Continuous bankruptcy
I’d like to propose a financial innovation that I think would actually be good (besides the ATM). It would be a new security that firms could market to investors, just like CDOs and all of that good stuff. But rather than being a means of expanding the supply of credit (the questionable purpose of most “financial innovation”), this investment product would change the character of credit provided by investors to firms. It would provide an alternative to the customary form of corporate debt.
True believers might argue that if what I suggest were a good idea, a free capital market already would have discovered it. I’m not a true believer, but I’ll make common cause in part, and point out that securities like those I propose are presently tax disadvantaged, so capital markets have not been free to discover them. In particular, if dividends on preferred equity were tax-deductible to firms like interest, perhaps these securities would already be commonplace. But I’ll reveal my cruel, statist heart by hinting that since firm managers may be myopic in their preference for cheap financing, and since distress costs are in part external to firms, an active policy tilt in favor of more robust capital structures might be worth considering. [1]
I’m suggesting a new financial instrument. Here’s its catchy name: “In-arrears convertible cumulative preferred equity”, or “IACCPE”. (“Yak-pee” for short?) Let’s chop that aromatic mouthful into tasty, digestible chunks:
Preferred equity is a form of investment that is like debt, in that the issuing firm promises to pay an agreed dividend level (like an interest rate), rather than a share of a firm’s variable profits. However, preferred equity is unlike debt, and like stock, because if a firm for whatever reason does not pay the promised dividend, aggrieved investors cannot sue for bankruptcy. Preferred shareholders’ only means of enforcing payment is priority: common equityholders cannot receive dividends if preferred shareholders’ dividends have not been paid.
Cumulative means that if the issuing firm has skipped some dividend payments, the firm is said to be “in arrears”, and must pay preferred investors all past skipped dividends before it can make any payout to common shareholders. “Cumulativity” ensures that, unless a firm goes bust before ever paying another dividend, preferred investors will eventually get all the payments they were promised, although they may suffer from delay. Cumulative preferred equity is more “debt-like” than noncumulative preferred equity, in that noncumulative investors permanently lose claim to some dividends if a company falls on hard times and suspends payments, while debtors always have claim to interest owed.
In-arrears convertible means that while payments on the preferred shares are “in arrears”, when the firm had failed to pay some of the dividends that it had promised and not yet cured the failure, investors would have the option of converting the shares to common stock on favorable terms.
It’s the in-arrears contingency that makes this security novel and interesting (I hope). But the feature requires some explanation. Usually, a convertible security has a par value and a conversion price that fix the number of shares of common stock an investor would get for converting a share of the security. This means that investors normally convert only when a firm is doing well. Suppose you have a share of preferred stock that (without the conversion feature) would be worth $100, but that can be converted to 10 shares of common stock. You would never exercise that right when the common stock price is less than $10, since the preferred share is more valuable than the stock you’d get. You would only convert when the common stock is doing well enough so that the value of the stock you would get on conversion exceeds the value of your preferred share. [2]
An “in-arrears convertible” would be pretty useless unless the conversion price were very low, since firms stop paying their preferred stock dividends in difficult times, when their stock price is depressed. So rather than fixing the conversion price in advance, these securities would be convertible at a discount to the market price of the stock at the time the preferred dividend was not paid. [3] That is, by going into arrears on the preferred shares, firms would open themselves up to dilutative preferred-to-common-equity conversions, at the option of the preferred shareholders. If a firm does have long-term, going-concern value, but is simply unable to meet the cash flow requirements of its capital structure, preferred shareholders could convert at a bargain rate during the limited in-arrears period. If a firm is not likely to be viable as a going concern, preferred shareholders could choose to hold tight. They’d be paid out in preference to common stock holders at the eventual liqudation.
Firms could issue multiple classes of “IACCPE”, like they now offer multiple debt issues, each with a distinct priority in the capital structure of the firm. Ordinarily, these securities would be indistinguishable from debt, both to the firm and to investors. Investors would fork over a set amount of cash, and then expect to be repaid with interest (formally dividends) on a predetermined schedule. But in bad times, firms that fail to meet their obligations would be forced to offer equity, including control rights, to creditors on very favorable terms. (Non-payment of a dividend could also provoke a special shareholders meeting, and holders of the unpaid preferred could be given the right to propose replacement directors, thereby maximizing the value of converters’ control rights.)
