How to avoid using tax payers’ money and maintain optimum capital structure to maximize shareholders value?

Every organization or banks main aim or motto is to maximize shareholders value. However shareholders were always concern about financial distress situation where they have to dilute their share to pay debt holders or govt. need to step in and use taxpayers’ money to bail out banks/institutions.

We have faced these kind of similar situation during 2008 financial crisis where billion of $ i.e. tax payers money were used to bail out several banks. How to undo this kind of financial distress situation & avoid using tax payers’ money? One answer to this question is adding contingent capital (coco bonds) in capital structure.

What is contingent capital? Contingent capital is a debt that converts automatically to equity after some triggering event like decline in the market value of equity or capital below threshold limit. Contingent capital is likely to play a very important role in new BASEL III agreement. As per estimate banks need to issue $ 1 trillion of contingent capital to replace existing security that no longer qualified as regulatory capital.

However generally contingent capital (coco bonds) are tied with certain regulatory ratio like capital ratio (core Tier 1 capital), once the banks breaches the ratio then the debt automatically gets converted into equity to avoid financial distress situation. However problem with this concept is that it is regulatory based not market based and it transfers wealth from shareholders to bondholders and kills the main motto maximizing shareholders value (Creating value for shareholders means creating value for all the stakeholders) as conversion takes place at predefined price or at current market rate.

Capital ratios are calculated on quarterly basis and doesn’t provide true market impact of current situation & can’t handle market manipulation properly.

 Mean & Median (Core Tier-1 Ratio in 2008) of 50 major banks (%) 

	March 31	June 30	Sept. 30	Dec. 31
Mean	8.07	8.14	8.16	9.12
Median	7.88	7.92	7.89	9.14

By comparing September 30 ratio with March 31 and June 30 ratio we can hardly make out occurrence of any financial distress situation but market reality was totally different as we saw during the crisis.

COCO bond seems ideal instrument to maximize shareholders value however they are not. In February 2011 Credit Suisse issued a coco bond that gets converted into equity whenever bank’s core tier 1 capital falls below 7%. However regulator can also force conversion if it sees that credit Suisse will need public fund to avoid insolvency. The conversion price was fixed at minimum of $ 20. As per these characteristics this bond seems risky.

First, trigger is based on capital ratio which is an accounting number therefore will be different from the market based measure of financial leverage, especially during financial crisis. Hence, there is no way to predict stock price at the time of conversion.

Second, if the stock price at the time of conversion is less than $ 20 then bondholders will incur significant loss.

Third, the possibility that regulators can force conversion before the trigger is reached creates an additional risk which is difficult to price. Though the bond was successful among retail investor but its base was very limited due to its riskiness.

Better contingent capital should be linked to current market situation and triggers are based on current stock price / market value of asset.

Generally market based trigger are criticized as they create instability. Bondholders has incentive to short sell shares to trigger conversion and at the same time fear of huge dilution makes shareholders sell their share and create death-spiral for a company.

What’s the challenge?

Main challenge in issuing these kinds of debt instrument is that instruments should carry minimum risk so that it can be catered to mass risk-averse investors and simultaneously protecting the motto of maximizing shareholders value. In normal convertible bonds wealth gets transferred from equity holders to debt holders. Shareholders don’t prefer these instruments in company’s capital structure.

What will be the ideal instrument that avoid share dilution, protect the money of contingent bondholders and handle market manipulation or panic perfectly?

CALL OPTION MARKET TRIGGER CONVERTIBLE (COMTC) BOND can be ideal contingent bond that can be issued above 20-30 basis point of risk-free bond and caters to mass risk-averse investors who know they will be paid at the time of financial distress situation.

How does COMTC works?  

COMTC bonds target to risk-averse investors and provides return above normal risk free bond. This instrument carry forced right to get paid at the time of financial distress situation. It carries a conversion trigger point which is less than then current market price. However in order to avoid market manipulation & panic shareholders got pre-emptive rights to buy-back shares from bondholders so that they can avoid any conversion that results from market manipulation or panic. At the same time in order to avoid huge dilution shareholders got the right to issue share (right issue) at the same conversion price and pay back the bondholders and maintain proper capital structure.  As bondholders will be paid back they have no incentive to hedge their investment by shorting the stock when the leverage ratio approaches the trigger point.

Why conversion trigger price is lower to current market price?

Conversion price of COMTC bond should be less than the trigger price. Suppose the market price of $ 10 share will come down to $ 5 during financial distress situation. In this case conversion price of the bond should be fixed at below trigger price say $ 1. We can understand this with an example.

