Friday, January 16, 2009

Debt-equity swaps: a capitalist solution to the crisis

By Renaud de Planta in the Financial Times:

Helping capitalists out of a predicament of their own making is a delicate business. It risks allowing them to continue as they please while sending ambiguous signals to other, more prudent, economic actors. Any rescue mechanism should have built-in sanctions to raise risk awareness and reduce the probability of future crises.

The current crisis originated in the excessive leverage of large US and European banks, which has soared from a historical average of 20 to between 30 and 50 times. Based on tangible equity alone (ie, not including goodwill and other accounting devices), the gearing of some large European banks reached as high as 80 by mid-2007.

Forced recapitalisations and buyback of toxic assets have already cost a multiple of national fiscal deficits or led to a ballooning of central banks’ balance sheets. Such intervention threatens to destabilise monetary and fiscal policy. The remedy may prove worse than the disease it was intended to cure.

Excessive debt should be repaid, not shifted from the private to the government sector. There are three solutions – time, inflation and balance sheet rehabilitation. Unfortunately, the time required to repair banks’ balance sheets organically is longer than otherwise healthy private and public borrowers can afford; and while inflation reduces the real value of debt, it too takes time to work and causes long-term macroeconomic imbalances and social injustice. That leaves rehabilitation.

At first, banks tried to strengthen their balance sheets through injections of fresh capital. But debt-equity swaps also reduce a bank’s debt ratio. A bank with an equity base of $2 for every $100 of liabilities has a debt ratio of 50. If 10 per cent of the debt is converted into equity, the bank’s debt ratio immediately falls from 50 to below 8 times.

The advantages are obvious: first, the debt ratio falls and insolvency risk falls sharply, reducing distrust and illiquidity risk. The interbank market would stabilise and central banks would gradually regain control of monetary policy. With sufficient equity, banks would benefit from high lending margins and supply cash to the real economy, helping prevent a collapse in economic activity and the labour market; all without a cent of taxpayers’ money. Furthermore, it would prevent unfair competition from “failed” institutions enjoying government guarantees.

In a debt-equity swap, the original risk-takers would pay. Shareholders would be diluted, in some cases massively. But, since many financial stocks already factor in a high insolvency risk, prices could bounce strongly without the threat of bankruptcy. Debt-holders would suffer too, although less than if the bank collapsed (as in the case of Lehman Brothers or Glitnir) or under hurried and poorly conceived rescue plans (eg, Washington Mutual). Here, creditors will have lost 60 to 95 per cent through forced liquidation in a market crisis. But a bondholder might conceivably be better off; with a bond trading at, say, 65 per cent of face value and a 10 per cent swap, a bondholder could end up with quasi-AAA bond at 90 per cent of face value plus an equity stake.

Bank liabilities include demand and time deposit accounts, but also interbank debt, bonds, replacement values of derivative transactions and others. Regulators, who license the banks, have a unique power – and duty – to force a reconstruction in cases where a bank is potentially insolvent. They would have to determine which claims categories should be swapped and which conditions should apply.

They should set a target maximum leverage ratio, such as 15 times tangible equity. If a bank failed to achieve its target in a given timeframe, forced swaps would be required, first in decreasing order of subordination up to the target leverage ratio. So subordinated bonds would be converted to common equity. Then senior debt, if necessary, would be swapped in decreasing order of maturity, as longer maturities are de facto subordinate to more short-term claims.

The main risk – endless legal disputes between the company, its shareholders and creditors and the triggering of default clauses in various off-balance sheet transactions – should be first eliminated by invoking force majeure and making a strong case that the process is in the general interest.

Large-scale swaps would need agreement between the key capital markets – the US and the UK – and national markets such as Germany, France, Switzerland, etc. It is precisely such “capitalist” solutions that the G20 and other global forums should be debating, rather than ill-conceived spending plans which, if anything, are likely to be laying yet more economic time bombs for the future.

Luigi Zingales of the University of Chicago has suggested that it is time ”to save capitalism from the capitalists”. Banking regulators, central banks and governments should answer bankers’ cries of help with a consistent and robustly capitalist approach. Let the authorities stick to their traditional tasks – namely, strict monitoring of banks to prevent moral hazard, a monetary policy aimed at price stability and a fiscal policy that does not jeopardise the prosperity of future generations.

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