Contingent Capital : The Case for COERCS

Transcription

1 George Pennacchi (University of Illinois) Theo Vermaelen (INSEAD) Christian Wolff (University of Luxembourg) 10 November 2010 Contingent Capital : The Case for COERCS

2 How to avoid the next financial crisis? Restrict risk taking activities of banks Increase capital requirements (Basel III) Encourage contingent capital

3 Contingent capital Bonds that mandatory convert into equity after a triggering event Motivation : providing discipline of debt in good times, avoiding costs of financial distress in bad times Basel III agreement is likely to include a role for contingent capital Swiss National Bank wants major banks to have capital/rwa ratios of 19 % with 9 % in the form of contingent capital

4 Design issues Trigger based on book values of leverage or market values? Trigger price relative to conversion price? How to avoid unjustified conversions as a result of manipulation or panic (death spirals)? How to keep bond risk low when assets can experience sudden jumps? How to avoid moral hazard (excessive risk taking)? How to minimize regulatory risk?

5 Book value triggers Example : Lloyds Bank notes convertible into equity whenever Tier1 capital ratio falls below 5 % Problem: capital ratios could be old as they are calculated only once every quarter =>Example: December 2008 Citibank capital ratio : 11 % =>This makes the bonds very risky : Lloyds Bank Notes yield 12%

6 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

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

8 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, cc are risk-free

9 Problems 1. Unjustified dilution because of manipulation or panic 2. Risk cannot be eliminated if asset prices experience sudden jumps

10 Figure 1 Percentage of 100 Largest U.S. Banks with a Daily Stock Return less than -10% 70% 60% 50% 40% 30% 20% 10% 0% /3/2007 2/3/2007 3/3/2007 4/3/2007 5/3/2007 6/3/2007 7/3/2007 8/3/2007 9/3/ /3/ /3/ /3/2007 1/3/2008 2/3/2008 3/3/2008 4/3/2008 5/3/2008 6/3/2008 7/3/2008 8/3/2008 9/3/ /3/ /3/ /3/2008

11 Unjustified dilution Assume stock price falls to $ 5 because of manipulation or panic Convertibles 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 = 16.1 (54 %) Bondholders have large incentives to manipulate stock downwards through false rumours or shorting (no short squeeze as company delivers shares for covering!)

12 Solution :COERC Whenever stock hits $ 5, bond holders have to convert at $ 1 But equity holders have the right to buy back shares from the bond holders at $ 1 We baptize this as a COERC : call option enhanced reverse convertible

13 COERC and manipulation Suppose stock falls to $ 5 through manipulation If bondholders convert 30 at $ 1 they would get 30 new shares Shares outstanding : 37 Ownership of bondholders α = 30/37 New fair value per share : $ 100/37 = $ 2.70 However, when trigger is hit, a rights issue will be announced for 30 shares at $ 1 per share As $ 2.70 > $ 1.00 the rights are exercised and bonds are repaid

14 Conclusion After the dust has settled shareholders have repaid the debt As debt overhang is eliminated it becomes possible to issue new capital No shares were delivered to cover short position of manipulator The call option allows investors to undo any wealth transfer to bond holders as a result of manipulation or market inefficiency

15 COERCs and true financial distress Stock falls to $ 5 because true value of assets falls to $ 1065 => Total capital falls to $ 65 Without repayment debt converts into 30 shares Then new fair equity value = $ 65/ (30 + 7) = $ 1.76 Bondholder wealth would then be 30 x $ 1.76 = $ 52.8 Shareholder will prevent this wealth transfer by subscribing to a rights issue for 30 shares at $ 1 Debt will be repaid ( $ 30) Dust settles with 37 shares outstanding and $ 65 equity or $ 1.76 per share

16 Why no trigger at $5 and exercise price at $5? When the rights issue price is $ 1, equity investors will exercise the rights (repay the debt) as long as the fully diluted stock price > $ 1 Or, as long as the value of firm > $ $ 30 + $ 7 = $ 1037 If the rights issue price was $ 5 investors will exercise rights (repay the debt) as long as the fully diluted value per share is > $ 5 Or, as long as the value of firm > $ $ 30 + $ 35 = $ 1065 The smaller the exercise price relative to the trigger price, the lower the risk of the debt

17 Basic intuition The COERC forces equity holders to put up money to pay back debt holders or to face massive dilution. It is a COERCive instrument! The force comes from the fact that we issue shares to bondholders at a discount below fair value. This wealth transfer can only be undone if shareholders repay the debt The larger the discount, the larger the dilution and the more likely the shareholders will repay the debt

18 COERC solves design problems First, the call option eliminates risk of bond holder manipulation at the expense of shareholders Second, with a sufficiently low exercise price relative to the trigger price, bonds have low risk Third, no regulator involved, no regulatory risk

19 Valuation and risk analysis: a formal model We use a structural credit risk model of a bank 1 to compare COERCs, standard CC, and non-convertible 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

