The hurdles of bank contingent capital

October 26, 2009

The Federal Reserve is getting serious about convertible debt.

Well, sort of. In recent weeks, Fed Governor Daniel Tarullo, New York Fed President William Dudley and even Chairman Ben Bernanke have mentioned it in public speeches as a way to create a “just in case” security blanket for banks that could otherwise turn to the taxpayers for another handout if trouble strikes again.

It’s just one of many ideas ghosting around the halls of power as regulators try to come up with ways to keep “too big to fail” institutions from returning to their wayward ways.

It’s understandable then that details are scarce about how such convertible debt would be structured, but Fed officials are going to have to do much more than just slip a few lines into their speeches if they want investors to get behind this debt.

The big picture idea makes sense: Have banks sell debt that automatically converts to equity when a financial institution hits the skids. The mandatory conversion, or to call it by another name, an “equity bomb,” would make both debt holders and shareholders more vigilant, since they both have much to lose if a bank gets into trouble.

It also theoretically means that Treasury officials could sleep on weekends knowing that they don’t have to spring to action with a cash injection.

Convertible debt isn’t new. Yet Fed officials appear to be proposing a novel take on the structure, by making the catalyst for converting the debt into equity determined by factors outside the executive suite.

The question of the trigger could be the first obstacle in using convertible debt as the contingent capital of choice; cost would be second.

The more triggers used, the more difficult it would be to price event risk. A breach of certain capital or share price thresholds, a decree from regulators or a violation of debt covenants could be catalysts for setting off the bomb. New York Fed’s Dudley favors market-based triggers.

Capital measures and share prices falling below a predetermined threshold would be easy to measure, but those triggers could create a destabilizing environment in markets if jittery investors attempt to front-run the conversion.

Having regulators make the call could address such market-made instability, but it would most likely result in higher cost for the banks, since it’s much more difficult for investors to estimate the timing through models.

There’s also the question of derivatives. There’s a better than even chance that investors would want to take out insurance against possible losses, should their debt holdings become equity. Would Wall Street create TDS — trigger default swaps — so debt investors could safeguard against possible losses? That’s a headache that the Fed and the system can do without.

Cost is another big unknown. Depending on how much of a buffer the banks would need to build, the cost could be prohibitive, especially for weak banks.

A large investor base would help, but the natural buyers for such debt would most likely be hedge funds, rather than longer-term investors who would be reluctant to add such risk to their portfolios when memories from the financial crisis are still so fresh.

It may not be a good idea for certain investors — insurers, pension funds — to hold such debt, given the possibility of steep losses.

Policy makers will need to consider whether in the end it’s worth it. Simply demanding banks hold more capital and take less risk is the better way to go.

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