Crush Cuckoo CoCo Coddling

Link to “The Trouble With CoCos” on Bloomberg View

Let me reprise part of what I wrote in the preface to “Cetier the First: Convertible Capital Hurdles” and augment it with the wise words of the Bloomberg View editorial board on the topic of debt that are converted into equity (stock) upon a certain trigger  (“contingent convertibles” or “CoCos”).

The Problem with Convertible Debt

Here is what I wrote back in August 2013:

…the basic problem with convertible capital, bail-ins, and so on is that they all require a decision–either drawn out an painful, or sudden and painful–to force those who have theoretically accepted a risk to actually take a loss. By contrast, equity holders take losses and make gains continually, without everything hingeing on a decision to make some group take the loss. The automatic nature of taking equity losses and getting equity gains is both an advantage in itself and tends to make these capital gains and losses more continuous and less sudden than for convertible capital and “debt” in bail-ins.

Another way of putting the problem is that the moment when conversion threatens is typically seen as a crisis, even if the approach to that moment was gradual, while a simple decline in the price of common stock is seldom seen as a crisis unless it is a very large and sudden decline. This crisis atmosphere is both damaging to confidence in and of itself and a temptation for government to do a bailout–a bailout they would be much less tempted to do after a simple decline in stock price.

And here is the Bloomberg View Editorial Board on February 12, 2016:

The incident serves to reinforce concerns, expressed by various financial economists, that CoCo bonds may make investors in banks and their debt more apt to take flight when trouble looms. After all, if CoCos protect taxpayers, they do so at the expense of bank shareholders and bondholders. Moreover, CoCos are complicated instruments. In a time of stress, uncertainty over the conditions that trigger conversions may add to the sense of alarm.

Paradoxically, a panic of that kind might eventually call forth a government bailout – the very thing that CoCos are intended to prevent. …

These flaws underscore the case for simply requiring banks to finance themselves with more equity, which has the advantage of absorbing losses without any special triggers or added anxiety.

The Problem with Debt in General

The problem with debt is that it is a bit of a pretense that there is not risk for the debt-holder. Given this pretense, debt-holders get alarmed when they are forced to face the reality of risk. Convertible debt does not escape this problem. The great virtue of common stock equity is that every day it goes up and down in price in a way that reminds its holders of the risk they face. Moreover, there is no obvious angle from which one can view common stock equity as risk-free. So stock-holders are made to face the reality of risk every day. They still may freak out at very large movements in price, but they become accustomed to substantial movements on a regular basis. Although in principle, one can think of bonds as just one more type of risky asset–one that is a bit more complex than stocks because of the complexity of default (and economists in their models often do imagine bonds in exactly that way), this is not always the way bond-holders view it. It is not good to set up a large group of asset-holders for freaking out because of a mismatch between the safety they think they are getting and the risk they are actually bearing. 

Avoiding CoCo Coddling

It is much better to have truth in labeling by requiring that half of all the liabilities of a firm be labeled and treated as common stock, and only pretending (now a more nearly accurate pretense) that the other half of the liabilities are safe. That is what a 50% common stock equity does. That is the single most important policy to avoid financial crises. 

As far the convertible bonds that are already in place, government authorities should act very much as if these convertible bonds were already converted in equity. It is no crisis for them to convert into common stock equity–that is what they should have been from the beginning. And anyone who thought their CoCo’s would be bailed out should be taught the reality of risk. 

Not how different this is from sending a bank into bankruptcy–the bank’s operations are fine and continue to function. It is only those who made a bet that the bank was safer than it really was that pay the price, not the customers and commercial counterparties of the bank. 

And if CoCo conversion makes it harder for banks to sell CoCo’s in the future, so much the better–it will make them more likely satisfy existing regulatory requirements by selling common stock equity, even if the regulators are sadly slow to insist on that as the way to satisfy capital requirements.