CONTINGENT CHOOSER BOND

Veronica MarchettiClaudio Morelli

Martina TognacciniBy MTM Royal Advisor

Agenda

1. Definition & Main Features Of The

Contingent Chooser Bond

2. Main Innovations

3. The Choice Of The Payoff

4. Costs For The Issuer

5. Possible Investors

6. Advantages & Disadvantages For The Issuer

The Contingent Chooser BondThe main purpose of this new debt instrument is to

recapitalize a troubled financial firm without the direct increase of equity, trying to avoid “systemic risk”.

The instrument is composed by a structured bond linked to the movements of the EuroStoxx 50. It has a maturity of 5 years and can correspond an annual coupon until the fifth year in which repays back also the capital invested.The payment of the yearly coupons and of the maturity capital is triggered by a pre-defined event: the value of the issuer’s Tier 1 ratio quarterly checked.

𝑰𝒇 𝑬𝒖𝒓𝒐𝑺𝒕𝒐𝒙𝒙𝟓𝟎 𝒗𝒂𝒍𝒖𝒆𝒕<𝟐𝟎𝟎𝟎→𝐦𝐚𝐱 (𝑻𝒊𝒆𝒓 𝟏;𝟗% )

𝑰𝒇 𝑬𝒖𝒓𝒐𝑺𝒕𝒐𝒙𝒙𝟓𝟎 𝒗𝒂𝒍𝒖𝒆𝒕>𝟑𝟎𝟎𝟎→𝐦 𝒊𝒏(𝑻𝒊𝒆𝒓𝟏 ;𝟗%)

𝑰𝒇 𝟐𝟎𝟎𝟎<𝑬𝒖𝒓𝒐𝑺𝒕𝒐𝒙𝒙𝟓𝟎𝒗𝒂𝒍𝒖𝒆𝒕<𝟑𝟎𝟎𝟎→𝐦 𝒊𝒏(𝑻𝒊𝒆𝒓𝟏 ;𝟕% )

With t = 1,2,3,4,5

At time t=5 the instrument repays also the capital invested.

𝑻𝒊𝒆𝒓 𝟏𝒓𝒂𝒕𝒊𝒐=𝑬𝒒𝒖𝒊𝒕𝒚 𝑪𝒂𝒑𝒊𝒕𝒂𝒍

𝑹𝒊𝒔𝒌𝑾𝒆𝒊𝒈𝒉𝒕𝒆𝒅 𝑨𝒔𝒔𝒆𝒕𝒔

Since Basilea III imposed a Tier 1 6% we decided to use this capital based ratio as trigger event quarterly checked. In particular:When Tier 1 6% the issuer has to pay the annual coupons as follows:

But…

Features of the contract (1)

When Tier 1< 6% the coupon payment ends and the investor has to choose between two opportunities:

1) Convert the bond into a Perpetual Bond

2) Convert the bond into Shares

• write down of the principal of 20%• yearly coupon = 7,5% of the new

principal payed only if the bank decides to pay dividends to the share holders• when Tier 1>8% the bank can decide to

pay yearly coupon of 7,5% on the 100% of the initial capital (write-back option) or to redeem the bond (callable bond)

• with Par Conversion = the Shares after conversion are worth the par value of the bond

• the investor can receive dividends

Features of the contract (2)

OR

If the investor doesn’t take a

decision within 2 days

The bank will decide for him according to its

preferences

• Conversion into Shares increases the Common Equity Tier 1

• Conversion into Perpetual Bonds increases the Additional Tier 1(Common Equity Tier 1+Additional Tier 1

=Going Concern Capital or Tier 1)

Features of the contract (3)

Whatever the choice of conversion, the bank will reach its target :

INCREASE OF THE CAPITALIZATION

Because:

Main Innovations Use of a Structured Bond with the Eurostoxx50 as

underlying Twofold use of Tier 1 Ratio:

• As Trigger Event.

• As discriminant value for the computation of the payoff

The investor, according to his preferences, has the possibility to choose between two alternatives when the trigger event occurs.

Conversion of the structured bond into perpetual bond with write down notional and write back option.

How have we built the payoff?The value of the payoff depends upon the future movements

of the Eurostoxx50 so we needed to analyze its trend.

To define the future movements of the index we have made a Monte Carlo simulation with random number generations.

We have modeled the underlying through the Geometric Brownian Motion (using the historical volatility) and the

stochastic interest rate through the Cox-Ingersoll-Ross model (using the correlation between Eurostoxx50 and Euribor 3m).

Using the data simulation and the analysis of the graph we have given different probabilities to the index movements above, inside

and below the constraints.

Starting from the analysis of historical data we have seen that during the last years the EuroStoxx50 has walked between two

values: a support at 2000 and a resistance at 3000.

How have we built the payoff?

