The lead up to the financial crisis saw the proliferation of complex financial products, such as colateralised debt obligations (CDOs), that no one was really sure if even the bankers fully understood. Along with these products, debt soared and equity shrunk to the point of collapse.
In the years following the crisis, regulations over the amount of equity a bank must hold have tightened in an effort prevent capital reserves from becoming too depleted again. Regulators prefer banks to have more equity as a cushion should something go wrong. Prior to its collapse in 2007, Lehman Brothers, equity infamously only accounted for 3.3 per cent of its balance sheet.
Despite this, banks are still partial towards debt - debt is cheaper than equity, as charges from creditors are often small, knowing that the banks will likely be bailed out by taxpayer money if things take a turn for the worse. There are also often tax breaks for interest payments that banks would not have with equity.
A new invention – contingent convertible bonds, or “Cocos” – aims to bridge the gap between debt and equity. Here are five thing you need to know about these products…
1. What is a Coco bond?
A contingent convertible bond is similar to a traditional convertible bond in that it has the ability to transform from a bond into a stock or equity once its value hits a certain strike price. When a bank is struggling and equity levels hit a low, Cocos turn into equity, thereby cutting down on the bank’s debt and interest payment. However, this does mean that they loose a great deal of their value.
2. Why is everyone Coco-nuts for these products?
These bonds are a hybrid product between debt and equity. They are a compromise for banks, who prefer debt for its tax breaks and boost to profits, and regulators, who want banks to hold more equity. They act like debt when times are good, and like equity to temper losses when times are bad.
3. Sounds great! What’s the catch?
Cocos will usually only convert from debt to equity when times are rough and the bank’s capital has fallen below a certain threshold. This perceived weakness can cause panic among investors and the bank’s clients. The newly converted shares are also often worth less than the bond the investor originally bought, which can be particularly painful for the bondholder if they are not able to withstand the loss.
4. How many have been issued so far?
About $64bn (£41.7bn) worth of Cocos have been issued globally so far this year - a steep rise from their non-existence a mere five years ago. Big banks are stepping up their issuance, with Credit Suisse expecting at least another $20bn (£13bn) by the end of 2015, and HSBC planning a $6bn (£3.9bn) issue.
5. Can these products really prevent another financial crisis?
That remains to be seen, seeing as these products cannot really be tested for a full blown crisis until a real one occurs. But let’s hope that the banks have done all the stress testing they could before upping their issuance. Every type of Coco bond will carry with it unique risks depending on its underlying asset, so some may be sturdier than others. For the time being, they seem to encourage banks to hold more equity, which will lighten the load for taxpayers in the event of another collapse.