The Broader Market

by Jordan Eizenga

The financial crisis laid bare the fact that, during periods of substantial market turmoil, financial institutions will often face capital adequacy issues.  Deterioration in the value of assets, an increase in the cost of capital, and an inability to obtain short term financing are typical of a distressed financial institution on the brink of disaster.  To prepare for future adverse market events, one notable group of economists, the Squam Lake Working Group at the Council on Foreign Relations has proposed that financial institutions be required to issue certain quantities of long term hybrid debt instruments that contain built in conversion features (see article here). 

The basic structure of the proposal is that these mandatory convertible bonds will function as debt-like instruments until the issuing institution begins to experience capital adequacy issues, at which time the debt would be automatically converted to stock equity, thus providing the issuer with much needed equity capital.  The recommended trigger for the conversion would be determined by the financial institution’s ratio of tier 1 capital to risk adjusted assets.  Crudely, it just converts what once was a liability on your balance sheet into an asset, and the increase in capital would simply be measured by the number of shares into which the bond converts multiplied by the price of the share.  To avoid the “death spiral” in which the conversion dilutes shareholders’ claims (which lowers share prices and thus leads to more dilution), the Squam Lake Group proposes that each dollar of debt be converted into a set quantity (and not a set value) of shares. 

In a vacuum, this proposal sounds like good policy.  It is a forward looking way for financial institutions to fund their activities with equity during unstable economic periods when raising equity or debt capital is very difficult.  This re-capitalization mechanism also reduces the likelihood of using tax payer funds to support an ailing financial institution and rightly places losses or costs of the conversion in the hands of risk seeking market participants (i.e., the investors).  However, debt issuances do not happen in a vacuum; to issue a bond, there must be both a seller and a buyer of the debt and it is not clear that there would be much of the latter.  A rational investor would not be willing to purchase a hybrid debt security that converts to stock at the worst possible moment – when the institution is shaky and the stock is likely plummeting. The only way in which issuers would be able to find buyers is if the instrument was priced at such a serious discount that would mean prohibitively high yields that even a well-run financial institution would be required to pay to bondholders.  In this sense, the mandatory convertible may simple function like a tax to the financial institution.  Such a tax may be a fair price to pay to be able to participate in a more stable financial system (particularly since the institution’s success is dependent on the stability of the system as a whole).