Federal Reserve Chairman Ben Bernanke recently endorsed the idea of contingent capital, or CoCos as some call this newfangled form of capital. The idea is to help “systemically important institutions” maintain adequate capital levels in the worst of economic or business circumstances.
As described by the chairman and other Fed officials in recent weeks, the idea has some appeal: an innovative instrument would allow a financial institution under duress to automatically convert debt to equity, thereby strengthening its tangible equity base at a time when it otherwise might not be able to raise capital in the equity markets. For the first time, we also are now seeing at least one firm attempting to come to the market with these types of instruments. Yet while this obviously is an attractive option for the financial firm, contingent capital would be an irresponsible investment for most market participants and is, therefore, bad public policy.
Why is contingent capital a bad investment? Because the notes are guaranteed to lose money in times of market turbulence and probably would underperform almost every other risk asset in the market. Think about it: a bond previously sold at par during times of calm and tranquility suddenly approaches a “trigger level” during a time of stress in the market. At the trigger point — a predefined criteria such as “in times of macroeconomic stress or when losses erode the institution's capital base,” in Mr. Bernanke's words — the bond will convert to common equity. The bondholder, realizing he or she may be forced into conversion that would transform their holdings into massively diluted equity at the worst possible time, will sell that bond in a hurry. And the bondholder will not be alone.
Given the high risk involved, who would buy contingent capital notes? The obvious buyers — regional banks, insurance companies or large commercial banks — are not likely to be allowed to purchase this type of security under the rules governing capital requirements. A contingent capital note issued by one financial institution would be a dangerous instrument for another levered financial firm to own on its balance sheet. The purpose of capital is to provide an adequate cushion so that a firm can continue to operate normally even in times of economic weakness and negative earnings. When a financial firm is experiencing negative operating earnings, increasing reserves to cover non-performing loans and trying to hedge falling collateral values across it balance sheet, where is the value in owning a bucket of equity from another failing financial firm?
Contingent capital notes do not belong in 401(k) plans, mutual funds or institutional investment accounts, either. The role of bonds, especially investment-grade bonds, in a diversified portfolio is to provide a steady, reliable stream of income with a high probability of capital preservation. In times of crisis, when most risk assets are declining sharply in value, the fixed-income portfolio should be a reliable store of value that allows the investor to reallocate into desirable risk assets in order to take advantage of the crisis. A contingent capital note would do the opposite. It would cause the investor to lose the income stream, suffer principal losses and accept an unwanted risk asset. This is not what the equity investors want to own in a crisis. Instead, they should own equity in firms with sustainable business models, managed by people who never allowed their companies to reach the stress-trigger levels in the first place.