Example:      Senior Debt    –     $ 1000

Equity Capital –   $ 10*7 = $ 70 (7 share with face value of $ 10)

COMTC          –        $ 30

Scenario 1    (Financial Distress Situation) = Market Price $ 5

Conversion Price = $ 5 (Conversion price = Market Price)

New diluted Share price = (6*5+7*5)/13 or (30+35)/13 or 65/13 = $ 5 per share

(Assume that repayment will be made after conversion)

Total Value of Assets = 1000+65 = $ 1065

Shareholders will exercise his option of right issue & pay back bondholder at its par value till the time value of assets is $ 1065. If value goes below $ 1065 shareholders will not exercise his call option and all the value above $ 1000 will be shared between bondholders & shareholders at the time financial distress or bankruptcy.

Scenario 2    (Financial Distress Situation) = Market Price $ 5

Conversion Price = $ 1

New diluted Share price = (7*5+30*1)/ (7+30) or (35+30)/37 or 65/37 = $ 1.76 per share (Assume that repayment will be made after conversion)

Total Value of Assets = 1000+65 = $ 1065

Shareholders will exercise his option of right issue & pay back bondholder till the time value of assets is $ 1037 or market value of share is $1. If the market value goes below $1 or total assets value becomes less than 1037 shareholders will not exercise his call option and all the value above $ 1000 will be shared between bondholders & shareholders.

Thus with $ 1 conversion price, bondholders become shareholder when value falls below $ 1037. With $ 5 conversion they become shareholders when value falls below $ 1065. Lower conversion price clearly reduces riskiness of convertible debt which lowers financial distress and makes the security more marketable among fixed income investor.

How COMTC bonds are different from COCO bonds?

COMTC BONDS	COCO BONDS
COMTC bonds are market triggered bonds that provides true financial leverage	Normally COCO bonds are regulatory triggered bond i.e. capital ratio. Such mechanism are accounting measure and  doesn’t work when company’s capital structure deteriorate rapidly
Regulators can’t intervene as it is totally market based	Regulators are aware that capital ratios are stale, they may be tempted to intervene and pull the trigger themselves and this regulatory risk may difficult to asses, even for major credit rating agency.
COMTC bonds are risk-averse bond, it can easily marketable & cater to mass market.	COCO bonds are difficult to market as investors know that capital ratio doesn’t provide true picture so in order to mitigate risk they demand higher spread however issuer thinks firms financial distress risk is lower and reluctant to pay higher risk premium.

Conclusion

COMTC bonds are risk-averse bond that can be targeted to mass market as it provides assurance that bondholders will be paid at the time of financial distress. These are market related bonds triggered at certain market price or market value of assets. It considers current financial leverage and provides absence of regulatory intervention. All the normal bonds carry tax deductible interest rate and in order to make COMTC bonds attractive it should also be tax deductible. These bonds can be issued by any institutions apart from bank to prevent financial distress situation and maintain optimal capital structure.

COMTC bonds are superior to COCO bonds and one of the best debt instruments to be part of organizations/banks capital structure.

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How to control & reduce “Systemic Risk” to avoid future Financial Crisis?

Systemic risk is very dangerous for economy, as we have seen in last 200 years majority of the financial failure occurs due to systemic risk. In United States’ history from the founding of the republic until 1933 it experienced banking panics roughly every fifteen to twenty years. When the Great Depression struck, it was “in a league of its own in severity” and the banking system near to collapse, government responded with federal intervention into the marketplace including creation of federal deposit insurance, securities regulation, banking supervision, and the separation of commercial and investment banking under the Glass-Steagall Act. This happens because of systemic risk involved in the system where failure of one bank leads to failure of another and every banks are interrelated which causes nearly total banking system failure.

However US govt. followed implicit strategy where they insured and regulated the most systemically dangerous part of the system, the commercial banks, and exercised a much lighter touch elsewhere, leaving the rest of the financial system to innovate, be dynamic, and do everything that markets do so well.

This has worked for US govt. for the next 50 years, they didn’t see any crisis during that period however significant financial failures returned to the marketplace in the late 1980s with the savings and loan crisis, followed by a rash of bank failures in the early 1990s that forced the government to recapitalize the FDIC’s Bank Insurance Fund. Long Term Capital Management, a largely unregulated hedge fund, came perilously close to collapse in 1998, threatening the global financial system. The tech bubble burst in 2001. Accounting scandals destroyed Enron in 2001 and WorldCom in 2002. And the current global financial crisis, the worst since the Great Depression, has yet to run its course.

As the country experienced no major financial crises for the longest period in the history lawmakers not only weakened or dismantled New Deal-era regulations, they also failed to enact new regulations to keep up with financial innovation spurred by technology and globalization of markets. Over time, a huge amount of financial activity migrated away from regulated and transparent markets and institutions and into the lightly regulated or unregulated shadow markets encompassing mortgage brokers, hedge funds, private-equity funds, off-balance sheet structured-investment vehicles, and a booming market in opaque derivatives, especially credit-default swaps. By the summer of 2007, the Treasury Department estimates, the shadow banking system had accumulated assets reaching roughly $10 trillion, equivalent to total assets in the entire U.S. banking system.

