U.S. Appetite For 'CoCo' Bonds Could Be Tested Soon--Bankers

http://online.wsj.com/article/BT-CO-20110215-712432.html

• "Many are pinning their hopes on a type of security called a contingent-convertible bond, or a 'CoCo', which converts from debt to equity when certain bank metrics, such as capital reserves or share price, fall below certain levels. The reduction in debt and increase in equity delivers a shot in the arm to the financial institutions' balance sheets."
• "While buyers are paid well for investing in CoCos--one batch of CoCos averaging 10 years to maturity currently yields around 10%, a full percentage point over comparable junk debt--the jury is out on how investors may respond when CoCos come to market."
• CoCos resemble hybrid securities because they convert from a bond-like instrument to an equity-like instrument, essentially recapitalizing the firm and staving off the sort of government bailout seen in the last crisis. Yet they differ from traditional hybrids because the conversion is mandatory, not at the option of the issuer.
• The trigger depends on the borrower's creditworthiness, as determined by a measure of financial cushioning called core Tier-1 capital--the strongest capital on a firm's balance sheet. Once CoCos convert into equity, investors would start to lose their principal and could be wiped out entirely before holders of subordinated and senior unsecured debt absorb any losses.
• A key consideration for investors is where that conversion trigger is set. The lower it is, the more attractive a CoCo is to a buyer because the issuer is more likely to be on its last legs when conversion occurs.

What are the Drivers of Security Design

William Silber studied 38 financial products/processes introduced between 1970 and 1982 and concluded that the primary drivers of financial innovation are: inflation (especially high interest rates due to inflation), volatility of interest rates, technology, legislation, and internationalism.

Merton Miller (best-known as the Nobel-Prize winning co-author of the Modigliani-Miller Theorem concluded that the primary drivers were regulation and taxation; tax and regulation are "the major impulses to successful innovation."¹ Miller described financial innovations as "seeds beneath the snow, waiting for some change in the environment to bring them about."²

There are a basic set of features of a financial product - "ingredients" which can be mixed and matched "bundled and unbundled" to create new products:

"At its basic level, the financial instrument is a contract written on paper and potentially all possible financial contracts can be written without any technological barrier (Desai and Low, 1987, p. 115). In this sense, financial innovations are not new goods. They are implicitly always there, but in zero supply (Greenbaum and Heywood, 1973). …. Dufey and Giddy (1981) argue that financial innovation largely consists in the development of new ways of bundling the basic services. While the bundling and unbundling exhibits an infinite variety, the basic products themselves have remained largely unchanged. As Niehans (1983, p. 538) puts it, 'Except for electronic technology, if an experienced banker from medieval Venice or Geneva came to life again, he could understand the operations of a modern bank in a matter of days.³"

Other factors include issuers desire to reduce information and agency costs when raising capital.

More info available here:

Security Design Reading List, Part I

• "Evolution of Security Design" http://papers.ssrn.com/sol3/papers.cfm?abstract_id=511044
• "Security Design in Initial Public Offerings "http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1008411
• A study of corporation securities : their nature and uses in finance / by Arthur Stone Dewing; Dewing, Arthur