So, you don't want to nationalize all the bad banks, and neither does Megan McCardle. After all, America is not Sweden, we're heterogeneous and fractious and really gosh-darn big. American politics are nasty, brutish, and interminable — no way to run a lemonade stand let alone a bank. Okay.
Unfortunately, the private sector approach to reorganizing and recapitalizing banks, forced debt-to-equity conversions, is too harsh on creditors. Yes, it is the free-market solution, and it's what we normally do (via the bankruptcy process) when firms are viable but undercapitalized. But, we are afraid of hurting lenders at a moment where credit markets are wobbly and a strike by lenders could be catastrophic. Okay.
Maybe these are two great tastes that taste great together. What if both the state and junior creditors could took equity stakes in reorganized firms, fifty-fifty. The former creditors would run the place without government interference, isolating management from politics and diminishing concerns of creeping socialism. Taxpayers would enjoy the upside as passive investors in ordinary, profit-maximizing businesses, and would buy shares at a bargain price (book value after very aggressive write-downs have been taken). Some creditors would still have to endure the indignity of being converted to equity, but the amount of debt that would have to convert would be cut in half (approximately), giving converted debtors a lot of capitalization bang for their buck. Junior creditors would go from owning very dodgy debt to relatively safe shares, and more senior creditors would see the value of their positions spike and stabilize as solvency concerns abate.
Here's how this would work:
Regulators would go over bank balance sheets, and come up with a very conservative account of their assets. Nothing would be carried at more than market, in-quantity bids. That's a fire sale price? Too bad. There's no market bid at all? That's a zero then.
Any bank that is undercapitalized on this basis, that is beneath the regulatory thresholds for an adequately capitalized bank, is insolvent. Equityholders, common and preferred, are wiped out. Sorry, Charlie. You levered up, you bought crap, you lost. That's how it goes. I love the smell of capitalism in the morning.
We choose a "well capitalized" leverage ratio, and that will tell us how much debt we'll need to convert to equity. Here are the formulas, if I've got my algebra right:
government_equity = converted_equity =
(total_assets / (2 * target_leverage - 1))
reqired_conversion = converted_equity - old_book_equity
...where old_book_equity is the book value (a negative number) of the now wiped old equity.
We define two classes of stock, one voting and one nonvoting but convertible to the voting shares, each with a par value of $1. The government puchases its share, by purchasing government_equity shares of the nonvoting stock at par. The government is forbidden from exercising the conversion option.
The required amount of debt is converted to converted_equity shares of voting stock, which is distributed to creditors pro rata based on the amount of equity converted. (Equivalently, a conversion rate of required_conversion / converted_equity is established.)
The firm would have the option of paying unsecured contingent liabilities that arise from contracts entered into prior to the reorganization in stock at the conversion rate established for other creditors. This has the effect of placing undercollateralized derivative counterparties where they belong, in the same boat as the most junior creditors of the firm. It's also good from a "moral hazard" perspective — we really, really want people to take counterparty risk seriously in whatever OTC derivaties market survives this episode, but we don't want to wipe out existing counterparties and set-off a cascade or meltdown. Counterparties to reorganized firms would take a haircut, and salutary uncertainty would be introduced in valuation schemes that too often begin by assuming away counterparty risk.
If a firm is so profoundly insolvent that, even with the government capital infusion, the required debt-to-equity conversions would have to hit depositors (at banks) or claims on assets held on behalf of clients (e.g. stocks held for clients by brokerages), then the firms should be liquidated, with the government honoring FDIC and SIPC guarantees. If any such firms are systemically important, they'd have to be nationalized outright, like AIG. Half-measures can't save such firms. (Thanks to Winterspeak for pointing out this issue.)
The aggressiveness of the writedowns in Step 1 is the core protection for taxpayers in this plan. If that's watered down, this could become a taxpayer subsidy to converted creditors. Also, to protect taxpayers, creditors should never be able to purchase shares more cheaply than the government. Under the formulas above, that would happen when the book equity of the reorganized firm is positive, but less than regulatory capitalization thresholds. In this case, the new owners effectively get a subsidy, a wealth transfer from old equityholders, during the reorganization. This subsidy should be shared by converted creditors and the government. The formulas above allocate old book equity to converted creditors, to ensure that creditors rather than taxpayers bear prereorganization losses, and would have to be modified when old book equity is positive:
(total_assets - (old_equity * target_leverage)) /
(2 * target_leverage - 1)
government_equity = converted_equity =
(total_assets + government_cash_infusion) /
(target_leverage * 2)
reqired_conversion = converted_equity - (0.5) * old_book_equity
...and the government would buy shares at the same conversion rate paid by creditors, rather than at par.
- 30-Sept-2008, 2:20 p.m. EDT: Replaced an "and" with "as", 'cuz that's what i meant.
- 30-Sept-2008, 2:45 p.m. EDT: "abated" to "abate"
|Steve Randy Waldman — Tuesday September 30, 2008 at 12:27pm||permalink|