Substituting this kind of security for debt in firms’ capital structure would enable a kind of bankruptcy in increments, an automatic and self-enforcing reorganization. I think this would improve value for all stakeholders compared to our present system. Chapter 11 bankruptcy was itself a great innovation, but it exposes even viable firms to large, indirect distress costs when capital structure and cash flows become misaligned. To the degree that a firm has widespread or important stakeholders outside its capital structure (customers, employees, financial counterparties, local governments, etc), Chapter 11 even at its best produces costly externalities, as stakeholders must provision for abrupt and unpredictable changes even when a firm is likely to survive and even thrive once arguments over who gets what are resolved. Because Chapter 11 bankruptcies (and receiverships for financial firms) are disruptive, governments sometimes intervene to prevent them or to the process with subsidies. The expectation of intervention causes investors in “systemically important” firms to over-lend and under-monitor. For large firms, the threat that contractually prescribed, preferred-to-common conversions might be triggered would be more credible than the threat of an uncontrolled bankruptcy without government subsidy. Investors would be forced to actually price the “lower tail”, rather than hoping it will be truncated by the state. Common stockholders would face a steep penalty for missing “debt” payments, but the extent of their dilution would be predictably related to the scale of the obligations they fail to meet.
IACCPEs wouldn’t replace or eliminate traditional bankruptcy, of course. Regardless of capital structure, firms that are not viable businesses will need to be liquidated. Sometimes firms have contractual arrangements other than straight debt that need to be modified if a firm is to become viable. Moreover, even if all “financial” debt were eliminated from firm capital structures (I think that would be a good thing), firms would still have transactional business creditors, for whom traditional “hard” debt makes sense. [4] This proposal does not directly address off-balance-sheet contingent liabilities or pension and health obligations, which are increasingly sources of firm distress. I think pension and health issues will have to be addressed on a national basis, that our employer-centric system of managing health and retirement issues will ultimately have to be, um, retired. But some contingent liabilities (uncollateralized derivative exposures) could and probably should be replaced by contracts that can be paid off in some form of equity (at punitive valuations) when they cannot be paid in cash.
Highly leveraged capital structures make individual firms, and networks of interdependent firms and communities, brittle. Replacing debt in firm capital structures with some form of preferred equity would serve as a shock absorber, allowing viable firms to survive transient cash flow shocks without affecting outside parties. It might be enough to simply level the playing field between debt and preferred equity by making preferred stock dividends tax-deductible for firms. But debt investors take some comfort in the fact that they have power, via the bankruptcy process, to enforce payment. That threat may reduce the cost to firms of debt finance. The sense of the present proposal is to define an instrument that gives fixed-income investors as much of the power they would have in a bankruptcy as is possible while reducing the likelihood of a “singularity” that creates far-reaching costs and uncertainties.
[1] The proposed “IACCPEs” would not necessarily be a more expensive form of financing than traditional debt: On the one hand, they take a weapon away from creditors, so creditors would want to be compensated for the additional vulnerability. On the other hand, by reducing the likelihood that a transient shock provokes an unnecessary bankruptcy, replacing debt with IACCPEs might reduce expected distress costs, and thereby increase overall firm value relative to a firm financed with traditional debt, which would be reflected in a lower cost of financing across the capital structure. Which of the two offsetting factors dominates would have to be an empirical question.
[2] Usually you would wait quite a bit longer than that, because the option of converting at any time makes the convertible security as valuable as the shares, but the agreed-in-advance payments of the unconverted security provides protection should the stock price tank. Exactly when it’s worthwhile to exercise the conversion option on convertible shares is complicated, and in real life depends on the level of dividends paid by common shares and the relative liquidity of the market for common and preferred shares. In frictionless markets for a firm that issues no common dividend, it would only be worthwhile to convert an instant prior to maturity of the convertible security (if it is not perpetual). For our purposes, however, all that matters is that investors usually convert preferred stock only when the common shares are doing well.
[3] Getting the conversion option trigger right would be an important technical issue in defining these securities. Managers might try to manipulate their stock price around the time of the triggering nonpayment, in order to minimize the cost of dilution to existing shareholders (and themselves). The conversion price might be based on an average stock price over 30 days prior. Managers would not have very much scope to time the nonpayments, because they would be required to skip dividends on the most junior class of preferred shares, whose dividend schedule would have been set in advance.
