Gillian Tett has an article criticizing the idea that CoCos — contingent convertible bonds — will solve the “too big to fail” problem. (And yes, she calls it “too big to fail,” even though Gillian Tett of all people understands what interconnectedness means.)
Contingent convertible bonds, a.k.a. contingent capital, are the latest fad to hit the optimistic technocracy in Washington and London. A contingent convertible bond is a bond that a bank sells during ordinary times, but that converts into equity when things turn bad, with “bad” defined by some trigger conditions, such as capital falling below a predetermined level. In theory, this means that banks can have the best of both worlds. They can go out and borrow more money today, increasing leverage and profits (which is what they want). But when the crisis hits, the debt will convert into equity; that will dilute existing shareholders, but more importantly it means the debt does not have to be paid back, providing an instant boost to the bank’s capital cushion. In other words, banks can have the additional safety margin as if they had raised more equity today, but without having to raise the equity.
Tett is skeptical for all sorts of reasons — defining the trigger point (remember, Bear and Lehman were well-capitalized on paper when they collapsed), finding people willing to buy these things, the impact on the market of triggering a conversion, etc.
I’m skeptical for a more basic reason. Contingent capital, like any other type of capital requirement, assumes that we can predict in advance how bad the crisis will be and therefore how much capital will be necessary to avert a bank-killing panic. That means we have to be able to predict (a) just how fat the fat tail is, based on virtually no data points, and (b) how panicked people can get and for how long. That seems to me technocratic hubris of the first order.
So why is contingent capital so popular? (It’s even mandated by section 107(b)(1)(D) of the Dodd bill.) Well, the people don’t matter don’t listen to me or to Gillian Tett. Here is Tett’s explanation:
“Even amid all those hurdles, the CoCo idea currently has many fans, not just among investment bankers touting for business, but some western regulators too. The reason stems from a big, dirty secret stalking the financial world: namely that while global policymakers have spent a year wailing about the ‘Too Big to Fail’ problem, they have hitherto done almost nothing tangible to remove that headache in a credible manner.”
Tett says what we need is a cross-border resolution system for bank failures. I’m a little skeptical of that too, for reasons I think I’ve outlined elsewhere. In case I haven’t, this is the problem: When push comes to shove, would the U.S. government use whatever “resolution” powers it has to take over JPMorgan Chase or Goldman Sachs against its will (or let an international body do so)? Leaving aside the issue of political connections for the moment, the political hit it would take from the right (SOCIALISM!!!) would make the health care debate look like a friendly game of flag football. If we can’t even get meaningful derivatives regulation in 2009, what makes us think that any government would have the political capital to take over one of America’s biggest banks when it needed to? More technocratic hubris.
But I agree strongly with Tett on why contingent capital is suddenly so popular. Policymakers in Washington are looking for something, anything that will allow them to declare victory over the TBTF problem — without having to break up the banks. The idea that any clever regulatory scheme we come up with today, which by definition will be untested, can be counted on to come through in the next crisis seems hopelessly naive to me. I think it would be more honest to admit that there are really only two choices:
- Break up any institution that is too big to fail.
- Leave them in place (because “big companies need big banks,” or whatever other nonsense justification you want to use) and admit that we’ve done nothing to solve the TBTF problem.
That’s the real choice.
By James Kwak
The Baseline Scenario 
If we arrange the chairs in such a manner that they are on the opposite side of the ship from where the collision with the iceberg occurs, our financial engineers assure us such a collision would not be a material event.
Cheers,
Carson
You nailed it. This is all vanity and misdirection, just ideologically-compelled Rube Goldberg device-building, all in order to prop up an unsustainable and evil but politically powerful thing.
There’s only one way out, break up the big banks, and everybody knows it.
How much one acknowledges and advocates it is a measure of how free one is of selfish interest and fanatical ideology.
the political hit it would take from the right (SOCIALISM!!!)
As I recall, more Democrats than Republicans voted for the TARP. By a 2:1 margin, in fact.
And thus far, I have seen less than zero will from the current Administration to tackle “too big to fail”. Are they part of “the right” that you are worried about?
I realize you have it wired into your brain that the world would be perfect if only those Neanderthals on “the right” were not standing in the way of “progress”. But in the case of bailouts and financial reform, the facts in the real world belie that narrative. Do you really think Chris Dodd and Barney Frank would support seizing JPM or GS under any circumstances whatsoever? Please.
In short, this is not a partisan issue. When you keep trying to make it into one, you are alienating half (or more) of the people who would otherwise support you.
James,
A few questions come to mind if the Feds are going to take down the big five:
• What is the impact on the economy? Will the bankruptcy of the big banks, ( can we say for discussion purposes that without government support the big banks are bankrupt at this point?) proceedings cause a collapse? or Panic?
• Who will preside of over the proceedings? Will it be Obama and his cronies presiding and using the banks for their own purposes like they did with GM and Chrysler? Or will it be a truly neutral party following statutory procedures?
