Amid the ongoing cleanup of this financial crisis, U.S. and European regulators are trying to figure out how to avoid another one. The latest plan: forcing banks to sell hybrid investments. The securities would morph from a bond into a stock during troubled times, thereby increasing companies' capital stashes and reducing their debt loads. But will the complex investments prevent the sort of panic that depleted banks' capital at the height of the crisis—a situation that prompted the U.S. to prop up the financial system with more than $4 trillion?
At first blush it seems a clever way to pad the industry's cushion of safety. Banks are required by regulators to set aside money to protect against losses. And these hybrid investments ideally would give companies an instant rush of extra capital just when they need it the most, as losses are mounting. That's why the securities, known as contingent convertibles, or "CoCos," appeal to regulators and lawmakers on both sides of the Atlantic. Federal Reserve Chairman Ben Bernanke and Treasury Secretary Timothy Geithner are floating the idea. In early November, Lloyds Banking Group (LYG), the largely state-owned U.K. bank, said it would issue up to $12 billion in CoCos.
But these investments have a checkered past. During the boom, banks aggressively sold similar securities, a move that only helped pump up the credit boom. In 2007 financial firms around the globe issued nearly $60 billion in hybrids, triple the amount in 2005. Insurance companies and other big investors gobbled up the investments like debt, figuring they were a safe way to get some extra yield.
Now the same financial instruments are aggravating the bust. Investors who thought they were buying bonds have been left holding something closer to stock. The difference can be painful. The government, for example, suspended regular interest payments on some hybrids issued by Fannie Mae (FNM) and Freddie Mac (FRE) after taking over the mortgage giants in September 2008. The U.S. is backing their traditional bonds in full. Prices on other hybrids plunged by as much as 55%. "The market never really dealt with that critical conflict: Is it debt or is it equity?" says Jeffrey A. Rosenberg, credit strategist at Bank of America Merrill Lynch Research (BAC).
Regulators hope to remove the doubt. In developing the latest version, the triggers for conversion will be outlined in advance so investors hopefully won't be surprised in the end with what they own. In the past the banks had a lot more discretion, and the securities rarely converted into stock, unless a company went belly-up. Now under various proposals, the debt would automatically switch into stock when a bank's financials deteriorate—when, say, troubled loans hit a certain level.
Trouble is, investors may not like this breed. Unlike previous hybrids, these will behave more like equity, which could scare off the usual buyers, who seek safety. Stock investors may not like them since they don't have the same upside potential. As a result, banks may have to jack up the interest rates they pay to attract buyers, a potentially costly proposition.
Meanwhile the securities remain untested. If there are unintended consequences to the risky instruments, they won't be discovered until banks are under pressure and it's too late. "It is ironic," says Simon Adamson of researcher CreditSights. "At a time when you're trying to simplify things, you're getting what appear to be complex securities."