[4] Broadly, “financial” investors should be expected to research and take some responsibility for the firms in which they invest, while customers and suppliers should be able to do business with a firm without worrying very much about its balance sheet. There is no bright line between transactional credit and financial debt, but it is nevertheless a distinction worth making, and even policing, in firms’ capital structure. The “cash efficiency” movement, which encourages firms to maximize their use of transactional credit as a source of cheap financing, is in my view pernicious. But that’s a rant for another day.
- 2-May-2009, 3:50 p.m. EDT: Reorganized a bit, changing the name “In-arrears contingent convertible cumulative preferred equity” to the more svelte “In-arrears convertible cumulative preferred equity”.
Very interesting and it makes sense- I think the only sticking point is that the firm has to be convinced that its in their best interest to issue this kind of thing, else they wont. Taking chances with losing control of the company/facing dilution is not something existing shareholders will enjoy (although they will certainly be thankful of it if it averts a bankruptcy and liquidation of their claims).
Might be interesting to see the adoption of these if they were packaged with some sort of regulatory capital relief, as regulators would recognize that a systemically important firm would have more options/oversight as it went through a “gradual bankruptcy process”.
Wonder if conversion of these would be considered a credit event…
May 2nd, 2009 at 5:19 pm PDT
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a security much like this technically exists in the insurance business. it’s called a catastrophic equity put (CatEPut). Aon Capital Markets developed it about 10 years ago. I think they even sold a few. (I seem to recall that LaSalle Re had one as part of its capital structure. of course, LaSalle was founded by Aon after Andrew so the sale may not have been truly arms length.)
the CatEPut was pretty straight forward. it paid a high fixed rate of interest (e.g., L+800) and matured in 10 years. if a reference event took place (a hurricane or earthquake causing more than some specified amount of property damage) the issuer called the security at par and replaced it with equity at a set price per share (negotiated at issuance). this way the reinsurer hopefully would have surplus capital in the aftermath of a cat event so it could take advantage of the hardening in prices.
the targeted investor base was high yield fund managers. the coupon was high and the risk was uncorrelated to macro-economic risks embedded in their bond portfolios. it should have flown off the shelves. unfortunately high yield bond managers were incredibly concerned about (a) the potential for moral hazard; and (b) the unpredictability of catastrophic events.
so, they ended up piling into CDO’s and CLO’s instead. crazy.
i still have some of the prospectuses for deals that never happened. they are fascinating reads.
May 2nd, 2009 at 10:24 pm PDT
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These sound a lot like the classic “death spiral” convertible bonds one heard a lot about during the tech bubble/bust. (Investopedia). Except that it seems that by tying the conversion option &price to the failure to pay dividends, you’re actually making somewhat of a deterrent virtue of the death spiral feature. Still, shorting the common like crazy and covering after conversion would seem a likely strategy for investors expecting a missed dividend. Would corporate managers have the incentive to pay dividends that they probably shouldn’t to attempt to avoid the death spiral?
May 2nd, 2009 at 11:30 pm PDT
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Awake — good points. in the “proposal”, i tried to make the structure plausible by keeping it as close as possible to familiar debt. for the issuing firm, the marginal benefit is that a partial dilution in case of an unexpectedly bad period is better than the outright bankruptcy that would occur with debt. for junior lenders, the marginal benefit is that one has a means of enforcing payment with hurting recovery values by putting the going-concern value of the firm into question.
that’s the theory. would it work? you tell me.
good point also re credit event uncertainty. one thing i think we are learning is that there is a conflict between expressivity and complexity in a financial system. a broad range of contracts permits does help “complete” markets, which in theory should help optimize risk bearing and increase our ability to mobilize capital productively. however, new contracts alter the ecosystem in complicated ways, changing functional systems that we thought we understood. if there were not credit derivatives, we wouldn’t have to worry about what is or is not a credit event. we’ve introduced endogenous uncertainty — risk — and that might undo the benefits of the added expressivity. (we may also introduce predictable adverse consequences, like separating control rights of creditors from the ultimate bearers of economic risk. that’s less uncertainty than a kind of clearly negative pollution.)
that’s sort of an odd soliloquy to attach to a proposal for a novel security. obviously i think the good consequences of what i propose would outweigh any negative unanticipated consequences. but i could be wrong. i appreciate comments trying to “stress test” this idea.
