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Contingent Capital: The Case of COERCs

Published online by Cambridge University Press:  08 July 2014

George Pennacchi ,
Theo Vermaelen  and
Christian C. P. Wolff
George Pennacchi
Affiliation:
[email protected], College of Business, University of Illinois Urbana-Champaign, 1206 S 6th St, Champaign, IL 61820
Theo Vermaelen
Affiliation:
[email protected], Finance Area, INSEAD, Boulevard de Constance, Fontainebleau, Cedex 77305, France
Christian C. P. Wolff
Affiliation:
[email protected], Luxembourg School of Finance, University of Luxembourg, 4 rue Albert Borschette, Luxembourg L-1246, Luxembourg and Centre for Economic Policy Research (CEPR).
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Abstract

This paper introduces and analyzes a new form of contingent convertible: a call option enhanced reverse convertible (COERC). If an issuing bank’s market value of capital breaches a trigger, COERCs convert to many new equity shares that would heavily dilute existing shareholders, except that shareholders have the option to purchase these shares at the bond’s par value. COERCs have low risk: They are almost always fully repaid in cash. Yet, they reduce government bailouts by replenishing a bank’s capital. COERCs’ design also avoids problems with market-value triggers, such as manipulation or panic, while reducing moral hazard and debt overhang.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 49 , Issue 3 , June 2014 , pp. 541 - 574
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2014 

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