CoCo bonds (contingent convertible capital notes) are a form of hybrid security that automatically converts into equity at a pre-set trigger (for example, when the issuer’s core capital falls below a certain level) at a predetermined price. What differentiates CoCos from other convertible bonds is that the trigger is a regulatory measure. CoCos were designed to avoid the difficulty that arose during the financial crisis, when banks that had issued hybrid securities faced the anger and panic of investors when the issuing bank or its regulator tried to take steps to convert them to equity.
CoCos were first offered by Lloyds Banking Group in the U.K. in November 2009. The trigger for conversion to equity was if Lloyds’ core tier one capital falls below 5 percent, the bonds convert to equity.
CoCos were at first hailed as a welcome replacement for hybrid securities, which were much criticized during the financial crisis. Wall Street executives and the Federal Reserve were reportedly in discussions in the fall of 2009 about developing a model that would work for U.S. banking institutions, and the New York Fed President stated publicly that an instrument such as a CoCo bond “seems to hold real promise.. If these contingent capital buffers were large .. then the worst aspects of the banking crisis might have been averted.” A bill was introduced by the Senate banking committee calling for banks to issue “long-term hybrid debt securities that will provide them with capital during a systemic crisis so failing institutions can provide their own life support.”39
However, investors and regulators have also expressed concerns that since these bonds would convert into equity at a time when the bank’s share price is likely to already be under pressure, the very act of converting could create turmoil. CoCos have been called “equity time bombs” and some critics have made the comparison with so-called “death spiral convertible” bonds, used in Japan in the early 1990s. In Japan, the expectation of a large amount of debt converting into equity accelerated share price declines and created investor panic.40
In the U.S., S&P has warned that while CoCos are a partial answer, they would not replace the need for banks to raise permanent capital through traditional forms of tangible equity. In February, Moody’s announced that contingent capital notes will "almost certainly" not be considered investment grade regardless of the issuing bank's strength. Moody's said ratings would depend on the predictability of the events that could trigger a conversion.41
In March 2010, French Bank BCPE sold €1 billion in tier one hybrid notes, saying that they expected the notes to be “grandfathered” in any new capital requirements enacted as a result of the Basel II recommendations. Also in March, Rabobank announced that it will begin marketing a new form of contingent capital that could serve as a template for other banks as well. Since Rabobank is a co-operative, it is not able to issue instruments that convert into equity. Rabobank’s notes would be treated like normal notes unless the bank breached pre-set ratios, at which point the value of the notes would be written down by 75 per cent and the remaining quarter returned to investors. Rabobank would be the first to use this type of “write-down” feature.42
The Basel Committee on Banking Supervision is currently reviewing criteria for tier one capital, including the role that contingent capital, convertible capital, and instruments with write-down features should play in a regulatory capital framework, and has indicated that it will discuss “concrete proposals in this area” at its July 2010 meeting.43 Therefore, as of the date of this article, the industry is waiting for further guidance from the Committee.
Covered bonds “could be the ticket to the return of U.S. residential-mortgage securitizations.”44 These bonds are common in Europe and serve to facilitate mortgage financing in a manner similar to a securitization of mortgages. Unlike a securitization, however, the lender that originates the mortgages continues to own the mortgages, and the covered bonds sold to investors are backed both by the mortgages and by the originating lender. Thus, the lender has 100% “skin in the game.”
