Contingent Convertible Debt

Many commentators have raised the idea of requiring banks and financial institutions to issue contingent convertible debt that can be converted to equity as a sort of pre-set form of re-capitalization in case of trouble.  Greg Mankiw has said that it is his favorite idea in financial regulation reform.  He has pointed to reports that Swiss authorities are going forward with a version of it for large Swiss institutions.  Here is how Mankiw described the idea in a recent NYT column:

MY favorite proposal is to require banks, and perhaps a broad class of financial institutions, to sell contingent debt that can be converted to equity when a regulator deems that these institutions have insufficient capital. This debt would be a form of preplanned recapitalization in the event of a financial crisis, and the infusion of capital would be with private, rather than taxpayer, funds. Think of it as crisis insurance.

Bankers may balk at this proposal, because it would raise the cost of doing business. The buyers of these bonds would need to be compensated for providing this insurance.

But this contingent debt would also give bankers an incentive to limit risk by, say, reducing leverage. The safer these financial institutions are, the less likely the contingency would be triggered and the less they would need to pay for this debt.

I agree it is a good idea.  But I’d like to ask what this would look like from the finance lawyer’s drafting point of view.  Suppose you proposed to do what Professor Mankiw says above.  First off, can anyone point me in the direction of any actual examples of what this is – any examples of convertible bond documents online designed to do this?  Any bond documents for this exist in real life?

Second, what would be the basic functional terms of the bond that would make this happen – what would the triggers be?  And finally, what would be the covenants and protections for, e.g., the regulator, the financial institution, and the bondholder?  What would they want to be protected against, respectively?

For that matter, is there any reason to think that while aligning some interests in controlling leverage, this proposal either creates other unintended perverse incentives, or perhaps creates other kinds of possibly unresolvable conflicts of interest between these three parties (and potentially the existing shareholders as well).  Put on your bond lawyer hats!

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