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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Obama's Political Capital Evaporates Over Health Care Proposal

First of all, it needs to be pointed out that Katie Couric completely misspoke - not 5 seconds into CBS's coverage of the "Presidential News Conference" concerning the budgetary impact of Obama's health care proposal. She clearly stated that the CBO estimated the proposed bill would increase Uncle Sam's budget deficits by $237B over 10 years. Ms. Couric: you were over $800B short, and we can't be certain whether or not it was intentional. *7/23/09 Clarification: We've received questions about this point. Technically, $237B is the figure provided in the CBO director's report as the projected deficit impact - <$1Trillion is the total cost. Our point though is that if we can't pay for the programs currently in place, won't $1Trillion in spending over the next ten years be Entirely Deficit Spending?

Second of all, this health care proposal is done; it has been killed, stonewalled, stymied - or whatever your word of choice may be. We're not sure whether President Obama has personally admitted to this yet - in secret that is - but the bill took two direct blows that it ultimately will never be able to recover from. Dagger #1 was the CBO's revelation that the proposal will add >$1Trillion to the deficit over ten years. Dagger#2, and the finishing blow we might add, was the strategic Democrat blunder that was the proposed "surtax" on families at certain income levels to help pay for the reform. This was a politically inept move by the more liberally inclined members of the Party, who for some reason forgot that a large portion of their newly achieved majority in Congress was provided courtesy of traditionally Red districts. The Democrats who were recently sent to Congress by these wealthier districts did not possess a mandate to increase their constituents taxes; quite to the contrary, many center-leaning Republicans voted in favor of a Democrat last November based upon that Party's promise to restore fiscal discipline to the nation. That has not happened.

Ultimately, we are not sure why Obama has chosen to conduct tonight's "press conference". The President is literally putting all of his political capital on the line; all in pursuit of an agenda that, in all likelihood, will not succeed. This bill will be stalled, and will either never come to a vote, or will remain in limbo while Congress takes it's cherished "recess". While Congress is in recess, this proposal will be torn to shreds by special interest groups. There is little to no chance of success; we are quite sure of it. Sphere: Related Content

Taleb Proposes Debt For Equity Swap

In today's Financial Times, Nassim Taleb (with Mark Spitznagel) lays out what could loosely be referred to as a "solution" to our current economic predicament; defined by Taleb as essentially the over-agglomeration of debt. As a remedy, Taleb proposes that a vast conversion of debt to equity take place. As he explains further:

"The only solution is to transform debt into equity across all sectors, in an organised and systematic way. Instead of sending hate mail to near-insolvent homeowners, banks should reach out to borrowers and offer lower interest payments in exchange for equity. Instead of debt becoming “binary” – in default or not – it could take smoothly-varying prices and banks would not need to wait for foreclosures to take action. Banks would turn from “hopers”, hiding risks from themselves, into agents more engaged in economic activity. Hidden risks become visible; hopers become doers.

It is sad to see that those who failed to spot the problem (or helped to cause it) are now in charge of the remedy. Just as the impending crisis was obvious to those of us who specialise in complexity and extreme deviations, the solution is plain to see. We need an aggressive, systematic debt-for-equity conversion. We cannot afford to wait a day."

Most intriguing for our purposes is the contrast drawn by Taleb between the current, balance sheet driven recession, and the equity based dot-com collapse at the turn of the millenium. The obvious differences in terms of degree of severity between the two situations is evidence for Nassim that equity is far more suited than debt to absorb the unpredictable shocks that will define the coming era of economic progression.

Nassim certainly has some good ideas, however we aren't sure that anybody powerful will benefit from the above proposal; potentially rendering a good idea useless.

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Lear Bankruptcy: More Than Meets the Eye?

Lear Corp.'s imminent bankruptcy filling, prefaced by it's failure to make a $38M bond payment, is unlikely to even dominate the news cycle for more than 15 minutes; probably due to the fact that, in the wake of GM "collapsing into the Government's arms", it isn't too shocking that the world's largest supplier of automotive interior products would have some issues. We also think that Joe-sixpack is probably unaware that Lear Corp. booked $17.8B in revenue in 2006. Let's not fool ourselves: this is a Major Bankruptcy.

The interesting aspect of Lear's trouble is that the majority - roughly four out of every five dollars - of Lear's revenue is attributable to business conducted Outside of the United States. Additionally, GM only accounted for 23% of the Company's revenue in 2008. This all said, we would argue that Lear is much more a barometer of the Global Auto Market than of the US auto market. Are we talking about re-de-decoupling?

Fortunately for auto maker's supply chains, Lear has apparently already arranged $500M in DIP financing; a hurdle that quality visitors to bankruptcy court seem to have had no problem with recently (think Smurfit-Stone). Ultimately though, we see this as a process that will have to play itself out again and again until an actual recovery can occur. Clearly, Lear accumulated too much debt during the heyday of US auto sales; as a company judged by the market to possess a sound underlying business, it is getting what amounts to a pass for this period of profligacy. For many zombie corporations that exist today in America however, there will be no pass; there will be no DIP financing, and there will be no collecting $200. These companies will vanish into the wind, leaving behind a wake of destruction in the form of unpaid creditors. Hundreds of billions of dollars worth of capital that once fueled corporate growth, will essentially be lost. That is what a deleveraging process looks like.

*no positions, thankfully

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Can Optimism Alone Spur Recovery?

Let us begin by stating that there is a certain degree of truth to the layman's assertion that psychology plays a significant role in periods of economic contraction. Clearly, when consumers notice the early signs of a recession, they assess the likely threat to their job, standard of living, premium movie package, wine tasting club, Junior's college fund, etc., and adjust spending according to the perceived threat level. This collective consumer retrenchment has the potential to create a negative feedback loop whereby decreased consumer spending begets a weaker economy begets bad news begets further cuts to household spending. The most logical conclusion that can be derived from this sort of logic then, is that a dose of Happyspeak and a dollop of optimism can cure all ills. While this logic may have been valid during the infantile recession that ended in 2003, the situation at hand today is beyond the scope of what Optimism Alone is capable of repairing.

At present time we are in the midst of a balance sheet recession, characterized by the fact that the Total Liabilities of the financial system far exceed the dollar value of Total Assets. The scary thing is, we have only seen phase 1 of this grand and inevitable deleveraging process that must be completed prior to any sustainable recovery. Various other categories and breeds of poorly underwritten debt, whose combined value dwarfs the issues in subprime residential real estate, are currently lurking in the shadows of the Banking Sector's balance sheet. As evidenced by today's bankruptcy filing by the Nation's second largest mall owner/operator, commercial real estate has joined the deleveraging party. Next, consider the impending credit card debt debacle: At the exact moment that household incomes are being decimated by job losses and pay cuts, credit card issuers are aggressively slashing credit limits and ramping up interest rates. To invoke a suddenly relevant comment made several months ago by an acquaintance of ours "Are these guys suicidal?"

The primary point we would like to make is that optimism, regardless of its source, can only provoke households to spend a few extra dollars. Optimism will not, in any way shape or form, hasten the inevitable deleveraging process, nor will it reduce the Totality of Pain that comes as a result of the process.

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