Will convertible-bond buyers help prevent bank nationalization?

By Felix Salmon
April 20, 2009

Edmund Andrews has the news that the Obama administration seems to have settled on its preferred method of recapitalizing banks which have failed its stress test: it’s going to take the TARP money that it’s already lent them, and convert it into equity. That makes perfect sense to me: it avoids the government having to ask Congress for extra funds, and it implies that banks will be nationalized to precisely the degree the government considers them to need its own recapitalization.

There will of course be one extra step in between. No bank can fail a stress test; instead, a preliminary stress test will reveal which banks require recapitalization. Then the banks will be given the opportunity to recapitalize themselves privately. If they can’t or won’t do that, then the government will step in with its debt-for-equity conversions.

And as far as that second step is concerned, it’s actually possible that there’s money out there now for banks willing to tap it. Richard Barley reports today on the revitalization of the convertible-bond sector, which is where most private-sector bank capital came from in the months immediately prior to the market shutting down completely:

Nomura said that before September 2008, 73% of its European trading in convertibles was with arbitrage-driven hedge funds. Now, 68% is with investors who buy the bonds outright. The global trend is similar, the bank said.

That change, combined with an investor focus on companies’ ability to refinance debt, means share prices are actually going up when convertibles are announced.

Steelmaker ArcelorMittal’s shares rose 7.6% when it sold a €1.1 billion ($1.45 billion) deal in March that was then increased to €1.25 billion…

Convertible investors are happy as prices are showing strong gains right after issuance, while traditional stock investors are getting a fillip as well. And investment banks are tapping into a fresh seam of fees.

Now banks, of course, aren’t steelmakers, and the fact that ArcelorMittal can successfully get a convertible away in Europe does not remotely mean that Bank of America, say, could manage to do one in the US. But BofA’s results this morning were solid, and bank stocks in general have been performing so well in recent weeks that there’s a reasonably large constituency of potential investors who might be interested in buying up some convertible bonds at attractive prices.

I’m just not completely convinced that the real-money market for convertible debt is as strong as Barley might like to think. If the hedge-fund bid disappears entirely, then of course the real-money investors will make up a higher proportion of the market. But that just means the market is a fraction of its former size. And what’s not obvious is that there are new real-money convertible-bond investors — people who might have been plain-vanilla equity investors in the past, but who now prefer the downside protection of a convert.

The fact is that convertible bonds are very scary things to most buy-siders: valuing them involves some pretty sophisticated option math, which is one reason why historically such bonds have been sold overwhelmingly to arbitrageurs. At the very least anybody buying a convertible bond should be able to work out the market price of trying to replicate it in the secondary market with a combination of debt and equity options, and should therefore be comfortable in the world of equity derivatives.

Are such people numerous enough to help recapitalize the entire US banking system? I’m sure that Treasury hopes so: the last thing it wants is to become the single largest shareholder in most of America’s biggest banks. But given how burned the last round of financial-institution convertible bond buyers ended up, I’m not holding my breath for a new set of investors to come galloping over the horizon on their white steeds, ready to save the government from being forced to implement its contingency plans.

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