The principal issue that bank regulators have raised concerning structured notes is that the securities are difficult to value. This valuation difficulty makes it challenging for the banking agency that serves as the resolution authority to effectuate an orderly resolution. What if the structured notes were not difficult to value and had an agreed-upon or stipulated value upon a resolution?
This may seem an unusual suggestion, but in many cases, it would not be a dramatic change. An indenture for debt securities provides that the principal amount of notes will become immediately due and payable upon an acceleration of maturity upon the occurrence of an event of default, such as a voluntary or involuntary bankruptcy of the issuer. This provision works well in the case of a fixed or floating rate note, where the amounts due and payable are easily ascertained.
Because the amount of principal to be paid at maturity for many structured notes may be uncertain, and, consequently, the principal amount to be paid at acceleration is also uncertain, some structured note issuers have defined a “default amount.”
Under this approach, upon an acceleration, holders would receive an amount equal to the cost of having a qualified financial institution expressly assume all of the issuer’s payment and other obligations with respect to the notes as of the date of acceleration and as if no default or acceleration had occurred, or to undertake other obligations providing substantially equivalent economic value to the holder with respect to its notes, less the costs to such institution for the assumption. Qualified financial institutions, which are highly rated U.S., European or Japanese financial institutions, would submit bids to assume the notes. The concept behind the default amount is that, during times when the markets are volatile, a truer value for the accelerated notes would be obtained by using an unaffiliated financial institution’s valuation, subject to objection to that valuation by the holders. Needless to say, it is likely that the default amount would be less than the principal amount of the notes. Mechanically, the default amount process generally works like this:
- If there is an acceleration, the note goes out for bid by a qualified financial institution;
- If any bids come in, the lowest amount will be used;
- The bid period starts on the day the acceleration amount comes due and continues for three business days;
- If there are no quotes, or all quotes are objected to by an objecting party, then the bid period extends until the third business day after a new bid is obtained; and
- The objecting party must do so in writing, in which case the bid will be disregarded.
If objections continue until the final valuation date, then the default amount will be the principal amount. In other words, if the note holders and the qualified financial institution(s) cannot agree on the value of the notes, the principal amount will be the amount due upon acceleration. The default amount method presents holders of accelerated notes with a choice. If bids are too low, holders have the option of objecting until the final valuation date in order to get the principal amount. If bids are not so low and the final valuation date is far in the future, the holders will need to consider the time value of money in deciding if it is worth it to continue objecting to the bids.
Of course, this default amount concept as currently used would not be practicable in the case of an orderly resolution, which is intended to take place quickly over the course of a weekend. However, inclusion of the default amount in a substantial number of outstanding structured notes seems to suggest that market participants accept in principle the notion of a stipulated value being ascribed to their structured notes upon the occurrence of a default.
Taking this a step farther, what if structured notes included a “resolution amount” or a “settlement amount” that was a stated amount that would be paid to the holder of the note in a resolution? This would provide certainty for the resolution authority. An investor in such a structured note would not be in a position very different from that of a holder of a contingent capital security or even than that of a holder of a fixed rate note of a G-SIB.
Issuers of structured notes that are G-SIBs have a number of other issuance alternatives available to them. They can offer market-linked certificates of deposit. They can offer structured notes that are issued by their subsidiary banks or by their bank branches. They can establish finance subsidiaries or subsidiaries that are capitalized and have these subsidiaries issue structured notes that are guaranteed by the parent bank holding company (provided that the guarantee does not provide for payment acceleration upon the failure of the bank holding company). They can continue issuing an array of rate-linked notes. Why not add to the possibilities a fixed resolution amount structured note?