Towards a sovereign CoCo ?

Cocos are contingent convertible bonds and are a hot issue of debate in the current quest for banking crisis solutions, ie, bail-in instead of bail-out. It briefly implies that these bonds are automatically converted from debt to equity at a fraction of their original price - haircut - once a pre-specified threshold of bank's working capital is breached. We have commented on this instrument in the past from out of a a different angle, namely the asset being mispresented to investors as a "fixed income" instrument with a yield pick-up. Today some economists however point to the idea of sovereign cocos as a way to get out of the current and future mess. And they might have a point.

In a recent article, Barry Eichengreen raises the subject in connection with the Greek debt saga which has been dragging along now for almost 2 years. He makes a plea to immediately include covenants for new sovereign bonds which would allow these mechanisms to be triggered. His arguments are pretty straightforward :

1) Forcing bondholders to accept a hair-cut on what they will be paid will avoid reckless lending to euro-zone governments in the future.

2) CoCo covenants could stipulate that if a sovereign's debt/GDP ratio exceeds a specific threshold, principal and interest payments to bondholders are automatically reduced. The idea is that if there is no adequate incentive to restructure once a crisis starts, it should be built in before the fact (!!)

Eichengreen admits that there could be some practical objections : you should outsource GDP calculation to an independent source (IMF ?) in order to avoid a "Greek chef cooking the books". It might raise governments' borrowing cost. On the other hand, coco activation would not constitute a credit event triggering credit default swaps written on the bonds.

It's certainly some interesting food for thought. It would indeed save us precious time and bring some discipline into the neverending carroussel of finance at all level, supra included.

For the full article :

http://www.project-syndicate.org/commentary/eichengreen35/english