Contingent Convertible Bond Ruminations

The latest idea to revolve around the task of inoculating the global financial system involves a financial instrument known as the contingent convertible bond. Overall, I'm somewhat pleased that the discussions surrounding financial reform have begun to deviate from the bonus-recipient-witch hunt mentality which has dominated the Obama Administration's rhetoric to date. Furthermore, it's encouraging to see the private sector begin to formulate it's own prescriptions; opposed to of course government solutions which amount to nothing more than throwing (other people's) cash at the situation, appointing czars of every shape and form, and hoping the problem solves itself.

Contingent convertibles are a nifty bit of financial innovation (isn't that supposed to be synonymous with evil and destructive?) that takes regular convertible bonds and adds a twist. The process would play out something like this:

1. Investors give cash to banks, and in return, they receive contingent convertible bonds.
2. Investors receive regular coupon payments, just like with any other bond.
3. If and only if the bank's capital ratio falls below a certain threshold determined by the bond contract, the instrument will convert into equity.

Part of the draw for contingent convertibles is that the conversion clause is not based upon observable market prices. In that sense, even the most concerted efforts by short-sellers can not trigger the conversion. Conceptually, assuming these instruments comprised a significant enough portion of global banks' capital structures, they would act as automatic stabilizers during periods of economic distress, bolstering banks' capital ratios without the need for TARP-like government interventions. As an aside, will widespread use of contingent convertibles be evidence of the Europeanization of financial markets? We all know how much the Europeans love their automatic stabilizers.

To briefly play devil's advocate, I could see the establishment of contingent convertibles causing a wholesale shift in the way bank stocks are valued. Capital ratios would be monitored very closely in order to develop a probability of equity conversion; this could cause bank stocks to prematurely fall in anticipation of a massive equity dilution. I could also see bank stocks' losing all of their appeal in terms of a dividend investment. That might not be an issue now, what with 1 cent dividends imposed by the Treasury; however, I have to assume that by say 2015, banks will once again be paying healthy dividends. The problem is from the banks standpoint, the debt to equity conversion will amount to the elimination of a contractual obligation to make semi-annual interest payments, and replace it with the extremely optional payment of a dividend. If I were investing in a bank's contingent convertibles from a current income perspective, I would prefer that the potential conversion be structured so that I received some class of preferential stock whereby a dividend comparable to the coupon rate was guaranteed. Nevertheless, the discussions surrounding contingent convertibles is a net positive in my book; we'll just have to wait and see if this new "movement" has the legs necessary to become a widespread reality.
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