While new systemic threats had emerged along the way, there was little effort to regulate them, undercutting the original New Deal strategy of targeting such threats. As a result, the American financial system was left more vulnerable than ever to a major shock.

Today, financial institutions deemed too big to fail already have a huge marketplace advantage – hundreds of billions of federal bailout funds unavailable to smaller firms in financial trouble. That gives big, complex firms a dramatic advantage that is inappropriate.

Since last fall, there’s also an implicit guarantee of government rescue for any firm that in the future may be identified as too big to fail. “What’s worse, these firms impose costs on society by creating systemic risks that they don’t have to bear on their balance sheets.

Implicit strategy has worked for the govt. in the past however it has created a trend where every big company feels that they can be protected by government whatever they do. This makes them to create more systemic risk by spreading their wings beyond the limit in the form of high leverage and overlooking regulated procedures etc.
After the Great Depression & till mid eighties there were not very risky financial innovation due to which even little unregulated environment doesn’t create panic. But after mid-eighties we have seen lot of volatile & risky financial innovations like mortgage brokers, hedge funds, private-equity funds, off-balance sheet structured-investment vehicles, derivatives and securitization etc. which requires healthy regulated environment but lawmaker & govt. always overrule it and these innovations were highly unregulated that ultimately causes biggest crisis since the Great Depression.

In order to protect future of financial market, government should follow Explicit Strategy rather than implicit. Following steps need to be taken-

• First, identify industry/firm/sector that poses systemic risk and then replace unlimited implicit guarantee with government defined limited explicit guarantee for the first time.

• Second, companies that create systemic risk should bear the cost of insuring against it, just as commercial banks pay into an FDIC insurance pool. And the government should insist on appropriate capital standards and liquidity requirements to limit the type of risks that these firms impose on society.

• Third, creating a receivership process would allow an efficient handling of failed companies. It really need to change the perception that no institution is too big to fail. In this process all systemic institutions would get limited support during a period of economic turbulence but if that turns out not to be enough then they are going to be taken into the receivership process and liquidated or restructured.

One thing that we don’t fully understand that the world in which we live right now will continues. It’s one of massive implicit guarantees that are open-ended, we need to be honest about these implicit guarantees, to define and limit them. That’s the purpose of this whole proposal, not to put systemic firms at a competitive disadvantage but rather to prevent them from imposing undue costs on the rest of the financial system.

“Implicit approach enhances systemic risk, Explicit approach controls and reduces”

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How Oil Prices & GCC countries Investment Strategy affects Global Economy?

Oil prices & Oil exporting countries are the major cause of high liquidity & leverage in global economy. Once liquidity overstretched then it creates asset bubble and, crash of financial market. We have seen the same in the last recession when oil price reached its highest level of $ 147.

What is the future of oil prices and how it is going to impact/shape global economy?

As I mentioned oil exporting countries plays a very important role in global capital flow. If oil prices rise then we see huge amount capital flow in global financial market. Apart from this lot depends upon these countries domestic investment strategy. In the past they have invested quite less as compare to emerging countries like China, India & Russia etc. If they increase investment domestically then we see less flow in global market which reduces liquidity globally and makes market to stabilize.

As per the survey conducted by top Consulting firm, exports of crude oil will earn Gulf Cooperation Council (GCC)/Petrodollar countries $5 trillion to $9 trillion from 2007 to 2020.

The GCC foreign-investment choices influence interest rates, liquidity, and financial markets around the world. And the domestic investments affect the region’s urban development, economic diversification, and ability to create jobs. Fortunately for the citizens of the GCC states and global policy makers, there will probably be enough petrodollars to satisfy both sets of needs.

Now the question arises how much of this capital will be deployed domestically by GCC countries?

Since 1993, GCC investment rates have averaged 20 percent of GDP, on par with European and US levels but almost one-quarter lower than the average investment rate of Brazil, China, India, and Russia combined. Petrodollars not invested locally will spill over into global capital markets. If oil lingers at around $100 a barrel and domestic investment stays at 20% level as mentioned above, the GCC would send $5.1 trillion in new funds into world markets and boosting these states’ total foreign wealth to $10.5 trillion by 2020. Domestic-investment rates as high as 28% combined with $70-a-barrel oil, would generate around $2.5 trillion of new funds for GCC investors to deploy in global capital markets until 2020. Only a major decline in oil prices-to less than $30 a barrel,-combined with high levels of domestic investment would make it difficult for the GCC to continue pumping significant liquidity into global capital markets which seems unlikely situation.

