How to prevent TARP 2.0

December 9, 2009

Henry Blodget explains how to prevent TARP 2.0 when the next financial crisis hits, which the WH embrace of TBTF makes more likely:

What’s the solution?

Debt that automatically converts to equity when a bank’s capital ratio falls below the required level.  What does that mean? It means that equity holders will still get hit first if the bank makes dumb-ass loans. But it also means that if the bank makes so many dumb-ass loans that its equity gets wiped out, bondholders, not taxpayers, will pick up the rest of the tab.

How does it work?  When the bank’s equity falls too far, some of the convertible bonds convert to equity, thus restoring the bank’s capital ratio. This happens automatically, without bankruptcy or fuss. It happens without surprise. It happens without threatening to bring the whole economy to its knees. It happens without Congressional moaning and hand-wringing and without Treasury secretaries dropping to their knees to beg and plead.

Bondholders who buy these bonds–now called CoCo’s, or “contingent convertibles”–know full well what they are buying, and the bonds are priced to reflect the equity conversion risk. Lloyds just sold a bunch of these in the UK, and there was a market for them.

To fix the banking system, all regulators would have to do would be to require banks to issue enough CoCos that they could withstand financial Armageddon without the taxpayer getting involved. The banks’ ability to make huge bets (and huge bonuses) with small amounts of equity would be preserved, so perhaps the bank lobbyists would agree to stand down for a while. The world could rest assured that SOMETHING had been done to prevent the same mess from happening all over again. And we could all return to peace, happiness, and prosperity.

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