1 Contingent Capital: The Case of COERCS George Pennacchi (University of Illinois) Theo Vermaelen (INSEAD) Christian Wolff (University of Luxembourg) October 2011

2 Contingent capital Contingent convertibles (CoCos) are bonds that mandatorily convert to equity after a triggering event. Motivation: providing discipline of debt (tax deductions?) in good times, avoiding COFD (bailouts!) in bad times. The Basel Committee continues to review CoCos and supports their use by national regulators. Swiss National Bank wants major banks to have capital/RWA ratios of 19 % with up to 9 % in CoCos.

In the academic spotlight Flannery (2005, 2009, 2010) Hart and Zingales (2009) Kashyap, Rajan, and Stein (2009) Duffie (2010) McDonald (2010) Coffee (2010) Albul, Jaffee, and Tchistyi (2010) Sundaresan and Wang (2010) Glasserman and Nouri (2010) Bolton and Samama (2010) Calomiris and Herring (2011) Barucci and Del Viva (2011) Berg and Kaserer (2011) Hilscher and Raviv (2011)

4 The ideal CoCo bond? Avoids bankruptcy: going concern rather than gone concern. Based on market-based triggers as opposed to regulatory capital ratios or regulatory discretion. Avoids economically unjustified conversions. Preserves pre-emptive rights of shareholders. Low risk-easy to value (facilitates ratings, large demand). Avoid risk-shifting and debt overhang problems No multiple equilibria. No negative signal around issue or conversion

5 Why regulatory capital ratio triggers are ineffective Regulatory capital ratios could be “old” as they are calculated only once every quarter. Poorly functioning triggers invite regulatory intervention. This makes CoCos very risky and/or difficult to value > low liquidity > no credit rating > bondholders will short the bank’s stock

6 What financial crisis ? Source : Y-9C Bank Holding Company Reports obtained from the Federal Reserve Bank of Chicago Mean 2008 Tier 1 Common Ratios of 50 Major U.S. Banks in percent

Source: Kevin Stiroh, FRB-NY 7

8 Market value based triggers Contingent Capital Certificates (Flannery (2005, 2009, 2010)). Now conversion takes place when equity market value hits a specific level. The corresponding stock price is also the conversion price.

9 Numerical Example Assets (A) Liabilities 1100 Senior Debt (D) 1000 CoCo (B) 30 Equity (E) B/D = 3 % E/D = 7 % (E+B)/D = 10%

10 Numerical Example (2) Assume that there are 7 shares outstanding, i.e. stock price of $10. Conversion takes place when equity falls from 70 to 35 (E/D = 3.5 %) and stock hits $ 5. This trigger price is also the conversion price so bondholders can convert $ 30 into 6 shares. Fully diluted stock price is now 65/13 = $ 5 Bond holders get 6 shares worth $ 30 Because of this, CoCos are risk-free.

11 Problems 1. Unjustified dilution because of manipulation or panic. 2. Risk cannot be eliminated because of sudden jumps. 3. Multiple equilibria.

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13 Unjustified dilution Assume stock price falls to $ 5 because of manipulation or panic CoCos convert into 6 shares Because the true value of the capital is still 100, the fully diluted stock price is now 100/13 = $ 7.69 Bondholder gain: 6 x 7.69 – 30 = 16.1 (54 %) Bondholders have large incentives to manipulate stock downwards through false rumours or shorting (no short squeeze as bank delivers shares for covering!)

14 Solution: COERC Whenever stock hits $ 5, bondholders have to convert at $ 1. But shareholders have the right to buy back shares from the bondholders at $ 1. We baptize this as a COERC: call option enhanced reverse convertible.

15 COERC and manipulation Suppose stock falls to $5 through manipulation. Bonds with par of $ 30 convert at $1, receiving 30 new shares. Shares outstanding: 37 Bondholders’ proportion of ownership: α = 30/37 New fair value per share: $ 100/37 = $ 2.70 However, when trigger is hit, a rights issue is announced for 30 shares at $ 1 per share. As $ 2.70 > $ 1, the rights are exercised and bonds are repaid.

