Actual or Prospective Recovery Rates from Converting Cocos

The recovery rate was previously treated as a control variable. Given the expected stock price in the event of conversion, the replacement or recovery rate could be set by choosing a conversion price that would yield it. For instance, if the estimated market price in the event of conversion [MPc] is projected to be $8 per share, setting a conversion price of $10 would imply an 80% recovery rate provided the estimate of MPc had already taken this target value of ρ—and what it implies for the number of shares outstanding after conversion—into account. It was argued that such a recovery rate would provide the right incentives for both cocos holders and pre-existing shareholders to be vigilant. The latter would be hurt by the de-capitalization that led to conversion and any associated stock price decline, but not by conversion itself so long as the recovery rate for cocos holders is less than 100%. There are indications from the first of the two cases that follow that the actual recovery rate to be expected has not gotten even close to 80%. This means that of all the bad consequences pre-existing shareholders may face when the capital ratio of their bank has declined to the trigger point, conversion of minimal-replacement cocos may be by far the sweetest for them while being unduly harmful to (usually institutional) cocos holders and their institutional counterparties. If there is a tendency in the finance sector to build up tail risk by favoring investment strategies that promise to generate high yields much of the time while courting a low risk of incurring disastrous losses on rare occasions, here is a good example of this destructive tendency.