1/2/

2009

4/24

/200

9

8/14

/200

9

12/4

/200

9

3/26

/201

0

7/16

/201

0

11/5

/201

0

2/25

/201

1

6/17

/201

1

10/7

/201

1

1/27

/201

2

5/18

/201

2

9/7/

2012

12/2

8/20

12

4/19

/201

3

8/9/

2013

11/2

9/20

13

3/21

/201

4

7/11

/201

4

10/3

1/20

14

2/20

/201

5

6/12

/201

5

10/2

/201

5

1/22

/201

6

5/13

/201

6

9/2/

2016

12/2

3/20

16

4/14

/201

7

8/4/

2017

11/2

4/20

171000

1500

2000

2500

3000

3500

ESTX50MEANUPPERLOWER

PROBABILIITY OF 75 %

PROBABILIITY OF 5 %

PROBABILIITY OF 20 %

We found out an higher probability for the values of the Eurostoxx50 to be inside the two bounds than outside (low

volatility)

To reduce the expected costs for the bank we have given a lower premium to most probable event and higher premiums to

the less probable events.

Possible ScenariosTier 1 Ratio >> 6% (i.e. 10%)

𝑰𝒇 𝑬𝒖𝒓𝒐𝑺𝒕𝒐𝒙𝒙𝟓𝟎𝒗𝒂𝒍𝒖𝒆𝒕<𝟐𝟎𝟎𝟎→𝐦𝐚𝐱 (𝑻𝒊𝒆𝒓 𝟏;𝟗% )→𝟏𝟎%

9%

𝑰𝒇 𝟐𝟎𝟎𝟎<𝑬𝒖𝒓𝒐𝑺𝒕𝒐𝒙𝒙𝟓𝟎𝒗𝒂𝒍𝒖𝒆𝒕<𝟑𝟎𝟎𝟎→𝐦 𝒊𝒏 (𝑻𝒊𝒆𝒓 𝟏;𝟕% )→𝟕%

Tier 1 Ratio = 6%

𝑰𝒇 𝑬𝒖𝒓𝒐𝑺𝒕𝒐𝒙𝒙𝟓𝟎𝒗𝒂𝒍𝒖𝒆𝒕<𝟐𝟎𝟎𝟎→𝐦𝐚𝐱 (𝑻𝒊𝒆𝒓 𝟏;𝟗% )→𝟗%

6%

𝑰𝒇 𝟐𝟎𝟎𝟎<𝑬𝒖𝒓𝒐𝑺𝒕𝒐𝒙𝒙𝟓𝟎𝒗𝒂𝒍𝒖𝒆𝒕<𝟑𝟎𝟎𝟎→𝐦 𝒊𝒏 (𝑻𝒊𝒆𝒓 𝟏;𝟕% )→𝟔%

WORST IN TERM OF COUPON PAYMENT

BEST IN TERM OF CAPITAL RATIO

BEST IN TERM OF COUPON PAYMENT

WORST IN TERM OF CAPITAL RATIO

but

but

Each year

Each year

Costs for the Bank (1)

Payment of the yearly coupon to the investors

There are three main costs for the bank:

It is the main cost for the issuer. Given the nature of the instrument and its risk, the cost for the bank is higher than the one of other bonds. This cost is stochastic and depends upon two variables: the Tier 1 ratio and the value of the Eurostoxx50. it is minimized when the index is not too volatile it is the most probable event (according to our analysis). With “normal” values of the Tier 1 the cost is 7% (yearly), otherwise it can decrease with the Tier until to 6%.it is high when the index has high negative volatility (very low probability of occurring) and the Tier 1 ratio is high: in this case it can become 10% or more (it assumes the value of the Tier 1).In the other cases the cost has intermediate valuesAccording to our analysis and

considering a well capitalized bank

The most probable annual cost is 7%

Costs for the Bank (2)

Payment of the yearly coupon to the investors who decide to convert the investment into Perpetual Bonds

When the trigger event occurs (Tier 1<6% ), the payment of cuopons ends and two different costs take over:

The payment of these coupons is made only if the bank pays dividend during that year and is a low cost for the bank: 6% (7,5% paid on 80% of the principal)

When the Tier 1 ratio becomes higher than 8% this cost can increase to 7,5% (the bank continues to pay the perpetual) or can be eliminated by redeeming the bond

Payment of dividends to the investors who decide to become shareholders

The bank can decide both the amount of the dividend and the eventuality to pay them or not low cost

Possible Investors (1)Retail Investors with Medium/Low Risk Aversion:

the trigger event is objective and cannot be easily manipulated

the instrument pays a high yield with a relatively low probability of trigger occurrence

if the trigger event occurs they can choose the perpetual bonds

they are attracted by the contingent capital’s yield relatively high

if the trigger event occurs they can choose to obtain shares with which speculate

to diversify their portfolio

Fixed Income Investors because:

Speculative Investors because:

High-Net Worth Investors:

Possible Investors (2)

as part of their variable compensation

to lock on to the high interest rates which are given either by the coupon payments if Tier 1 >6% or by the coupon payent if they choose the conversion into perpetual bonds when Tier 1<6

To diversify their portfoliosTo assume speculative positions

Bank’s Employees

Institutional InvestorsInsurers and Pension Funds

Investment Funds, Banks and Hedge Funds

Investors’ Risk AversionThis instrument has higher risk than other debts

because it is considered by the law as a subordinated debt so, in the event of bankruptcy of the issuer, these investors will be paid after the others

the investors who have perpetual bonds will be paid only after that all other creditors have been satisfied but they will be paid before shareholders

Less risk averse investors will be

attracted to choose stocks.