May 3rd, 2009 at 1:30 am PDT
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SRW,
This is very interesting.
Continuous bankruptcy – and continuous risk.
Do you think that IACCPE investors in total would be looking for a “waterfall” structure of dividend suspension ordering, and option strike sets? Would they naturally gravitate toward an overall preferred equity structure that implicitly included an embedded debt ordering?
Would this have promise, if not as a comprehensive replacement for debt, as an instrument that could expand the marketability of preferred equity and therefore bolster equity capitalization generally? How much does the feasibility of the idea depend on its comprehensiveness as a debt replacement? Does it require that investors price the entire “lower tail” or just more of it than they do now?
Unless I’m misinterpreting the nature of CatEPut as referenced in bondinvestor’s comment, it sounds like capital insurance, which is the firm’s put option. “IACCPE” is the investor’s call option to provide common equity capital under stressed conditions, which is not the same as capital insurance.
“Investors would fork over a set amount of cash, and then expect to be repaid with interest (formally dividends) on a predetermined schedule.”
Did you mean dividends (formally interest), or am I not understanding this?
May 3rd, 2009 at 1:32 am PDT
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bondinvestor — i’ve encountered catastrophic equity puts before, but i wouldn’t have made the connection. if investors perceived “IACCPEs” to be as risky as those, then the proposal couldn’t work in the sense of serving as a cost-effective alternative for firms and investors who would otherwise write debt contracts.
i suppose the main difference would be a lot less moral hazard: existing shareholders and potentially managers are badly punished by the conversion event, since the conversion price is set to deliver near-par-value at the time of the event. plus, since conversion is optional, preferred holders are less screwed by the adverse event. with “CatEPuts”, investors lose when the hurricane comes. with “Yak-Pees”, investors get pretty good options even in the bad state. they can convert and sell immediately, and depending on the conversion price and market response, anticipate a solid recovery despite the substantive default. their primary risk (foreseen by Alex R) is that firms pay out until they are empty shells, but the market learns only upon nonpayment, tanking the stock so that all at once the conversion option falls way out of the money and the preferreds go worthless as recovery becomes implausible.
in other words, if the information asymmetry between firm managers and stock investors is sufficiently gaping, insiders can screw “Yak-Pee” holders, either via looting the firm (screwing common shareholders as well), or as a consequence of “gambling for redemption” on behalf common shareholders that ex post fails to pan out.
so while i’d never want to suggest something that depends on perfectly “efficient” markets, this proposal does require that markets for individual securities are not so radically inefficient that a failure to make a dividend payment would not be substantially anticipated by markets in the 30 days prior, but would cause a very sharp downward revaluation immediately after. if the typical effect of the bad news inherent in an actual non-payment is usually moderate because markets would have largely priced them in, preferred shareholder can be protected from the extra drop on actual news by insisting on a conversion price at a discount to the prior market price.
May 3rd, 2009 at 1:57 am PDT
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Alex R:
My thoughts on “death spiral” securities precisely.
SW:
I have seen preferred shares with “variable” conversion rates. The preferred is convertible into say $1 million of common. At issuance suppose the common is $1 per share. The conversion is 1 million shares. Suppose the “trip wire” is met, i.e., the common falls below say 50 cents per share for 30 days, the conversion ratio changes to 50 cents a share or 2 million shares. Other “trip wires” or multiple “trip wires” for one security are possible.
Is this what you have in mind? I have seen these things.
May 3rd, 2009 at 2:22 am PDT
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Alex R — i hadn’t made the connection with “death spiral convertibles”, but yeah, there is a similarity. that’s okay — these are supposed to be debt substitutes, so it’s not supposed to be a happy day for managers and common shareholders when a dividend is skipped. as you suggest, the adverse consequences are supposed to deter managers from risk incommensurate with their leverage, just as bankruptcy does.
