Bank debt-for-equity swaps: Where do you draw the line?

April 30, 2009

David Leonhardt seems to be on roughly the same page as me when it comes to debt-for-equity swaps at America’s banks:

In February, the Treasury began twisting the arms of some holders of Citigroup preferred stock to get them to convert it into common stock. (Preferred stock, despite its name, is something between a loan and stock.) The credit markets hiccupped, but quickly returned to their previous state. In the wake of the stress tests, the Fed and the administration may well push for more conversions along these lines.

The trickier issue is what to do with holders of so-called subordinate debt. In the spectrum of investments, subordinate debt is considered safer than preferred stock and tends to be subject to haircuts only when a company slides toward bankruptcy. Pushing a bank to the brink of bankruptcy would raise the specter of Lehman Brothers.

What Leonhardt doesn’t say, but leaves implicit, is that if you’re this nervous about touching the sub debt, then that means there’s no question of touching the senior unsecured debt — let alone depositors. This could be the beginning of a consensus: when a bank needs more recapitalization than the government has money to provide, then it’s certainly OK to convert preferred stock to equity (we’ve already seen that, at Citigroup), and in extremis one can convert sub debt to equity as well. But we’d be getting far ahead of ourselves if we started talking about tapping senior unsecured debt — which is banks’ chief wholesale funding mechanism.

After all, there’s no point in solving the solvency problem in the banking sector if you don’t solve the liquidity problem as well — which means that banks need to continue to have the ability to fund themselves in the private markets. If you start touching the senior debt too often — as we did in the cases of Lehman Brothers and WaMu — then even healthy banks’ ability to fund themselves rapidly disappears.


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