A Debt/Equity Swap To Recapitalize European Banks: A Real World Example
September 23, 2011
(This item originally appeared at Forbes.com on September 23, 2011.)
I’ve been talking about using a “debt/equity swap” to recapitalize large banks in Europe or the U.S. This is actually a form of bankruptcy, but since that term is often misunderstood, let’s call it “receivership” or “nationalization” instead. We will use a real-life example, BNP Paribas, to see how it might work.
BNP Paribas tells us that as of the end of the first half, it had 1,926 billion euros of assets (loans, bonds), 1,839 billion euros of liabilities (borrowed money), and equity of 87 billion euros. There are a number of different ways of computing capital or equity, but for now we can use the simple accounting definition. From this we can see that the bank is levered 1,926:87 or 22:1. In other words, it has a capital base of 4.5%. In practice, a bank gets into trouble long before its capital officially goes to zero, as Paribas is getting into trouble today.
The problem here is that if the bank takes a 4.5% loss on its assets – a Greece default, for example – then it becomes insolvent. Even before that, its lenders and depositors will likely begin to flee. Thus, the bank enters receivership or is nationalized.
At this point, the equity holders lose everything. Next down the chain of capital, preferred equity and derivatives liabilities are eliminated. The subordinated debt also goes out the window. Repurchase agreements are canceled, the lender taking the collateral. This would leave liabilities of 1,273 billion by my count.
This sounds promising, but it is likely that removing such a major derivatives and lending counterparty would also precipitate insolvency among other large banks. The most likely result would be a “bank holiday,” in which the entire banking system enters the workout process simultaneously. The end result is that assets would fall to about 1,625 billion by my count, eliminating derivatives assets.
As we know, the remaining assets are not worth as much as the bank has said they are worth. The bank takes a big write-down on assets, of 30% or 488 billion, reflecting their fair value. This leaves assets of 1,137 billion.
Our liabilities are still in excess of our assets, so now the bondholders enter the picture. There are 223 billion of bonds, and another 117 billion due to credit institutions, for a total of 340 billion. This gets converted to equity. Let’s just pick an arbitrary number and declare that for each fifty euros of principal, the bondholders get one share of equity. Thus, there are 6.80 billion shares outstanding.
Now we have 933 billion of liabilities, 1,137 billion of assets, and 204 billion of equity. This is a capitalization ratio of 18%, which is quite cushy, and appropriate for the sort of environment that the bank finds itself in. We will assume that the bank trades at a modest premium to book value on the stock market, of 1.5x book. Thus, the equity market cap is 306 billion euros and the price per share is 45 euros.
Note that the bondholders didn’t actually lose much money. They started with 340 billion of bonds, and ended with 306 billion euros of equity. Not a bad trade, all considered.
Admittedly, this process is very dramatic. By way of the “bank holiday,” we have effectively eliminated the entire outstanding derivatives book – which, I would argue, is a good thing. At this point there are few other options except for extravagant lying, robbing the taxpayer, and printing money. Probably all three.
The bank would continue operating. This whole process amounts to taking a red pencil to the balance sheet, and doesn’t inherently require any liquidations or mass layoffs.
From this we can also come to a few conclusions regarding how things should be done in the future. I support some form of the Glass-Steagall Act, which separates commercial banking from broker/dealer operations. In other words, large deposit-taking banks would not engage in derivatives dealing and investment banking business, which is at the core of many of the problems facing these giant money-center banks today.
Second, it would be worthwhile to define a more detailed hierarchy of seniority for commercial bank lenders. Demand deposits would be senior to time deposits and bondholders. Also, there would be a requirement that demand deposits constitute no more than 70% of liabilities. This would provide a clearer sequence of seniority, as opposed to my somewhat arbitrary example, which would allow the process to be much more forthright.
We can also see from this why taxpayer-funded “bailouts” are not likely to be very successful. They would have to fill the huge 488 billion euro hole, plus add some additional equity of perhaps 100 billion euros, for a total of 588 billion euros. That doesn’t include any nasties hidden in the derivatives book. For just one bank. The taxpayer would likely get some pathetically small slice of equity, perhaps 20% of the total, amounting to a direct ripoff.
The time for kicking the can is about over in Europe. We can only hope that leaders there do something sensible.