i appreciate your trying to “game out” what investor behavior would be if these things were real. i certainly think that you are right: to the degree that stock investors anticipate a nonpayment, they should short common (and potentially buy the preferred). shorting prior to nonpayment helps preferred shareholders (by increasing their conversion ratio) and harms common equity (and, if incentives are aligned, current management). so managers would want to try very hard to avoid a situation where they are forced not to pay when investors anticipate the nonpayment. instead, they ought to skip dividends preemptively. if they surprise the market, a sharp ex post price drop will put the preferred conversion option out of the money. by doing so, they can conserve cash, and limit the dilution dramatically. (if the firm is clearly a going concern and the nonpayment is precautionary, many pseudo-debt investors might hold through the cure, and not dilute at all. those who do convert would do so at the prenegotiated discount to a still healthy stock price, limiting the damage.)
so it seems to me that firms have two basic strategies: suspend payments early, when the firm still clearly has the resources to pay, in order to maximize the probability of weathering an incipient rough period. alternatively, managers might try to hide their difficulties for as long as possible, until the firm would be nearly valueless on nonpayment, gambling for redemption all along the way (see response to bondinvestor above).
the first scenario seems pretty benign to me: overleveraged firms, upon realizing that operational performance might be inconsistent with their degree of leverage, accept modest costs to undo some of their leverage insure against larger-than-anticipated risks.
the second scenario is the troubling one. perhaps this could be mitigated by having the conversion option triggered whenever common shareholders’ “skin in the game” dwindled to the point that bad gambles would be tempting, a “knock-in” call triggered when the 30 avg share price fell below some level, or where the ratio of mkt-value-of-equity to par-value-of-preferred &debt fell sufficiently low? in other words, maybe there should be both a discretionary conversion trigger (suspend dividends) and a mandatory conversion trigger, so that managers would be inclined to voluntarily conserve cash early rather than risk being forced to transfer control of a still-valuable firm when the mandatory trigger kicked in.
what do you think?
May 3rd, 2009 at 2:33 am PDT
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JKH — i think it would be a waterfall structure. more senior IACCPE holders would anticipate owning a greater share per dollar of par-value if things go sour than more junior IACPE holders, because by the time the seniors were hit with nonpayment, the stock price would have tanked.
i think it’s too much to try to replace debt comprehensively, it’d be too abrupt a change. as proposed, this is intended as you suggest as an incremental solution, a perhaps attractive instrument that could be inserted between common equity and bankruptcy triggering debt, which would increase the robustness of “leveraged” firms, but not eliminate all bankruptcy hazard from financial debt.
the proposal might be redundant, in the sense that if preferred dividends were deductible like interest, already conventional forms of preferred would be sufficient to supply a decent cushion. that’d be fine by me. IACCPEs are just an attempt to make preferred stock as close a substitute as possible to debt, in order to minimize the cost to firms of switching from debt-heavy to preferred-stock-heavy forms of leverage.
I agree with your distinction re catastrophic equity puts, in that with these securities the preferred investors are long an option after the trigger, while with CatEPuts, bond investors are short an option after the trigger.
“Investors would fork over a set amount of cash, and then expect to be repaid with interest (formally dividends) on a predetermined schedule.”
This is what I meant, but it is unfortunate phrasing. I wanted to say that “investors get repaid with interest”, using the colloquial meaning of “with interest”, that is they get paid more than they put in. But formally, preferred equity does not pay interest, it pays dividends. Thus the “formally dividends” caveat.
make any sense?
May 3rd, 2009 at 2:46 am PDT
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IA — yeah, that’s pretty much what I have in mind, except for the main tripwire is going into arrears on the cumulative preferreds. (but as in the response to Alex R, there might be secondary tripwires too.)
there’s very little new under the sun, or at least very little that issues from my mind. mostly this idea tries to put together a bunch of pre-existing elements to come up with something that both firms and investors would treat (and price) as near substitutes to traditional debt, but that would let debt-to-equity conversions happen gradually rather than by provoking discrete, disruptive bankruptcies.
May 3rd, 2009 at 2:52 am PDT
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SRW,
Makes sense. You typed formally. I typed formally. I saw formerly. Smart me.
