The Financial Times has created a Flash animation to explain the basics—kind of a cocos for dummies, where a veddy, veddy British narrator explains the conceptual framework of cocos in measured tones.
Here's a thumbnail sketch of the material:
Bank capital can exist in one of three forms: Equity, debt, and hybrid securities—which combine features of the previous two.
Operating on low levels of equity means higher leverage, which can improve equity return ratios —and therefore raise a bank's stock price.
(At least if all is going well: High leverage, of course, can also dramatically amplify losses.)
Regulators require a certain amount of equity capital for a bank to operate, in order to ensure the stability of an institution.
And so it came to pass that banks began issuing hybrid securities, instead of straight debt, because hybrid securities could be counted as equity capital.
The reason for allowing hybrids to count as equity capital rather than debt is that while hybrids actually look and function like debt, they can be converted into equity if a bank runs into trouble.
At least, in theory, hybrid debt was supposed to be converted into equity in the event that a bank experienced major capitalization issues.
What actually happened in practice was another matter.
While the hybrid debt appeared as though it should have converted into equity once a bank hit the skids, that didn't seem to happen during the financial crisis.
Instead, hybrid bondholders insisted that they not get haircut or converted.
Bondholders, according to the FT animation, wielded tremendous influence with the banks, and threatened to boycott any institution associated with a debt to equity conversion.
So the question arose: Why should hybrids get counted as equity if bondholders will never allow them to actually be converted in a crisis?
And, perhaps more to the point, how could new securities be designed so that conversion would actually occur in times of financial distress?
One of the proposed solutions was the creation of cocos.
Cocos automatically convert to equity when a pre-defined trigger condition is met.
The obvious example of a potential trigger event would be core tier 1 capital falling below a specified level.
In the event that core tier 1 fell below, say , five percent, cocos would automatically convert to equity.
This would simultaneously reduce the banks debt burden and increase its equity capital.
As I wrote, Cocos certainly sound like a brilliant idea in theory: Whether they will work in practice is another matter.
(For example, investors might not be willing to embrace the model—and might price the bonds at prohibitively high yields. Or any attempt at a forced conversion to equity might become mired in endless litigation.)
It's difficult to speculate about all of the things that might potentially go wrong - but in capital structures, as in life itself, betting on anything being a panacea for a complex problem is rarely a wise choice.
In fact, nothing short of another major crisis may reveal just how the cocos perform under pressure.
But there is one thing about which we can be fairly certain in advance: The armies of lawyers, bankers, accountants, and consultants who advised on the deals will reap the rewards of innovation - even if the end result is far from a successful one.
Companies mentioned in this post
Questions? Comments? Email us atNetNet@cnbc.com
Follow NetNet on Twitter @ twitter.com/CNBCnetnet
Facebook us @ www.facebook.com/NetNetCNBC