636 Part Seven Debt Financing
bre44380_ch24_618-651.indd 636 10/05/15 12:54 PM
Asset-backed securities provide another instance of a market that was encouraged
by regulation. To reduce the likelihood of failure, banks are obliged to finance part of
their loan portfolio with equity capital. Many banks were able to reduce the amount of
capital that they needed to hold by packaging up their loans or credit card receivables
and selling them off as bonds. Bank regulators have worried about this. They think that
banks may be tempted to sell off their riskiest loans and to keep their safest ones. They
have therefore introduced new regulations that will link the capital requirement to the
riskiness of the loans.- Reducing agency costs. We have already seen how convertible bonds may reduce
agency cost. Here is another example. At the turn of the century investors were
worried by the huge spending plans of telecom companies. So when Deutsche
Telecom, the German telecom giant, decided to sell $15 billion of bonds in 2000, it
offered a provision to reassure investors. Under this arrangement, Deutsche Telecom
was required to increase the coupon rate on the bonds by 50 basis points if ever
its bonds were downgraded to below investment grade by Moody’s or Standard
& Poor’s. Deutsche Telecom’s credit-sensitive bonds protected investors against
possible future attempts by the company to exploit existing bondholders by loading
on more debt.
Here is a third example where bond design can help to solve agency problems. Bank-
ers love to borrow rather than issue equity. The problem is that when banks encounter
heavy weather, the shareholders may refuse to come to the rescue with more capital.
One suggested remedy is for the banks to issue contingent convertible bonds (or cocos).
These are bonds that convert automatically into equity if the bank hits trouble. For
example, in 2011 Credit Suisse issued CHF6 billion of Swiss franc cocos. If Credit
Suisse’s capital falls below a specified level, the cocos reduce the bank’s leverage by
changing into equity.
Dreaming up these new financial instruments is only half the battle. The other prob-
lem is to produce them efficiently. Think, for example, of the problems of packaging
together several hundred million dollars’ worth of credit card receivables and allocating
the cash flows to a diverse group of investors. That requires good computer systems.
The deal also needs to be structured so that, if the issuer goes bankrupt, the receivables
will not be part of the bankruptcy estate. That depends on the development of legal
structures that will stand up in the event of a dispute.
BEYOND THE PAGE
mhhe.com/brealey12eContingent
convertibles24-3 Bank Loans
Bonds are generally long-term loans and more often than not are sold publicly by the borrow-
ing company. It is now time to look at shorter-term debt. This is not usually issued publicly
and is largely supplied by banks. Whereas the typical bond issue has a maturity of 10 years,
the bank loan is generally repaid in about 3 years.^41 Of course, there is plenty of variation
around these figures.
In the United States, bank loans are a less important source of finance than the bond mar-
ket, but for many smaller firms, they are the only source of borrowing. Bank loans come in a
variety of flavors. Here are a few of the ways that they differ.(^41) See D. J. Denis and V. T. Mihov, “The Choice Among Bank Debt, Non-Bank Private Debt, and Public Debt: Evidence from New
Corporate Borrowings,” Journal of Financial Economics 70(2003), pp 3–28.