May 3rd, 2009 at 8:41 am PDT
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Here’s a potential twist. Within a particular class, the dividend due dates could be staggered (say each holder was due dividends twice a year, there could be 100 different due dates in the first half of the year and 100 in the second half). This way, there could be no gaming by short sellers or management right before a due date. It could lead to a more gradual conversion process as only certain holders would have been defaulted on, and perhaps this partial conversion would be a sufficient change in the capital structure to make the firm viable again
May 3rd, 2009 at 9:46 am PDT
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“I appreciate your trying to “game out” what investor behavior would be if these things were real. i certainly think that you are right: to the degree that stock investors anticipate a nonpayment, they should short common (and potentially buy the preferred). shorting prior to nonpayment helps preferred shareholders (by increasing their conversion ratio) and harms common equity (and, if incentives are aligned, current management). so managers would want to try very hard to avoid a situation where they are forced not to pay when investors anticipate the nonpayment. instead, they ought to skip dividends preemptively. if they surprise the market, a sharp ex post price drop will put the preferred conversion option out of the money. by doing so, they can conserve cash, and limit the dilution dramatically. (if the firm is clearly a going concern and the nonpayment is precautionary, many pseudo-debt investors might hold through the cure, and not dilute at all. those who do convert would do so at the prenegotiated discount to a still healthy stock price, limiting the damage.)”
In my defense, I’m reading this Sunday morning. I don’t follow this paragraph. I thought your preferred idea allowed for flexible conversion values at a slight discount to whatever the common price is at conversion. If so, I think the short the common/convert would be the likely scenario.
As to surprising the shareholders by pre-emptive non payments, that sounds very unsettling to me and a real non-starter from an investment standpoint.
From the buy side, there is a tremendous need for stable, contract specific, bonds. I think a lack of these securities created the derivatives boom. Reducing even further the availability of securities that satisfy this real world need seems to be a classic “tail wags dog” mistake.
But who knows.
May 3rd, 2009 at 11:42 am PDT
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While these Yak-pee securities are tempting, I think the new General Obligation Amortizing Taxable Preferred Interest Swap Securities are a better investment. And the Treasury’s new Retroactively Appreciating Tranched Floating Universal Credit program promises to be a great deal for investors.
May 3rd, 2009 at 6:46 pm PDT
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How would this be considered? As a material credit event? Or could they somehow bypass that? I think you have to remember that firms are very unlikely to stop payments on preferred unless they are in death mode already. They don’t want to lose access to the capital markets. Also, remember, the big issue now is financials, and they couldn’t use these. By and large they need to be AA to survive.
May 3rd, 2009 at 7:41 pm PDT
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bill — i like that idea, and am trying to think along those lines. in some sense, the trouble is that a nonpayment is a discretionary discontinuity, like a bankruptcy. so it invites a lot of gaming, and conveys a lot of information. any means of “gradualizing” the transfer of equity implicit on an overleveraged but viable firm restructuring is helpful.
May 4th, 2009 at 1:00 am PDT
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beezer — i’m also troubled by the exercise early (or exercise very late) scenarios. it creates too much uncertainty. these securities would create incentives for managers to make firms more opaque, so that they could trigger by surprise (or hold off on triggering and maintain a reasonable valuation while looting or gambling away firm value). that strikes me as a very bad thing. fundamentally, there’s an inconsistency between wanting to penalize equityholders in favor of IACCPE holders but leaving the triggering event at the discretion of firm management. putting aside agency issues, why would equityholders consent to penalizing themselves unless their straits were very dire? so this proposal needs some work. i think there may be small tweaks to fix it (by making the conversions both less punitive and less discretionary on the part of management), but maybe not. i’ll try to have more to say soon.
i will take issue with this, though:
the trouble is is that tremendous demand for something doesn’t mean it’s a good idea for it to be supplied. that there was tremendous demand for safe, simple debt meant that firms could fund themselves extraordinarily cheaply (and take tax shelter to boot) by overleveraging. managers who were cautious about leverage and distress costs produced poor short-term outcomes than those who were adventurous, so firms (not all, but financials and PE targets) often found their way to those willing to give the people what they want, despite the fragility it created.
the purpose of this proposal is to invent a kind of soy-milk, something not quite as tasty as the real thing, but that is close enough to an item for which there is a great deal of pre-existing demand that it can mostly substitute, but do so with fewer adverse side-effects than heavy cream. some forms of synthetic debt certainly did turn out to be worse than the real thing (although CDOs and the like hurt investors, which is less damaging systemically than overleveraged firms… unfortunately overleveraged firms often were the investors.) but that doesn’t mean it’s a bad idea to try to find a safer replacement for debt, which is associated with hardening of the balance sheet and systemic cardiac arrest.