Bankruptcy proceedings are not socialism. It’s only when the government and this Administration refuse to use the procedures already in place in order to save the butt of some their cronies, does the Right get upset. The Average Joe on the Right, and probably the Middle and Left as well, will likely say at this point ” let “em fail”. No more bailouts!
This is not that hard. My only concern, if done properly is what is the fallout?
Tett brings up an excellent point on the contingent capital. Cross-border resolution is the DUMBEST idea I have heard on this issue yet.
My question is this: How can Tett be smart enough to bring people’s attention to contingent capital (no joke that is a public service), and yet DUMB enough to believe in cross-border resolution??? Obviously certain parts of Tett’s brain function better than other parts.
“ideologically-compelled Rube Goldberg device-building, all in order to prop up an unsustainable and evil but politically powerful thinga”
Sounds exactly like health insurance reform, where Democrats and “progressives” are happily declaring victory as well. Yay!
Yep. Obama whipped for TARP, too, let us remember. He was by no means a passive bystander.
… and then AIG Financial Products and the hedge funds started selling “Capital Conversion Swaps.”
First off, when push came to shove the US govt did seize AIG. We know we know Uncle Sam, John Bull, Marianne et al will do it because they have. It’s a sure bet. Call it whatever you want — socialism, averting the apocalypse, whatever — it is the reality. Here in the US, the banks and two remaining investment banks — those guys who were given the midnight conversion to commercial banks so they could borrow directly from the Fed at flat (i.e., zero interest charge) — just have to make sure they have the right people in place to pull it off again. If so, they all can issue CoCos.
The necessary and sufficient condition for issuing CoCos is the certain knowledge the failed institution (or the institution on the brink of certain failure) will retain the full faith and credit of govt support for its risk-taking activities when it faces collapse again. That these risk-taking activities are no longer banking qua banking — trading derivatives with other failed institutions supported by the full faith and credit of the various federal agencies hardly qualifies as banking — is of little consequence. A massive concentration of real risk has been created that must have the illusion of support.
CoCos are the perfect form of capital for the institutions we have now. What we’ll end up with is a handful of artificial banks supported by artificial capital. This handful of handful of “banks” are and will continue to be the black hole of systemic risk. They dwarf all other financial institutions in terms of their risk to the system. And they know, as we all know, they will not — indeed, can not — be allowed to fail. The only real requisite here is these institutions create the artifice of integrity (structural, that is … the other kind is long gone). None of these guys could ever afford the true cost of the call on their debt + the put on equity embedded in these CoCos. That is indeed a fat tail investors would be trying to price. In fact, it is the entire distribution. Such hybrid risk can exist only with government support. Without the certain knowledge the equity an investor will surely be left holding is in an institution supported by the full faith and credit of the federal government — explicit or understood — none of this paper could be issued.
CoCos are the perfect vehicle for the markets that have evolved out of this crisis. We’ve entered an alternative universe in which the vocabulary and mathematics from an earlier era is being used to describe something it cannot subsume. These are derivatives of contingent exposure that have no coordinates. CoCos correspond to nothing real or tangible. However, the concentrations of risk at which they’re being directed are massive — not unlike a collapsing star.
I don’t think CoCos are the answer, in themselves.
What’s obviously needed is an array of derivatives based on CoCos, and then derivatives based on those derivatives.
And then, we eliminate the US dollar, and subsititute CoCo basket derivatives as currency. That should eliminate any problems in the future.
The problem has been that people can still understand the concept of “value”, and if we make things so complicated that the value can’t be in any way understood or metered, then how can anything become de-valued, as happened?
There, and my degrees aren’t even in economics.
Yup. Health care reform is very simple: single payer.
But where they’re ideologically compelled to prop up the insurance racket, they’re driven to all the idiocy and policy violence we’ve seen.
But try telling them the lessons of the banks, that you can’t regulate entrenched rackets. Hoo boy.
would someone explain to me how breaking the biggest banks will work if the broken pieces still all engage in the same dangerous behavior.
Won’t they all then morph into forming a solid block of insolvent institutions? h
I think you’re right. On this issue, at least, it’s a congealed elite vs. much of the people.
(Here Obama gets his beloved “bipartisanship” in spirit if not in crossover votes.)
Gillian Tett “of all people” understands interconnectedness? Why? Based on her vast experience in banking?
But I guess if some ex-management consultant can be considered an “expert” on finance, a journalist can be a finance expert too. After all, the two of you have a combined total of 0 years of experience in the financial industry! It’s a cute little world you guys inhabit.
(Speaking of fads: Gilliant Tett. She mangled the description of even basic structured products in her book, and yet somehow she’s considered an authority on structured finance? Oh please.)
I wonder what kind of financial sector would a technocracy have since physical efficiency and cost efficiency are often mutually exclusive.
What about derivatives of derivatives’ derivatives??? We need to spread and balance out the risk on those derivatives’ derivatives!!! And also we should create a derivative based on the annual number of Op-eds Jamie Dimon gets in major newspapers.
I challenge James Kwak and Simon Johnson — the two most relentless advocates of the ridiculous “breaking up the banks” idea — to address the fact that both Continental Illinois ($40 billion in assets) and LTCM ($80 billion in assets) were considered “too big to fail” and were bailed out. Are we going to force the banks to shrink to below $40 billion in assets?
