CHAMPAIGN, Ill. - An old-but-new-again line of hybrid securities could solve the "too-big-to-fail" problem that spawned billions of dollars in unpopular government bailouts to prop up the nation's banking industry, a University of Illinois legal expert says.
But Robert Beard warns that the retooled securities could strain banks instead if Congress approves a proposed regulatory overhaul that would force big banks to sell them rather than letting free markets rule.
He says contingent convertible bonds, known as CoCos, hold promise as a safety net during tough times because they convert from liabilities to equity if a bank's capital ratio falls below a predetermined level, shoring up the bottom line without tapping into tax dollars.
To compensate investors for the risk of losing bond repayments in exchange for reduced benefits as equity holders, CoCos pay higher interest rates than traditional lending, said Beard, an expert in finance and securities law who has studied convertible debt instruments for more than two years.
But he says those rates could soar if the government requires big banks to sell CoCos, included in a sweeping financial overhaul bill that was narrowly approved this month by the House and now heads to the Senate.
A mandate would flood the market with CoCos, and investors would know banks have no choice but to sell them, driving up the 1 to 2 percent premium that the bonds likely would carry otherwise, said Beard, a visiting professor in the U. of I. College of Law.
"To attract investors, banks would have to pay such high interest rates that it would actually harm them," he said. "So much of their earnings would be wrapped up in interest that they would be severely constrained in their ability to run their businesses, to expand and to explore new opportunities."
Beard predicts CoCos will sell without government mandates. Banks know that future government bailouts are unlikely, at best, and CoCos have emerged as a promising alternative to get banks through another market meltdown.
"I think it's infeasible that government could bail out banks if markets collapsed again in the next few years," he said. "The man on the street would be so incensed by another round of bailouts that it could cause serious political problems. If the electorate finds out the problem hasn't been fixed, incumbents are going to be in trouble."
Along with injecting equity to carry banks through tough times, Beard says the bonds would restore a watchdog function to keep banks from drifting into financial peril.
Bondholders have less incentive to police banks if they know government will step in with bailouts to save institutions considered too big to fail, he said. With CoCos, though, bondholders have a big stake in a strong bottom line because distress could slash their income, he said.
"Bondholders would do everything in their power to make sure their bonds aren't converted to equity," Beard said. "CoCos would realign incentives so bondholders actually do the policing they should be doing."
The bonds, which have been endorsed by Federal Reserve Chairman Ben Bernanke and other top regulators, first surfaced in 2000 as a tool to help companies raise capital inexpensively, he said.
Then, bondholders accepted lower interest rates in exchange for the right to convert to equity at discount rates if stock prices reached prescribed thresholds. The bonds became widely popular, but virtually disappeared when a change in accounting regulations required companies to factor bonds into per share earnings estimates at the time of issue.
Lloyd's Banking Group of Britain is the first financial institution to use the latest incarnation of CoCos, receiving broad support for a recent offer to convert existing bonds into the revamped securities.
But Beard says Lloyd's success is a faulty barometer for how CoCos might fare in the U.S. because bondholders faced receiving no interest for two years under terms of a government bailout, but will get 1 to 2 percent interest by switching to CoCos.
He expects U.S. banks to begin issuing CoCos in early 2010, before the Senate wraps up debate on the proposed financial overhaul, and also expects a good response from investors.
"If the market can show that CoCos can be issued and sold without government intervention, that will provide an indicator that CoCos will work fine without mandates," Beard said.
"At this point, I don't think a lot of people know what a CoCo is," he said. "It's going to take some explaining, but the more people learn about them the more they're going to see some real potential."