More risk averse investors will be

attracted to choose perpetual bonds.

Indeed the choice of convert the instrument into shares instead of perpetual bonds is more risky.

In case of trigger event and of bankruptcy of the issuer:

Main Benefits for the Investors (1)

TRIGGER EVENT

• Power of control of a firm with significant value remaining, especially

if the trigger is not high.• Shares of stock have the

potential to appreciate over time and these can be used to speculative purposes.

• Dividend-paying stocks can provide a steady source of income.

The Bond is converted into Stocks

• Payment of interest for an indefinite period of time.

• Steady income source that does not fluctuate with other market changes and conditions.

The Bond is converted into Perpetual Bonds

TIER 1 ≥ 6%They will receive quite high coupons and the repament of the principal at maturity

Contingent Chooser Bond initially enter a bank's capital structure as debt instruments, thus providing the debt-instrument benefits that are expressed by

• Possibility to maintain minimum levels of equity capital.

• Lower cost of opportunity w.r.t. financing through equity.

• The investor does not receive an ownership share in the business.

• Tax advantage, because the interest paid on loans is generally deductible.

Main Benefits for the Bank (1)

BEFORE THE TRIGGER EVENT

Main Benefits for Bank (2)

• The option to convert bonds into shares or perpetual bonds allows for a wide range of investors (both those that invest in CoCo bonds and those who invest in perpetual bonds)

• Banks can have the additional safety margin as if they had raised more equity today, but without having actually to raise the equity.

• Companies with poor credit ratings can issue such instrument in order to lower the yield necessary to sell their debt securities.

• The capital based Trigger Event chosen i.e. of the Tier 1 Ratio is transparent, objective and, above all, it is not subject to market manipulations

this is an incentive for investors it is a good limit because it is set high enough to achieve the

desired level of bank safety accordingly to regulatory standards. A limit on Tier 1 higher could be an impediment to economic growth, as it would limit the amount of capital banks can make available to lend.

GENERAL BENEFITS

• Automatic recapitalization of the bank with the increase of the going concern capital, at a stage of distress when equity issues would be quite difficult.

AFTER THE TRIGGER EVENT

Main Benefits for Bank (3)

• The issuer has the power of choice after the trigger event if the investor doesn’t take a decision between the conversion of the bond either into stocks or perpetual bonds within two days.

• If the bank decide to not distribuite dividends, accordingly with the structure of the financial instrument, it is allowed to not pay the coupons to the investors in Perpetual Bonds.

• The debt does not have to be immediately paid back, providing an instant boost to the bank’s capital cushion. In case of recovery the bank can decide to expiry the notional at investors in perpetual bonds by its mere discretion as established in the contract.

• Dilution of existing shareholders. If conversion is highly dilutive to existing shareholders, banks can be incentivized to reduce risk and leverage at the early signs of distress.

Because it is a low-cost mechanism to avoid the costs that otherwise arise with the bankruptcy of systemically important banking firms.

Main Benefits for Bank (4) IN CONCLUSION

We have introduced Contingent Chooser Bonds :

Because of the several benefits it apports to a financial institution as we have previously showed.

Because it represents a convenient new opportunity for a financial institution to increase capitalization

Because by definition the reduction in expected bankruptcy costs ensures a net gain to the bank and such kind of instrument allow banks to face distressed scenarios with a great margin of discretion. Because the inclusion of CCBs in the capital structure provide a useful regulatory instrument for expanding the safety and soundness of banks that are acknowledged to be too big to fail according to the regulators’ requests.

Eventual Disadvantages for the Bank

Lehman Brothers, for example, reported a Tier 1 capital ratio of 11% before its collapse, well above the regulatory minimum level.

However there are several ways to make capital ratios more robust:• By using Stress

Tests• By enforcing more rigorous and standardized disclosure requirements

that would allow investors to better assess the health of the bank.

Such standardized disclosures could relieve regulators of the burden of conducting regular stress tests, and would significantly enhance transparency.

Error in forecast the evolution for EuroStoxx future value wrong assignment of probability of events wrong interest rate too much premium for the investors.

Hedging problem In case of the trigger event the banks not only could be damaged by

the decreasing of the Tier1 ratio but also by the fact that also unwanted investors become shareholders Capital-based trigger can be vulnerable to financial reporting

that fails to actually reflect the underlying health of the firm.