A New Term To Reckon With

It is fairly safe to say that up until about a year ago, not many investors knew what the acronyms MBS, CDO, CDS, or CDS Squared were – nor did they care. But since these four labels did their darndest to cripple the banking system and probably cost you a fair amount of money in the process, it is also safe to say that no one wants to get fooled again by anything they don’t understand.

So here's a tip. If you are planning on buying bonds of the nation's banks anytime soon, you’d best acquaint yourself with something called "contingent capital," because if you're not paying attention, that bond you bought could become a stock in the blink of an eye.

Contingent capital is the latest idea the Fed has been tossing around in their efforts to come up with a way to avoid the systemic risks the biggest banks present. The so-called contingent capital would allow banks to convert debt instruments such as bonds, into equity (or some other type of important banking capital) in an emergency. This would increase the capital banks need to get onto their balance sheets without having to go to the open market to actually raise the capital needed on the books.

While we won't bore you with a rehash of the credit crisis, one of the key points to understand is that it began as what we call "a crisis of accounting." To review briefly, banks ran into trouble with their books when those derivatives everyone came to know and hate stopped trading. With the mark-to-market rules still in play, the last price at which these securities traded (usually driven by bankruptcy or some other forced sale) became the price banks had to use on their balance sheets. And with each new bankruptcy bringing new distressed prices, any bank holding these now toxic assets started running into trouble with regard to the capital they needed to maintain.

So, at precisely the time when it was nearly impossible to raise new capital, most of the big banks in the U.S. needed to do just that: raise capital – and a lot of it. And with no real ability to acquire the vast billions of dollars of the "right kind of capital," the government was faced with either bucking up or letting the banks fail.

Thus, the Fed is trying to come up with a mechanism to avoid just such a calamity in the future. And it is beginning to sound like "contingent capital" might just be the ticket.

For the second time in a week, a top Fed official talked up the idea. This time it was Federal Reserve Bank of New York President William Dudley who said Tuesday that the idea of contingent capital "holds real promise." And since Federal Reserve Governor Daniel Tarullo also publically spoke of the concept last week, it would appear that the FOMC is now running the idea up the central banking flagpole.

On Tuesday, Mr. Dudley said that contingent capital "has the potential to be more efficient because the capital arrives as equity only in the bad states of the world when it is needed. It also has the benefit of improving incentives by creating two-way risk for bank managements and shareholders. If the bank encounters difficulties, triggering conversion, shareholders would be automatically and immediately diluted. This would create strong incentives for bank managements to manage not only for good outcomes on the upside of the boom, but also against bad outcomes on the downside."

In simpler terms, contingent capital would convert from debt to equity at pre-set levels that would likely be tied to the condition of the bank or the overall banking system. Thus, if the bank from which you bought these new fangled bonds began to fail, the bank could simply convert the debt to equity and presto – new capital would be formed. And since you, as the buyer, knew this was a possibility, it becomes a "no harm, no foul" type of scenario.

Another way to think about this type of instrument is that these could be akin to a convertible bond turned inside out. Instead of the buyer of the bond deciding if and when to convert the security to equity, it is the debt issuer's call to make.

Mr. Dudley went on to say, "in my view, allowing firms to issue contingent capital instruments that could be used to augment their common equity capital during a downturn may be a more straightforward and efficient way to achieve a countercyclical regulatory capital regime compared to trying to structure minimum regulatory capital requirements (or capital buffers above those requirements) that decline as conditions in the financial sector worsen."

In non-Fedspeak, we believe Mr. Dudley means that this approach could save everybody a boatload of money if we ever face a banking calamity again.

For more "top stock" portfolios and research, visit TopStockPortfolios.com

David D. Moenning

www.TopStockPortfolios.com

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