As oil prices continue to set new records, investors outside Europe and the United States are increasingly shaping trends in financial markets. Petrodollar investors have a newfound influence, and the more than tripling of oil prices since 2002 makes them the largest and fastest-growing component of a broad shift in global economic markets-a shift that also includes Asian central banks, private-equity firms, and hedge funds. High oil prices are, in effect, a tax on consumers, generating windfall revenues for oil-exporting nations, which in 2006 became the world’s largest source of net global capital flows, surpassing Asia for the first time since the 1970s. A majority of these revenues have been recycled into global financial markets, making petrodollar investors increasingly powerful players.

Fueling liquidity—and creates asset bubble

Since 2002, oil prices have tripled, and much of the incremental increase has ended up in the investment funds and private portfolios of investors in oil-exporting countries. Most of the money is then recycled on global financial markets, whose liquidity is therefore rising.

In fixed-income markets, this added liquidity has significantly lowered interest rates. Estimated total foreign net purchases of US bonds have brought down long-term rates by about 130 basis points. Twenty-one of them can be attributed to purchases by the central banks of oil-exporting countries, and impact as large as that of the capital flows from financial hubs such as the Cayman Islands, Luxembourg, Switzerland, and the United Kingdom, though less than half the impact of Asia’s central banks on US interest rates. Petrodollars have added liquidity to international equity markets as well.

The story is different in global real-estate markets. According to research by the Economist Intelligence Unit, real-estate values in developed countries have increased by $30 trillion since 2000, reaching $70 trillion in 2005 and far outstripping GDP growth over the same period. This rise reflects not only the preference of petrodollar investors for global real estate but also the home-equity loans and larger mortgages that low interest rates and risk spreads have made possible.

Indeed, petrodollars have helped increase global leverage in many forms. Low interest rates and credit spreads have enabled the rise of hedge funds and the private-equity boom. Although low rates and spreads have created ample liquidity for consumer credit in the United Kingdom, the United States, and many other countries, a reassessed appetite for risk could burst this global credit bubble, causing pain to lenders and borrowers alike. In mid-2007 problems in the US sub-prime-mortgage market sparked a re-pricing of credit risk and a credit crunch.

Growing concerns

Despite the many beneficial effects of petrodollars in increasing global liquidity and spurring the growth of various financial-asset classes throughout the world, the rise of investors in oil-exporting countries has created concerns.

One worry is that the huge size of petrodollar sovereign wealth funds, coupled with their relatively high appetite for risk, could make global capital markets more volatile. The limited transparency of these funds amplifies the anxiety. Research, however, finds that their investment portfolios are widely diversified not only across asset classes and regions but also through a number of intermediaries and investors. Diversification reduces the risk that the funds could make financial markets more volatile. Moreover, petrodollar investors have a track record of sensitivity about the broader market impact of large flows and use derivatives and intermediaries to lessen it. ADIA, for instance, reportedly invests 70 percent of its funds through external asset managers—intermediaries who know they must move slowly in markets to avoid adverse price adjustments. Direct petrodollar investors tend to adopt a relatively low profile.

A second concern has also attracted growing attention among financial-market regulators in Europe and the United States; the prospect that sovereign wealth funds could use their growing financial heft for political or other non-economic motives. The rise of large government investors in financial markets is a new phenomenon-and one at odds with the shrinking role of state ownership in real economies. Given the limited transparency and enormous size of these investors, some observers question the motivations underlying their investment strategies. How will state investors behave as public shareholders or owners of companies in foreign markets? Will they seek to maximize value creation and long-term growth, or will their investments reflect the political objectives of their governments and the interests of businesses in their home countries? Financial markets require the free flow of information to function efficiently. The presence of huge, opaque players with non-economic motives could distort the pricing signals that other investors need. A growing number of economists and policy makers in Europe and the United States now support the creation of disclosure standards for government investors.

Final concern the long-term economic impact of higher oil prices. In the 1970s their rise sparked inflation in the major oil-consuming economies and sent global banks on a petrodollar-fueled lending spree in Latin America. Both developments inflicted significant economic pain on the countries involved. Today higher oil prices have been a boon for global financial markets, but, paradoxically, inflation hasn’t risen very much. Can higher oil prices really be good for the world economy? As we have seen, petrodollars are creating inflationary pressures in markets for illiquid investments, such as real estate, art, and companies. If the pressures move beyond those markets, the potential asset price bubbles could burst. So far the world economy has accommodated higher oil prices without a notable rise in inflation or a economic slowdown, but this may change in the future.

Conclusion

High oil prices will create more revenue for GCC countries and if domestic investment of these countries will not increase appropriately then more money will be available in global financial market which may cause high liquidity & emergence of more private equity & hedge fund players that increases global financial leverage and may create asset bubble & crash of financial market.

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