Opinion

Felix Salmon

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

By Felix Salmon
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.

Comments
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This touches on an area that this layman has been trying to get an education in for some weeks now to no avail. My broad question is, “why are the policy makers acting as if the bondholders of C and BAC have to take a major haircut in a restructuring that yields banks with clean balance sheets, the world as we know it will come to an end?” I would think that someone who invested in the bonds of a bank that through its bad judgement became insolvent should expect to lose at least some of his principal. But if I give the policy makers the benefit of the doubt, there must be some cataclysmic consequence for the economy (and hence the man on the street) of giving the bondholders a haircut. I think if I understood your last paragraph better, I might have my answer.

I consider you one of my better level-headed educators over the last six months. Care to expand, covering the basics that some of us non-finance guys may still not understand?

Posted by Robert Ash | Report as abusive
 

It’s not a matter of whether or not the government wants debt for equity swaps. The government cannot compel debt for equity swaps under current law. Creditors who swap a senior security for a junior security generally lose relative to those who did not go along with the conversion. The government is the only party willing to absorb the losses from converting preferred to common stock for banks it is afraid to push into Chapter 11.

 

I think you are conflating capital and funding. “Senior Debt” is I think usually a form of capital and relevant to solvency, vide WaMu, ranking behind depositors (although ahead of most other forms of capital). When banks talk of funding and liquidity, it is commonly either about deposits or about inter-bank lending which ranks with deposits.

As noted by Linus Wilson, the government lacks powers to discriminate in some things. In a serious situation it is left with intervention by the FDIC. If the best route then is sale as a going concern, this seems to mean that the senior debt is at risk. And the degree of risk is partly a function of regulators’ behavior from time to time, a kind of risk that market professionals are typically not keen to take.

Posted by RogerS | Report as abusive
 

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