November 30, 2009
Cuckoo for CoCo Bonds: Can Contingent Convertible Debt Curtail the Moral Hazards of Being Too Big to Fail?
Posted by Rob Beard

Thanks to Christine for her interest in my work, and for suggesting to Gordon that I take some time to share my research interests with the Glom readership. Thanks also to Gordon for agreeing to have me. I’m thrilled for the opportunity to make the (temporary) leap from Glom reader to Glom contributor!

I hate to admit this, but as a child I was particularly susceptible to certain forms of advertising— particularly ads for sugary, chocolatey cereals (though my mother was, sadly, much less vulnerable). It’s no surprise, then, that the tremendous surge of interest in contingent convertible bonds (CoCo Bonds) over the past several weeks calls to mind one of my favorite sugary cereal ad characters: Sonny the Cuckoo Bird, who tried to no avail to perform simple tasks without being distracted by the “munchy, crunchy, chocolatey” goodness of Cocoa Puffs. Poor Sonny never could get on with his business, as temptation invariably overcame him and drove him “Cuckoo for Cocoa Puffs!”

Like Sonny, some in the financial world appear to have gone cuckoo, but for CoCo Bonds, a type of convertible debt instrument with a history, but also a new, potentially game-changing use. Though they are not new, CoCos owe their new lease on life to their recently-discovered potential to provide banks an automatic capital cushion during times of stress. This new brand of CoCo will provide that cushion by converting from debt to equity when a bank crosses a predetermined threshold that indicates the bank is in trouble—exactly the time when it will need capital, but have a difficult time raising it. The argument goes that this conversion will provide banks a soft landing, thus making government capital injections unnecessary. The equity conversion also ensures that bondholders get some value for their investments, but eliminates the moral hazard issues associated with “too big to fail” policies that bail them out. Regulators have thus far been unable to constrain these moral hazards; CoCo Bonds offer a promising and (because taxpayer money is not involved) politically desirable solution.

Critics warn, however, that CoCo Bonds are not “a panacea for banks,” stressing that it is difficult to set conversion triggers at the proper levels and uncertain investor appetite may make pricing infeasible. Some go so far as to call these instruments “CoCo the Clown Notes” and their proponents “CoCo nuts.”

Over the next few days, I will introduce Glom readers to CoCos, explain how they work and identify how they appeal to bankers and bank regulators. I will also highlight the practical difficulties that may limit the CoCo's effectiveness as a capital cushion, such as the difficulty in ascertaining the proper trigger point, pricing constraints, and equity dilution. I will further explore how CoCos alter the conflict between shareholders, bondholders, and management. Finally, I will investigate how regulators appear to be creating and shaping the early market for these products, and query whether CoCos would have legs without government intervention. Today's entry introduces the traditional CoCo Bond concept.

Merrill Lynch and Tyco International introduced CoCos to the world in 2000. CoCos are convertible securities, but unlike most convertibles, they cannot be converted into shares of common stock until the issuer reaches a pre-conversion threshold. For example, a holder may only convert a contingent convertible note with a $10 stock price at issue, a 25% conversion premium, and a 120% contingent conversion trigger if the stock trades above $15.00 ($12.50 x 120%) over a predetermined period. The holder would convert at $12.50. Like most equity-linked debt, CoCos were attractive to issuers because the issuer could issue debt with a lower coupon than it would have to pay on a traditional fixed income security. CoCos, however, offered issuers an additional benefit: the equity securities underlying them were not included in the issuer’s diluted EPS calculation (because accounting rules at the time provided that if the right to convert was subject to a meaningful contingency that did not disappear through the passage of time, the underlying equity securities did not have to be included in diluted EPS until the contingency had been satisfied).

CoCos were extremely popular from their introduction to July 2004; investors snapped up more than 360 CoCo issues, valued at more than $125 billion, in less than four years. CoCos became much less attractive beginning in the fall of 2004, however, when the FASB’s Emerging Issues Task Force sought to standardize the accounting treatment of all convertible bonds by requiring issuers to include all underlying securities in EPS calculations when the conversion trigger depended on market prices. The FASB did not grandfather in the more than $125 billion in outstanding CoCos, forcing many companies to quickly pay down the CoCos they issued to avoid massive EPS reductions.

The FASB rule change all but killed off the CoCo until earlier this fall, when Lloyds Banking Group, plc, perhaps at the behest of the Bank of England and the FSA, resurrected it in a different form. Tomorrow we’ll explore the new form, and discover why regulators are so attracted to it.

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