'Too Big to Fail' Bonds are Too Good to Pass UpChris Farrell
A time-honored way to kill off an idea in Washington is to call for further study. Does anyone really remember the Bush White House commission for major tax reform in 2005? It produced an excellent—and quickly forgotten—report that's gathering dust alongside hundreds of similar blue-ribbon panel recommendations.
Among the many initiatives in the sprawling 2,300-page financial services reform bill signed into law by President Obama on July 21 is a call for the Federal Reserve to look into the wisdom of requiring too-big-to-fail financial firms to issue debt that coverts into equity during a credit meltdown. Contingent capital bonds—also known as crisis convertibles, reverse convertibles, or contingent capital certificates—are the hot idea among economists and other card-carrying members of the financial regulatory cognoscenti. A requirement that Big Banks issue them was in an earlier version of the Congressional financial services reform legislation. Large banks and their lobbyists opposed the requirement (among a number of other mandates), and it was subsequently watered down, though not killed, during negotiations. The final legislation requires the Fed to study the idea and, if officials decide it has merit, adopt it.
Shades of the early 1990s? It sure looks like it. Back then there was pressure for the Fed to mandate that banks issue subordinated debt—bonds that could signal trouble since they are at the bottom of the barrel when it comes to bondholder rights. These are risky securities, thus a rise in interest rates on a company's subordinated debt could act as an early warning from the market of future trouble. The Gramm-Leach-Bliley Act of 1999 (the legislation that officially ended the Glass-Steagall era) required that regulators study the idea. The Federal Reserve and the Treasury Dept. issued their report toward the end of 2000. While acknowledging that the proposal had merit, it said the "net benefits of a mandatory policy over voluntary issuance are currently too uncertain to justify a mandatory policy." The conclusion: Let's study this some more. Little wonder it died.
Out From the Crypt
As the late mutual fund pioneer Sir John Templeton famously quipped, the four most dangerous words in the English language are "this time is different." But after the global credit crunch and the worst downturn since the 1930s, maybe it's true. The desire for reform is strong. The Basel Committee on Banking Supervision, a meeting of central banks and regulators from 27 nations, released on July 26th a preliminary agreement on bank capital and liquidity rules that included contingent capital as a key part of its ongoing discussion for reform. Canadian officials are actively pushing for mandatory contingent capital. A number of Fed officials have praised the idea, most notably William Dudley, president of the Federal Reserve Bank of New York. A far larger community of scholars, practitioners, and regulators is engaged with the idea this time around, writing research reports, speaking at conferences on the feasibility of crisis convertibles, and putting out op-eds on the desirability of the reform.
Simply put, it's going to be a lot harder this time to bury the idea. That's why contingent capital could be the Trojan horse for real, live radical regulatory reform.
All the proposals for crisis convertibles are essentially the same. The goal is to create a market-based mechanism that reinforces regulatory discipline and oversight while limiting the odds of a government handout. The too-big-to-fail financial companies would be required to issue, while they are still healthy, crisis convertibles with covenants that automatically turn the bondholders into equity owners in times of trouble. In essence, it's a market-driven prepackaged bankruptcy procedure—and a deterrent against failure. Bondholders take a big hit and end up as owners of the troubled business. "It puts the fear of God into CEOs and their boards," says Garrett Jones, professor of economics at George Mason University. Adds Gary Stern, the former president of the Federal Reserve Bank of Minneapolis: "It makes sense, since you end up with a better equity cushion in extremis."
Stimulating Bank Runs?
Still, the need for additional study is real. The devil is in the design, especially the trigger mechanism that transforms debt into equity. For instance, one set of proposals has ownership shifting when there's a sharp drop in the company's equity price. The distress signal can be buttressed by adding the requirement that a broad financial stock index also falls dramatically. Nevertheless, ideas that rely on market prices as a trigger raise concerns that financial gunslingers could gang up on relatively healthy Big Banks and set off crisis conversions. Indeed, a poorly designed system based on market prices could end up exacerbating bank runs rather than preventing them.
At the other end of the proposal continuum, debt isn't converted into equity until financial regulators declare the banking system is in crisis. Considering the natural aversion, however, of regulators to declare a systemwide emergency, much of the financial damage would have already happened before the debt converted into equity. At that point the fix seems trivial. "There are legitimate issues about how to design the trigger," says Anil Kashyap, professor at the University of Chicago's Booth School of Business and a supporter of contingent capital reform. A good summary of the major proposals is covered in a paper by finance professor Robert L.McDonald at the Kellogg School at Northwestern University.
Fact is, the Fed and other regulators came out of the financial-overhaul battle with greater regulatory powers than before. Yet the increased power doesn't really eliminate the too-big-to-fail problem. Thanks to a number of rescue missions engineered during the global financial crisis, the largest financial institutions are bigger than ever. CEOs are hardly shouting it from their skyscraper aeries, but these behemoths now benefit from an implicit guarantee of a taxpayer bailout with a lower cost of capital.
This is where crisis convertibles could come in. They would complement and strengthen regulation. There is no simple solution to solving the too-big-to-fail dilemma. Still, as a practical matter, it will take harnessing the power of the bond market vigilantes, stronger international capital ratios, and newfound national regulatory authority to hold out a genuine hope of dramatically reducing the odds of another too-big-to-fail crisis. "It's a package," says Stern.