20 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) Bank deposits have short maturities and are paid a fair credit spread 3) The bank targets a 10% total capital-to-deposits ratio by adjusting deposit growth (mean-reverting leverage)

21 Assumptions: bonds and equity 5) Bonds are issued at their par value of 3% of deposits, pay either fixed or floating coupons, and have a five-year maturity 6) The type of bonds considered are: a) COERC with conversion triggered when total capital = 6.5% of deposits (3.5% equity value) b) Standard contingent capital 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) when the value of bank asset falls below the par value of deposits plus any non-convertible bonds

22 Result: Fair new issue yields on COERCs decline as the proportion shares they receive, α, increases Figure New Issue Yields on Fixed-Coupon COERCs For Different Numbers of Shares Issued Five-Year Maturity, Initial COERC Value = 3% of Deposits, Conversion Triggered when Equity = 3.5% of Deposits Dashed Line is Five-Year Default Free Treasury Yield Coupon Rate COERC shares to total shares ratio α = 20/27 COERC shares to total shares ratio α = 30/ Percent Capital to Deposits

23 Result: Delaying conversion of COERCs to when capital is lower increases their new issue yields Figure 4 New Issue Yields on Fixed-Coupon COERCs For Different Equity Trigger Thresholds 6.6 Five-Year Maturity, Initial COERC Value = 3% of Deposits, COERC Shares to Total Shares Ratio α = 30/37 Dashed Line is Five-Year Default Free Treasury Yield Coupon Rate Conversion Triggered when Equity = 2.0 % of Deposits Conversion Triggered when Equity = 3.5 % of Deposits Percent Capital to Deposits

24 Result: New issue yields are highest for contingent capital without a call option (minimum α = 6/13) Figure New Issue Yields on Fixed-Coupon COERCs versus Contingent Capital without Call Option Five-Year Maturity, Initial Bond Value = 3% of Deposits, Conversion Triggered when Equity = 3.5% of Deposits α = COERC Shares to Total Shares Ratio Dashed Line is Five-Year Default Free Treasury Yield Coupon Rate Contingent Capital without Call Option 5.5 COERC α = 10/17 5 COERC α = 20/ COERC α = 30/ Percent Capital to Deposits

25 Result: Credit spreads on COERCs are lower than those of both standard CC and non-convertible debt Figure New Issue Credit Spreads on Floating-Coupon COERCs, Contingent Capital, and Subordinated Debt Five-Year Maturity, Initial Bond Value = 3% of Deposits, Conversion Triggered when Equity = 3.5% of Deposits α = COERC Shares to Total Shares Ratio Non-convertible Subordinated Debt Credit Spread (bp) Contingent Capital without Call Option COERC α = 30/37 Percent Capital to Deposits

26 Coercs eliminate moral hazard Moral hazard : incentive to take excessive risk at expense of debtholders Following graphs shows Coercs eliminate this incentive by showing the sensitivity of the coercs to increases in risk : - increase in frequency of jumps - increase in volatility of jumps - increase in size of jumps

27 Result: A bank that issues COERCs has less incentive to invest in assets having a high probability of jumps Figure Change in the Value of Shareholders Equity For a 25% Increase in Frequency of Jumps (λ) Five-Year Maturity, Initial Bond Value = 3% of Deposits, Conversion Triggered when Equity = 3.5% of Deposits α = COERC Shares to Total Shares Ratio Contingent Capital without Call Option E/( λ/λ) (%) Non-convertible Subordinated Debt COERC α = 30/ Capital to Deposits (%)

28 Result: A bank that issues COERCs has less incentive to invest in assets having a high volatility of jumps Figure Change in the Value of Shareholders Equity For a 25% Increase in the Volatility of Jumps ( σ y ) Five-Year Maturity, Initial Bond Value = 3% of Deposits, Conversion Triggered when Equity = 3.5% of Deposits α = COERC Shares to Total Shares Ratio E/( σ y /σ y ) (%) Non-convertible Subordinated Debt Contingent Capital without Call Option COERC α = 30/ Capital to Deposits (%)

29 Result: A bank that issues COERCs has less incentive to invest in assets having higher average jump losses Figure 9 Change in the Value of Shareholders Equity For a 25% Decline in the Mean Jump Size ( µ y ) 0.18 Five-Year Maturity, Initial Bond Value = 3% of Deposits, Conversion Triggered when Equity = 3.5% of Deposits α = COERC Shares to Total Shares Ratio Contingent Capital without Call Option E/( µ y /µ y ) (%) Non-convertible Subordinated Debt COERC α = 30/ Capital to Deposits (%)

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

31 Conclusion and policy implications COERCs solve the debt overhang problem and should be of interest to all companies concerned about reducing costs of financial distress. Policy makers should treat COERCs as Tier1 capital Tax authorities should not discriminate against COERCs

32 Comments welcome

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