May 4th, 2009 at 1:16 am PDT
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James B — i’m very excited to read the prospecti of thise securities. for the second one, i’d really like to get a look at the marketing video.
May 4th, 2009 at 1:18 am PDT
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JoshK — i think the world would and will have to adapt to a world where credit events and credit-agency ratings don’t have the same significance in the future as they did in the past.
if securities like this became prominent, the meaning of a nonpayemnt of dividend would have to be worked out by experience, and how participants in side-contracts based on firm credit treated it would be something for those side-contractors (and their regulators and/or clearing houses) to work out.
it’s an occupational hazard in finance that fragile ephemeral things get written into contracts as if they were fixed, permanent and reliable. the fed used that to screw consumer lenders in the early nineties, by adversely changing the definition of the prime rate out from under them. what if LIBOR stopped being calculated, or was dramatically changed? people who unwisely based contracts on unreliable indices would have to find a way to adapt. the present proposal suffers from the same flaw, in that it depends on continuously quoted stock prices. what if a firm is delisted? what if we collectively decide that overmuch liquidity breeds bubbles, and transact stocks only in occasional auctions (a case can be made)? securities like this, if they grew popular, would change the credit ecosystem, and the ecosystem would have to adapt. (but proposers of such securities ought have some idea of what the eventual new equilibrium would look like — i’m taking a blogger’s cop-out a bit, because this proposal is very green, and there’s lots i haven’t completely thought through.)
re financials, these securities are absolutely intended to sit in the capital structure of financials. this proposal needs to be “fixed”, it’s got some clear problems. (i thank commenters for thinking them through with me!) but if there is a way to fix the proposal, so that nonpayment/conversions are seen as often successful means of evading defaults higher in the capital structure rather than as precursors to inevitable “hard” default, then they would be very appropriate for financials. governments could withhold bailouts and let these securities turn into common equity (or something with no cash-flow obligations before a solid turnaround, if left unconverted). if these securities do substitute for debt in capital structures, which is the intention, it is possible that even quite troubled banks could recapitalize via a gradual transfer of ownership sufficiently to leave depositors whole, and without external funds. (the losses would still have to be borne, of course, but they’d be borne first by common equity and then by holders of these junior securities, in a gradual and automatic process.)
inserting these bonds into capital structures would improve the credit rating of firms with respect to whatever debt sits above it, since this would be junior-to-debt preferred equity. for the purpose of having a good credit rating, firms should want a lot of this, just like they should want a lot of other forms of equity. again, the hope is that this would substitute for debt, so that firms would end up much less leveraged above the magic debt/equity barrier.
(but for financials, who thanks to deposit insurance and other mischief can often issue debt very cheaply, this kind of thing can’t substitute for regulation to prevent overleveraging. a bank leveraged 30:1 on top of “Yak-Pees” would be just as fragile as any other 30:1 levered firm.)
May 4th, 2009 at 1:40 am PDT
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Hi, interesting post. I have been thinking about this topic,so thanks for writing. I’ll definitely be coming back to your posts.
May 4th, 2009 at 8:02 am PDT
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I think there’s an Islamic structure where the isssuer pays either a cash coupon, or a set number of shares (adjusted for split/dilution/etc) at their option. The idea being that a failing firm would gradually give up control of their own accord, and the bond holders are less exposed to a messy bankruptcy.
Similar idea…
May 4th, 2009 at 8:57 am PDT
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EU: Deutschland wieder Defizitsünder
Europa in der Rezession
Deutschland wird in der Wirtschaftskrise wieder zum Defizitsünder. Entgegen früherer Prognosen bricht Berlin schon im laufenden Jahr mit einer Neuverschuldung von 3,9 Prozent den Euro-Stabilitätspakt, wie die EU-Kommission am Montag in Brüssel vorhersagte.
Im kommenden Jahr drohen 5,9 Prozent Defizit vom Bruttoinlandsprodukt. Europa steckt mitten in der tiefsten Rezession seit dem Zweiten Weltkrieg. Das Heer der Arbeitslosen wächst. Ein leichter Hoffnungsschimmer zeichnet sich für 2010 ab.