Avoids death spiral or other incentives to short the stock Preserves pre-emptive rights of stockholders Setting trigger price >>> conversion price keeps bond risk low Low risk means no incentive to engage in risk-shifting Under no condition tax payers have to bail out bondholders Multiple equilibria avoided No negative signal as trigger is based on observed variables The COERC is a credible commitment to refinance because it is a COERCive tool Benefits of COERC

Multiple equilibria Sundaresan and Wang (2010) show that if the conversion event transfers value between CoCo investors and shareholders, then the individual values of the bank’s shares and CoCos are not unique. Thus, a trigger based solely on the market value of the bank’s shares can lead to multiple equilibria. However, the sum of the values of CoCos and bank shareholders’ equity is unique. Thus, we avoid multiple equilibria by basing the COERC (CoCo) trigger on the market value of total capital ratio, defined as If senior debt CDS spreads depend on this market capital ratio (as it does in our valuation model), then a senior debt CDS spread trigger also avoids multiple equilibria (c.f., Hart and Zingales, 2009).

Valuation and risk analysis: a formal model We use a structural credit risk model of a bank 1 to compare COERCs, standard CoCos, and non-convertible (subordinated) debt in terms of: 1.New issue yields (credit spreads) 2.The issuing bank’s risk-taking incentives 1 Pennacchi, G. (2010) “A Structural Model of Contingent Bank Capital,” Federal Reserve Bank of Cleveland Working Paper

Assumptions: assets and deposits 1)To model potential sudden, extreme losses as might occur during a financial crisis, the value of a bank’s assets follows a jump – diffusion process. 2)The term structure of interest rates follows the model of Cox, Ingersoll, and Ross (1985). 3)Bank deposits have short (instantaneous) maturities, are default-risky, and are paid a fair credit spread. 4)The bank targets a 10% total capital-to-deposits ratio by adjusting deposit growth (mean-reverting leverage).

Assumptions: bonds and equity 5)Fixed- or floating-coupon bonds are issued at their par value of 3% of deposits and have a five-year maturity. 6)The types of bonds considered are: a)COERC with conversion triggered when total capital = 6.5% of deposits (3.5% equity value). b)Standard CoCos with conversion triggered when total capital = 6.5% of deposits. Conversion price = trigger price. c)Non-convertible subordinated debt. 7)A bank is closed by regulators (and equity holders are wiped out) if the value of bank asset falls below the par value of deposits plus any non-convertible bonds.

Result: Fair new issue yields on COERCs decline as the proportion of shares they receive, , increases.

Result: Delaying conversion of COERCs to when capital is lower increases their new issue yields.

Result: New issue yields are higher for CoCos without a call option (minimum  = 6/13).

Result: Credit spreads on COERCs are lower than those of both standard CC and non-convertible debt.

Result: A bank that issues COERCs has less incentive to invest in assets having a high probability of jumps.

Result: A bank that issues COERCs has less dis- incentive to issue new equity (debt overhang).

Intuition for results Converting COERCs to a large number of shares coerces shareholders to repay them at par, making COERCs less default-risky. Shareholders find it difficult to transfer value from COERCs to themselves by increasing risk. Shareholders’ risk-taking incentives become closer to those under unlimited liability, reducing moral hazard and debt overhang, thereby enhancing bank stability.

28 Summary and conclusions A COERC mitigates debt overhang and should be attractive to all firms wishing to reduce costs of financial distress. It is an early stage CoCo designed to prevent bankruptcy. It has a forward-looking, market-based trigger but is free from manipulation or death spirals. With a trigger value above its conversion value, its has low credit risk (high credit rating, easy to value, marketable). It preserves pre-emptive rights of shareholders by protecting them against dilution of control by bondholders.