Working Paper: CEPR ID: DP8028
Authors: George G. Pennacchi; Theo Vermaelen; Christian C. P. Wolff
Abstract: In this paper we propose a new security, the Call Option Enhanced Reverse Convertible (COERC). The security is a form of contingent capital, i.e. a bond that converts into equity when the market value of equity relative to debt falls below a certain trigger. The conversion price is set significantly below the trigger price and, at the same time, equity holders have the option to buy back the shares from the bondholders at the conversion price. Compared to other forms of contingent capital proposed in the literature, the COERC is less risky in a world where bank assets can experience sudden jumps. Moreover, the structure eliminates concerns about putting the company in a ?death spiral? as a result of manipulation or panic. A bank that issues COERCs also has a smaller incentive to choose investments that are subject to large losses.
Keywords: banks; financial crisis; financial stability; security design
JEL Codes: G01; G20
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| coerc (J47) | reduce the risk of financial distress (G33) |
| coerc (J47) | automatic conversion of debt into equity (G32) |
| automatic conversion of debt into equity (G32) | alleviate the need for protracted negotiations with creditors (G33) |
| coerc (J47) | recapitalize without government intervention (G28) |
| coerc (J47) | mitigate the debt overhang problem (F65) |
| mitigate the debt overhang problem (F65) | enhance the marketability of the coerc bonds (G10) |
| coerc (J47) | prevent wealth transfers from shareholders to bondholders (G32) |
| prevent wealth transfers from shareholders to bondholders (G32) | maintain their value (D46) |