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Will These Investments Fly?

Amid the continuing cleanup of this financial crisis, U.S. and European regulators are figuring out how to avoid another one. The latest plan: forcing banks to sell hybrid investments designed to morph from a bond into a stock during troubled times. But will these complex securities prevent the sort of panic that prompted the U.S. to prop up the financial system with more than $4 trillion? At first blush it seems a clever way to raise capital. The hybrid investments ideally would give companies an instant rush of capital just when they need it most, as losses are mounting. They could also help the financial system by reducing debt. That's why the securities, known as contingent convertibles, or "CoCos," appeal to regulators on both sides of the Atlantic. Federal Reserve Chairman Ben Bernanke and Treasury Secretary Timothy Geithner are floating the idea. Senator Christopher Dodd (D-Conn.) included such reforms as part of a proposed bill on Nov. 10. The British government is field-testing them: Earlier this month, Lloyds Banking Group , the largely state-owned bank, said it would issue as much as $12 billion in CoCos. But such investments have a checkered past. During the boom, banks aggressively sold similar securities, money that only helped pump up the credit boom. In 2007 financial firms around the globe issued nearly $60 billion in hybrids, double the amount in the prior year. Insurance companies and other big investors gobbled up the investments like debt, figuring them a safe way to get some extra yield. Now the same financial instruments are aggravating the bust. Investors who thought they were buying bonds have been left holding something closer to stock. The government, for example, suspended regular payouts on some hybrids issued by Fannie Mae and Freddie Mac after taking over the mortgage giants in September 2008. The U.S. is backing their traditional bonds in full. Prices on other hybrids plunged by as much as 55%. "The market never really dealt with that critical conflict: Is it debt or is it equity?" says Jeffrey A. Rosenberg, credit strategist at Bank of America Merrill Lynch Research . shooting for clarityRegulators hope to remove that doubt. In developing this latest version, the triggers for conversion will be outlined in advance so investors know better what they're getting. Under various proposals, the debt would automatically switch into stock when a bank's financial profile deteriorates—when, say, its capital ratios or troubled loans hit certain levels. In the past the banks had a lot more discretion, and the securities rarely converted into stock, unless a company went belly-up. Trouble is, investors may not like this breed. Unlike previous hybrids, these will behave more like equity, which could scare off the usual buyers in search of safety. And stock investors may not go for them since they don't have the same upside potential. To attract buyers, banks may have to jack up the interest rates they pay to investors. That proposition may prove too costly. Meanwhile the securities remain untested. If there are unintended consequences to the exotic financial instruments, they won't be discovered until banks are under pressure and it's too late. "It is ironic," says Simon Adamson of research firm Credit­Sights. "At a time when you're trying to simplify things, you're getting what appear to be pretty complex securities." ^
Henry is a senior writer at Bloomberg Businessweek.

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