Bundesfinanzminister Peer Steinbrück sagte in Brüssel zum europäischen Arbeitsmarkt: «Das macht mir Sorge.» Es sei kein Trost, dass die Lage in Deutschland wegen der Reformen der vergangenen Jahre besser aussehe. Laut Kommission werden 2009 und 2010 insgesamt 8,5 Millionen Jobs in der EU verschwinden. Die Arbeitslosenquote soll im kommenden Jahr im Eurogebiet auf 11,5 Prozent steigen nach 9,9 Prozent im laufenden Jahr. Deutschland schneidet mit 10,4 Prozent (2010) und 8,6 Prozent (2009) etwas besser ab.
May 4th, 2009 at 4:10 pm PDT
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Thomas — Do you know where I could find out more about that structure, what it’s called, how it is supposed to work, whether it has worked in practice roughly as intended or how things have gotten complicated?
Anyway, if you have a pointer, I’d appreciate.
May 4th, 2009 at 9:03 pm PDT
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This sounds a lot like Mark Flannery’s “reverse convertible debentures” proposal, which he laid out in the book Capital Adequacy Beyond Basel: Banking, Securities, and Insurance.
Flannery’s proposal is interesting, even though there’s a 0% chance it’ll ever see the light of day. I’m pretty sure I have access to the book in pdf form, if you’re ever interested. Just shoot me an email.
May 5th, 2009 at 10:46 pm PDT
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EoC — Thanks, a lot. Excellent catch. By the way, an ungated version of “reverse convertible debentures” can be found here.
Flannery’s proposal is very close in spirit to this proposal, except of course that he came up with it years ago, and his proposal is better thought through. In particular, by making the conversion no party’s option, he eliminates some (but not all) of the strategic gaming that might make how these securities perform in the wild difficult to predict.
It’s dealing with gaming that makes this a hard problem. Ideally we want a security that is as simple as debt, except the equity transfer of bankruptcy comes earlier and more in a manner preserves aggregate firm value and penalizes early equity for bad risks. How the pseudominibankruptcy is triggered and how losses are shared so that they fall disproportionately on equity (but still “fairly”) is the key to these proposals. Flannery has done a better job on this than I have, although there are still issues, since the proposal uses a market-price trigger. (To do: find out if anyone has studied market manipulation and barrier — knock-in or knock-out — options.)
Anyway, I want to read the proposal more carefully, and will come back to this soon.
Thanks again. That was a really helpful reference.
May 5th, 2009 at 11:44 pm PDT
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Steve: this has a vague similarity to islamic sukuk convertibles, although they use the structure for different reasons, usually the objective is to convert to equity (via ipo) and if it doesn’t happen then the convert coupon goes up dramatically, which has the same effect as cutting the convert price.
so it is like your proposal a “death spiral” convertible, since the lower the convert ratio is, the higher the delta hedge ratio and therefore the higher the number of shares required to sell to hedge the convert.
the history of these sukuks is not pretty, the largest issuer was rescued by the dubai government and that papoer trade at over 50% yield.
May 6th, 2009 at 7:26 am PDT
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Steve,
It’s an interesting idea that may be good. There’s a lot to think about though, and I haven’t had time to really think through the implications.
By reducing the expected bankruptcy costs (the legal costs, the disruption, etc.) it may lower the cost of capital for the existing shareholders, giving them an incentive to use it.
At the same time, though, complication is costly, and often many of the costs are externalities (In addition, complication costs are often very large and underrated). For example, when clothing companies keep coming up with their own definitions of small, medium, etc., there may be some advantage to them doing it for their own company, but they make it harder for people all over the market to buy clothes, especially online. Government enforced standardization, in many areas, not just clothing sizes, can sometimes substantially increase efficiency and utility.
Another key point is that debt, in of itself, as opposed to equity, can impose huge costs and inefficiencies, and not just bankruptcy costs. Certainly, it’s not something the government wants to favor, and yet it does, greatly, by allowing corporate debt payments to be tax deductible. This is an enormous problem that needs to be dealt with. This deduction should immediately be removed. It would be a fantastic way for Democrats to raise money for high NPV investments.
For more on the problems with favoring debt, see my article, “Supply Side Explanation of the Equity Premium Puzzle” (this doesn’t refer to supply-side pseudo-economics), and Wharton’s Jeremy Siegel’s book, “Stocks for the Long Run”, 4th Edition.
May 16th, 2009 at 7:39 pm PDT
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