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Wednesday, September 24, 2008

 

a different way


martin wolf in the ft:

The simplest way to recapitalise institutions is by forcing them to raise equity and halt dividends. If that did not work, there could be forced conversions of debt into equity. The attraction of debt-equity swaps is that they would create losses for creditors, which are essential for the long-run health of any financial system.

The advantage of these schemes is that they would require not a penny of public money. Their drawback is that they would be disruptive and highly unpopular: banking institutions would have to be valued, whereupon undercapitalised entities would have to adopt one of the ways to improve their capital positions
.

If, as seems plausible, a scheme that imposes such pain on the financial sector would be rejected out of hand, the next best alternative would be injection of preference shares by the government into decapitalised institutions, on the lines proposed by Charles Calomiris of Columbia University. This would be a bail-out, but one that constrained the behaviour of beneficiaries, not least on payment of dividends. That would make it far better than dropping benefits on the unworthy, via mass purchases of overpriced toxic paper.

What then do I conclude? Yes, there may well be a place for intervention in the market for toxic securities. But this is a costly and ineffective way of meeting today’s deepest challenge. What is needed, still more, is a clear and effective way of deleveraging and recapitalising the financial sector, ideally without using taxpayer funds. If such funds are to be used, they must also be injected in as carefully targeted and controlled a way as possible. Comprehensive action is essential, as Mr Paulson has decided. But let the US take the time to make that comprehensive action right.


this university of chicago roundtable assesses the fundamental problem correctly -- there is too much leverage, and a way must be found to delever and recapitalize -- and in part advocates forced debt-to-equity swap.

the idea is fundamental to restructuring distressed companies, and involves creditors agreeing to write off a portion of the lender's debt in exchange for equity participation. the result is a lessening of the lender's liabilities, raising balance sheet equity, and improvement of cash flow (as debt service is no longer required on the forgiven debt).

though equity is summarily diluted and existing stockholders can realize terrific losses, the serious pain is on the creditor side -- and is part and parcel to an admission by primary market participants that bondholders, not just stockholders, will have to suffer too for the risks they have taken in funding banks.

this is not currently the case -- the paulson plan concept (to call it a plan is to irresponsibly glorify it) is all about making the chinese central bank taxpayers take all the pain instead, leaivng bondholders whole and stockholders perhaps off lightly. the paulson concept seems to be that, by offering the ridiculous prices of 2005 through the magic of government borrowing, both delevering and recapitalization will be abetted.

that will be true, too -- for some, probably goldman sachs and morgan stanley as they now go about finding depositors and delevering its asset book into compliance with bank holding company regulatory leverage. as brad setser pointed out, though, it will be only some. the size of the effort will have to be much larger than $700bn if the government intends to pay top-dollar for bad assets, or it simply won't move enough bad assets to make the difference. for the rest, delevering must continue apace for the foreseeable future.

that said, debt-to-equity conversion would be painful, contracting and deflationary -- which is why the financial community and their captured government proxies are not even mentioning it as a possibility.

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