Covered bonds are issued by the entity (usually a bank) that owns the mortgages. In Europe, there are specific laws that give covered bondholders statutory priority to the cover pool of assets (the mortgage loans) if there is a default under the indenture. However, this structure does not work in the United States because there is no legislation in place giving bondholders a priority in the event the issuer (the bank) becomes insolvent. There is currently a push to enact such legislation (see discussion below). In the meantime, covered bond structure in the U.S. is two-tiered: a special purposes vehicle (SPV) is the issuer of the covered bonds, and the SPV uses the proceeds of the bonds to purchase mortgage loans from its affiliated bank. The bank issues mortgage bonds to the SPV and pledges the mortgage loans as collateral. The mortgage bonds are pledged to the mortgage bond trustee, for the benefit of the covered bondholders, to secure the covered bonds.45
Covered bonds will not be accelerated even if there is a default under the applicable indenture and the collateral is insufficient to cover principal and interest payments on the covered bonds. At the time of issuance, the issuer enters into a guaranteed investment contract (GIC) or similar agreement. If a default occurs under the mortgage bonds, then the covered bond indenture trustee, on behalf of the covered bondholders, deposits all payments from the loans in the cover pool with the GIC provider for investment. If there is a default under the covered bond indenture, the covered bond trustee liquidates the mortgage pool. The liquidation proceeds are then invested under the GIC and the proceeds of the investment are used to make all payments due on the covered bonds through maturity.46
Both the Federal Deposit Insurance Corporation (FDIC) and US Treasury Department have issued guidance intended to promote covered bond issuances in the US. The FDIC issued a Final Policy Statement to clarify for investors the circumstances under which the FDIC will grant consent to expedited access to pledged covered bond collateral. The Treasury Department has published Best Practices for US covered bonds, designed to work in conjunction with the FDIC’s policy statement.47
Representatives of the securities industry have pointed out that regulatory guidance is not certain enough to promote an active covered bond market, and they have urged Congress to enact legislation which would establish definitive rules similar to the ones in place in Europe, in order to clarify the covered bondholders’ first claim on the pool of mortgage loans securing the covered bonds. The industry points out that the covered bond market could play an important role in restoring liquidity to the market, and the types of loans that could be included in the pool include not only home residential loans, but also commercial mortgage loans, student loans, auto loans, credit card receivables, municipal and state obligations, and small business loans. At a hearing on covered bonds held by the House Financial Services Committee in December, one consultant testified that there are $21,513 billion of loans in the U.S. that could potentially be funded by covered bonds. Congress is expected to take up the issue again in 2010.48
The Securities Industry and Financial Markets Association (SIFMA), a group of more than 650 securities firms, banks and asset managers, has undertaken initiatives to support the growth of the covered bond market in the United States. In January 2010, Canadian Imperial Bank of Commerce sold $2 billion of covered bonds, and bankers hope that this will set the ground work for further covered bond issuance.49
Build America Bonds (BABs) and Recovery Zone Bonds (RZEDBs)
Build America Bonds (BABs) were created by the Obama Administration’s 2009 stimulus package enabling state and local issuers to issue bonds to finance infrastructure projects. The bonds are taxable, and issuers receive a 35% federal tax subsidy on their interest costs. Since the program began in April 2009, $78 billion worth of these bonds have been sold, and the financial press has described this as a fast-growing and significant business for Wall Street.50
One of the largest deals was a $1.3 billion Build America Bond issued in October to rebuild the San Francisco-Oakland Bay Bridge and make it earthquake-resistant. The Municipal Electric Authority of Georgia recently announced that it plans to sell BABs in the amount of $2.5 billion to finance what could be the first new nuclear reactors in the US in more than 30 years.51
By the end of this year, bankers estimate that as much as $150 billion more of the bonds will be sold, comprising more than one-third of the municipal bond market. Under the President’s 2011 budget proposed in February, the Administration proposes to make BABs permanent, to extend eligibility beyond local governments so as to include private non-profit entities, and to reduce the interest subsidy to 28% from 35%.52
Recovery Zone Bonds in an amount up to $10 billion were authorized by the American Recovery and Reinvestment Act signed into law in February 2009. Each state is allowed at least 0.9% of the total allotted amount. The bonds must be issued by the end of 2010, and may be issued only by qualified counties and municipalities. To qualify, the project must be constructed, renovated, or purchased after the area was designated as a recovery zone. Issuers receive a 45% federal tax subsidy on their interest costs.53