FRBNY Staff Propose Floating Rate Contingent Capital

The Federal Reserve Bank of New York has released Staff Report #448, by Suresh Sundaresan and Zhenyu Wang, titled Design of Contingent Capital with a Stock Price Trigger for Mandatory Conversion:

The proposal for banks to issue contingent capital that must convert into common equity when the banks’ stock price falls below a specified threshold, or “trigger,” does not in general lead to a unique equilibrium in equity and contingent capital prices. Multiple or no equilibrium arises because both equity and contingent capital are claims on the assets of the issuing bank. For a security to be robust to price manipulation, it must have a unique equilibrium. For a unique equilibrium to exist, mandatory conversion cannot result in any value transfers between equity holders and contingent capital investors. The necessary condition for unique equilibrium is usually not satisfied by contingent capital with a fixed coupon rate; however, contingent capital with a floating coupon rate is shown to have a unique equilibrium if the coupon rate is set equal to the risk-free rate. This structure of contingent capital anchors its value to par throughout the time before conversion, making it implementable in practice. Although contingent capital with a unique equilibrium is robust to price manipulation, the no-value-transfer condition may preclude it from generating the desired incentives for bank managers and demand from investors.

They commence with an overview of the market and current issuance:

Recently there have been a few issues of junior debt with such conversion provisions. Lloyds Bank recently issued the so called contingent convertible (CC, or “Coco bonds”). These bonds will convert into ordinary shares if the consolidated core tier one ratio of Lloyds falls below 5%. The bonds themselves are subordinated bonds, which prior to conversion count as the lower tier 2 capital, but count as core tier 1 in the context of the Financial Services Authority (FSA) stress tests. They will count as core tier 1 for all purposes upon conversion. Swiss regulators are encouraging Swiss banks to issue contingent capital. In Germany, preferred stocks have been issued with similar features.

I didn’t know about the German prefs!

The authors are obsessed with value transfer:

The main thrust of our paper is the following: when triggers for mandatory conversion are placed directly on equity prices, there is a need to ensure that conversion does not transfer value between equity and CC holders. The economic intuition behind CC design problem is as follows. In the contingent capital (CC) proposed in the literature, junior debt converts to equity shares when the stock price reaches a certain threshold at low level. This sounds like a normal and innocuous feature. However, the unusual part of the CC design is that conversion into equity is mandatory as soon as stock price hits a trigger level from above. Since common stock is the residual claim of bank’s value, it must be priced together with the CC. Keeping firm value fixed, a dollar more for the CC value must be associated with a dollar less for the equity value.8 Therefore, a value transfer between equity and CC disturbs equilibrium by moving the stock price up or down, depending on the conversion ratio specified. The design of the conversion ratio must ensure that there is no such value transfer. The design proposals in the literature usually ensure that there is no value transfer at maturity, but do not ensure it before maturity.

Basically – as far as I can tell, the case against value transfer is not made explicit – value transfer will create an incentive for manipulation. If a Contingent Capital issue has a price and conversion feature such that conversion will be profitable, it will be in the interest of the investor to attack the bank stock in an attempt to force this conversion. My problem with this obsession is that I don’t have a problem with that and don’t think the regulators should, either. The potential for value transfer has been discussed on PrefBlog, in the post Payoff Structure of Contingent Capital with Trigger = Conversion.

The only way to prevent this is to ensure that there is no value transfer at conversion. This requires that at all possible conversion times, the value of converted shares must be exactly equal to the market value of the un-converted CC. This requirement implies that the conversion ratio usually cannot be chosen ex-ante once the trigger level has been chosen: this is due to the fact that the trigger level multiplied by the conversion ratio must equal the market value of the un-converted CC. However, there is one scenario when we can select the conversion ratio ex-ante: this corresponds to the design of CC such that the coupon payments are indexed in such a way that the CC always sells at par. In this case, we can set the conversion ratio as simply the par value divided by the trigger level of stock price at which mandatory conversion will occur. We explore this design possibility further in the paper.

In order to ensure that the CC is always priced at par, they take a huge leap:

To use the par value for conversion ratio, we need to focus on a structure that makes the market value of the CC immune to changes in interest rates and default risk. For example, if the CC had no default risk, then by selecting the coupon rate at each instant to be the instantaneously risk-free rate we can assure that the CC will trade at par. See Cox, Ingersoll and Ross (1980) for a proof of this assertion

It has been a long time since I’ve read the Cox, Ingersoll & Ross paper and, frankly, I don’t remember that conclusion. But I don’t need to remember it, since it’s nonsense. It implies that there is a zero (or at least constant) liquidity premium: if I am holding short term paper, it’s because I may want cash in the near future. Why would I buy long dated paper that I might be able to turn into a known quantity of cash when I can buy actual Treasury Bills that will definitely turn into cash? I need a premium to buy the long stuff, and that premium will be based on my assessment of the likelihood of my actually needing the cash. The premium will change according to my – and the market’s – changing assessment of the potential need. That’s basic Liquidity Hypothesis stuff.

With default risk, however, no design of floating coupons will actually guarantee that the CC will sell at par. However, by choosing the coupon to reflect the market rates on short-term default-risky bank obligations it is possible to keep the price close to the par value. For example, if the coupon is tied to London Inter-bank Offered Rates (LIBOR) then the price of CC, which is a bank floater should remain close to par.

There are notes like this already – for instance Scotiabank’s perps:

August 2085 Floating US $182 million bearing interest at a floating rate of the offered rate for six-month Eurodollar deposits plus 0.125%. Redeemable on any interest payment date. Total repurchases in 2009 amounted to approximately US $32 million

There was a craze for securities of this type in the late 1980’s. It collapsed. Just like Monthly Auction Preferred Shares and all the other crap that seeks to fund long term debt at short term rates [and who knows? Maybe FixedResets will be the next example!]

This disregard of financial history mars the paper, but there are some other good references and notes:

Consistent with many other observers (e.g., Acharya, Thakor and Mehran, 2010), we note that the mandatory conversion of junior debt should automatically result in suspension of dividends to all common stock holders. Holding other factors the same, this should serve to alleviate the selling pressure: any attempt to short the stock by the holders of CC will also result in losses in foregone future dividends on their long positions.

I don’t agree.

However, it is nice to see a Fed paper looking at the type of CC structure that I have been arguing in favour of for a long time! It’s also pleasant to see a proper paper, with proper references and no outright fabrications, unlike those produced by Julie Dickson of OSFI.

3 Responses to “FRBNY Staff Propose Floating Rate Contingent Capital”

  1. […] point he considers critical (which was further discussed, albeit in a highly unsatisfactory manner, by FRBNY staff) is: A critical issue is the precise manner in which conversion occurs, and the possibility of […]

  2. […] have more difficulty – similar to my problems with recent advocacy of floating rate contingent capital: If a bank’s asset returns follow a pure diffusion process without jumps, and fixed-coupon […]

  3. […] highlights one concern that has been of interest to the Fed, and which seems to be the thing that industry professionals focus on when I discuss this with […]

Leave a Reply

You must be logged in to post a comment.