decline by 3%. Trusty Bank’s P/B remains constant at 1.5, but Sleazy Bank’s P/B declines to 0.8.

In order to get its Market Ratio back up to the 10% regulatory minimum that is assumed, Trusty Bank needs to solve the equation:

[7.5+x] / [87 + (5-x) + (7.5 + x)] = 0.10

where x is the Market Value of the new equity and is found to be equal to 2.45. With a stock price of 0.75, this is equal to 3.27 shares

Sleazy Bank solves the equation:

[4.0+x] / (87 + (5-x) + (4.0 +x)) = 0.10

and finds that x is 5.60. With a stock price of 0.40, this is equal to 14.00 shares.

Sleazy Bank doesn’t have the capital on hand – as shown by the negative value of balance sheet RCD at t=1 – so it goes bust instead. In effect, there has been a bank run instigated not by depositors but by shareholders.

Note that in the calculations I have assumed that the price of the common does not change as a result of the dilution; this alters the P/B ratio. Trusty Bank’s P/B moves from 1.50 to 1.34; Sleazy Bank’s P/B (ignoring the effect of the negative value of the RCDs) moves from 0.8 to 0.91. Whether or not the assumption of constant market price is valid in the face of the dilution is a topic that can be discussed at great length.

I will note that the Price/Book ratio of Japanese banks in early 2008 was 0.32:1 and Citigroup’s P/B ratio is currently 0.67:1.

While Dr. Flannery’s idea has its attractions, I am very hesitant about the idea of mixing book and market values. From a theoretical viewpoint, capital is intended to be permanent, which implies that once the bank has its hands on the money, it doesn’t really care all that much about the price its capital trades at in the market.

Using a fixed conversion price, with a fixed market price trigger keeps the separation of book accounting from market pricing in place, which offers greater predictability to banks, investors and potential investors in times of trouble.

Update 2009-11-1: Arithmetical error corrected in table.

It should also be noted that the use of market value of equity in calculating regulatory ratios makes the proposal as it stands extremely procyclical.