Columns July 28, 2010, 11:01PM EST

'Too Big to Fail' Bonds are Too Good to Pass Up

The financial overhaul sent a good idea off to be studied, but that doesn't mean it won't be back

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A time-honored way to kill off an idea in Washington is to call for further study. Does anyone really remember the Bush White House commission for major tax reform in 2005? It produced an excellent—and quickly forgotten—report that's gathering dust alongside hundreds of similar blue-ribbon panel recommendations.

Among the many initiatives in the sprawling 2,300-page financial services reform bill signed into law by President Obama on July 21 is a call for the Federal Reserve to look into the wisdom of requiring too-big-to-fail financial firms to issue debt that coverts into equity during a credit meltdown. Contingent capital bonds—also known as crisis convertibles, reverse convertibles, or contingent capital certificates—are the hot idea among economists and other card-carrying members of the financial regulatory cognoscenti. A requirement that Big Banks issue them was in an earlier version of the Congressional financial services reform legislation. Large banks and their lobbyists opposed the requirement (among a number of other mandates), and it was subsequently watered down, though not killed, during negotiations. The final legislation requires the Fed to study the idea and, if officials decide it has merit, adopt it.

Shades of the early 1990s? It sure looks like it. Back then there was pressure for the Fed to mandate that banks issue subordinated debt—bonds that could signal trouble since they are at the bottom of the barrel when it comes to bondholder rights. These are risky securities, thus a rise in interest rates on a company's subordinated debt could act as an early warning from the market of future trouble. The Gramm-Leach-Bliley Act of 1999 (the legislation that officially ended the Glass-Steagall era) required that regulators study the idea. The Federal Reserve and the Treasury Dept. issued their report toward the end of 2000. While acknowledging that the proposal had merit, it said the "net benefits of a mandatory policy over voluntary issuance are currently too uncertain to justify a mandatory policy." The conclusion: Let's study this some more. Little wonder it died.

Out From the Crypt

As the late mutual fund pioneer Sir John Templeton famously quipped, the four most dangerous words in the English language are "this time is different." But after the global credit crunch and the worst downturn since the 1930s, maybe it's true. The desire for reform is strong. The Basel Committee on Banking Supervision, a meeting of central banks and regulators from 27 nations, released on July 26th a preliminary agreement on bank capital and liquidity rules that included contingent capital as a key part of its ongoing discussion for reform. Canadian officials are actively pushing for mandatory contingent capital. A number of Fed officials have praised the idea, most notably William Dudley, president of the Federal Reserve Bank of New York. A far larger community of scholars, practitioners, and regulators is engaged with the idea this time around, writing research reports, speaking at conferences on the feasibility of crisis convertibles, and putting out op-eds on the desirability of the reform.

Simply put, it's going to be a lot harder this time to bury the idea. That's why contingent capital could be the Trojan horse for real, live radical regulatory reform.

All the proposals for crisis convertibles are essentially the same. The goal is to create a market-based mechanism that reinforces regulatory discipline and oversight while limiting the odds of a government handout. The too-big-to-fail financial companies would be required to issue, while they are still healthy, crisis convertibles with covenants that automatically turn the bondholders into equity owners in times of trouble. In essence, it's a market-driven prepackaged bankruptcy procedure—and a deterrent against failure. Bondholders take a big hit and end up as owners of the troubled business.