If Continental and LTCM were TBTF, what good would it do to break Goldman up into four separate $250 billion institutions? That “policy proposal” (and I use that phrase loosely) from Simon Johnson is based on the fact that Goldman had around $250 billion in 1998 — but he fails to address the fact that Goldman was TBTF back in 1998 too! What a joke!
Neither Kwak nor Johnson can or will address these incredibly simple objections to their so-called “proposals,” because they’re not interested in having a real debate on TBTF. They’re just interested in being quoted in the press and having the rest of the blogosphere worship them.
If you’re not willing to offer a concrete proposal, or to address blindingly obvious problems with the “break up the banks” idea, then shut up.
p.s. James — if you can’t think on a much more granular level than this, then you’re going to have a very tough time getting a job at a good firm when you graduate. Just FYI.
This may surprise Ms. Tett, but all unsecured corporate debt in the United States is “contingent convertible.” So long as the debtor has access to Chapter 11, a judge can modify its capital structure by cramming down debtholders.
Anyone holding the bonds of a bank holding company should be aware of this risk. It is exists now, it existed in September 2008, it existed when Continental Illinois went down. That the government refused to use an existing system of resolution designed specifically for the contingency of excessive debt should give some clarity on the government’s willingness to do so in the future.
Shareholders in big finance companies were not given billions of federal gifts because the federal government was bound to do so. They were given the gifts because the federal government chose to do so. It had plenty of other options. An alternative to the bailout regime needs to find a way to avoid the government making the choices it made, not to introduce yet another alternative it will not choose.
I agree with the idea that breaking the big banks will not solve the TBTF problem as this is a problem with financial instruments. However, it will make it harder for big banks to influence the government.
just a thought….
TBTF = Too Big To Fail.
But wouldn’t it be more appropriate to take out the Too and To from the acronym to make it into…
BF = too Big to Fail
…thereby hightlight BIG and FAIL?
Just a thought…
For non bank firms all debt is contingent – if the firm declares bankrupty the orginal shareholders are wiped out and the bond holder’s debt is turned into equity.
This does not work in the finanical servers sector because if a firm declares bankrupty it becomes worthless immeadiately because of the nature of how how banks work.
This puts the government is an impossible situation where they either have to bailout bond holders or let systematically important firms fail, taking out the economy with them.
Contingent capital greatly increases the government’s ability to make debt holder pay for some or all the the bailout, and really just makes bank failures equivalent to non-bank failures.
“Contingent capital, like any other type of capital requirement, assumes that we can predict in advance how bad the crisis will be and therefore how much capital will be necessary to avert a bank-killing panic. That means we have to be able to predict (a) just how fat the fat tail is, based on virtually no data points, and (b) how panicked people can get and for how long. That seems to me technocratic hubris of the first order.”
Not to disagree with you about hubris, but any investment in equity is a guessing game.
Now, we already have bonds that can be converted to equity — at the choice of the bondholder. They have markets and prices. People believe, rightly or wrongly, that they can evaluate them. If we have bonds that can be converted to equity at the choice of the issuer, that choice is worth something, and presumably such bonds will have markets and prices, as well. People will believe, rightly or wrongly, that they can evaluate them, too. (After all, markets self-correct in the long run, right? {hehe})
Now, CoCos are not simply convertible at the choice of the issuer, so they should be worth more than bonds that are. There should be markets and prices for them, too. :)
Consider the alternatives. First, if the issuer goes bankrupt, bondholders lose a lot of money, as a rule. They get pennies on the dollar. If their bonds have been converted to equity, they lose everything. OTOH, if the conversion of their bonds manages to save the issuer, they will do better, and may do better than if they held regular bonds and the issuer went bankrupt. Second, if the issuer is bailed out, from the point of view of the society, better that the bondholders do the bailout than the taxpayers, and if the taxpayers do a bailout, better that the bonds are converted to equity.
Yes, the buyers of CoCos may be fools, but better that they take on the risk privately than socializing it. :)
“First off, when push came to shove the US govt did seize AIG.”
‘Scuze me, wasn’t it the other way around?
;)
dk: “For non bank firms all debt is contingent”
Precisely. The solution to JK’s concern (“we can’t predict in advance how much capital will be necessary to avert a bank-killing panic”) is to require that all bank debt — aside from deposits — is convertible.
I think the two choices are a little more stark:
1. The nation is the only institution that is too big to fail.
2. The nation has failed.
Hear, hear!
Russ seems to have it pretty much on the money with a nice phrase to boot.
Are you sure that Tett’s brain is not hardwired to his pocket book?
Taunter hit the nail on its head.
Who’s going to buy these things? They increase risk and decrease return.
The only people to profit will be the first one out the door when the building starts crumbling.
What a sad obfiscatory solution to the tight capital problem existing in the entire banking economy, but especially in the big boys. Sure, let’s let them solve their problem with what I believe will become the master smoking mirror. God save us, if not Him, who (and I don’t even believe, for God’s sake!!)?