Recapitalizing Banks with a
Debt/Equity Swap
November 13, 2011
This is a topic we've covered before, but that was a while ago
(three years!) and it is still important -- more important now than
then, actually.
October
12, 2008: Effective Bank Recapitalization 2: Three Examples
October 5, 2008: Effective Bank Recapitalization
I got an email from a reader who read about the debt/equity swap
idea in the Forbes article below, but couldn't figure it out. He's a
medical doctor, so he certainly has the capacity to figure out these
very simple ideas. However, nobody ever teaches anyone these things
-- why is that? -- and I figure, if an M.D. can't figure it out,
without further study, then what about a politician or a journalist?
October
24, 2011: Europe's Economic Crisis Is Not A Euro Crisis
"As soon as men abandoned the life
of wandering, tribal hunters to till the soil they needed to
predict the seasons. Such knowledge was required in order to know
when to plant, when to expect floods in fertile valleys, when to
expect rainy seasons, and so on. Months of backbreaking work were
wasted by the unavailability of the calendar, a convenience we
take for granted. The men who first studied and grasped the
regularities of sun, moon, and stars that presage the seasons had
a valuable commodity to sell and they milked it to the fullest at
the expense of their credulous fellowmen. The occult priesthoods
of early astronomers and mathematicians such as the designers of
Stonehenge, convinced their subjects that they alone had contact
with the gods, and thus, they alone could assure the return of
planting seasons and weather favorable to bountiful harvests. The
staging (predicting) of solar and lunar eclipses was particularly
effective in awing the community. The general success resulting
from following the priesthood's tilling, planting, nurturing, and
harvesting timetables insured the priesthood's power. Today's
Christmas holiday season continues the tradition set by ancient
priesthoods, who conducted rituals on the winter solstice to
reverse the retreat of the sun from the sky. Their
invariable success was followed by wild celebrations.
Popular knowledge of seasonal regularities was discouraged by
every manner of mysticism and outlandish ritual imaginable.
Failures in prediction were blamed on sins of the people and used
to justify intensified oppression. For centuries people who had
literally no idea of the number of days between seasons and
couldn't count anyway, cheerfully gave up a portion of their
harvests, as well as their most beautiful daughters, to their
"faithful servants" in the priesthoods.
The power of our finance capitalist money cult rests on a similar
secret knowledge, primarily in the field of economics."
July
10, 2011: The Occult Technology of Power
It might seem incredible that "the priesthood" could wield such
influence just because they could count days on a calendar. However,
this business about how banks work is actually not much more
difficult than that. But, nobody seems to have been taught this
stuff. As a result, those who understand it can wield great power.
You notice, for example, that none
of the bankers are talking about this debt/equity swap idea.
I'm sure they know about it. But, they have discovered that if they
don't talk about it, then politicians don't consider it as an
option. This makes politicians manipulable, and makes them easy to
drive towards policies which amount to stealing very large amounts
of money from taxpayers ("a bank bailout" or "recapitalizing the
banks") and giving it to the bankers.
First, you have to understand how banks work. It's actually quite
easy, so just jump in and figure it out.
March
23, 2008: How Banks Work 7: the Lender of Last Resort
March 16, 2008: How Banks Work 6: Liquidy Crises and Bank Runs
March 9, 2008: How Banks Work 5: Selling Loans
February
24, 2008: How Banks Work 4: Banks and the Economy
February
17, 2008: How Banks Work 3: More Elephant Poop
February 10, 2008: How Banks Work 2: Shitting Like an Elephant
February 3, 2008: How Banks Work
However, that series has a lot of generalized info, covering a broad
range of situations. Let's take a specifc example, as it applies to
our topic today. We will look at Citibank, as Citi is in fact a
prime candidate for a "debt/equity swap" right now, today.
Here are the assets of Citigroup. This is a rather complicated
balance sheet, as it is consolidated and includes all sorts of
activities, not just the usual making of loans. Some of the
terminology is confusing. "Federal funds sold" is, I think,
short-term collateralized lending to other financial institutions.
"Trading account assets" is probably mostly derivatives, and other
stocks, bonds etc. "Investments" are probably mostly bonds, such as
government bonds, mostly held to maturity. Then there are some
loans, of course. This is what Citigroup owns -- assets worth
supposedly $1,913 billion.
Here is what Citigroup owes to other people. We see $844 billion of
deposits, "Fed funds purchased" (short-term borrowings), and $381
billion in long-term debt. All in all, liabilities amount to $1,748
billion.
The difference between the assets and the liabilities is the
shareholders' equity or "book value," here $165 billion. Thus, we
have a capital ratio of $165 billion/$1,913 billion, or 8.6%.
This means that, if Citi's assets fall in value by 8.6%, then the
company owes more than its assets are worth. This is sort of like
"being underwater on your house." You owe more than the house is
worth. Actually, a crisis begins long before the capital ratio falls
to zero, because if it is approaching zero, pretty soon people will
start pulling their money from the bank. If nobody is willing to
loan money to the bank, for fear that it will be defaulted upon,
then the bank will soon run out of money, and default.
In other words, the bank enters bankruptcy. "Bankruptcy," oddly
enough, is one of those things that is not particularly well
understood. All it means is that you then have a process of what
happens after an organization defaults on an obligation. Lots of
things can happen -- that's why there are various "chapters" of the
bankruptcy code. You have probably heard of "Chapter 11." This means
that the organization continues to function, although bondholders
won't get paid as much as they expected. There are other chapters
that deal with liquidation and the like.
The point is, the company can still continue to fuction. General
Motors recently went through bankruptcy, but it didn't stop making
cars. The airlines seem to go bankrupt every fifteen years or so,
but they keep flying planes. Likewise, a bank can continue to
function in bankruptcy.
Let's say, arbitrarily, that the real value of Citigroup's assets
falls by 20%, to $1,530 billion. Now we have a rather large
"negative equity" of $1,748 billion - $1,530 billion, or $218
billion. This is when the banks come screaming to the politicians,
to get the taxpayer to make up for their losses.
The bankers would ask for around $218 billion to make up their
losses, and then another $1,530*10%=$153 billion or so to provide
the needed equity. This is a total of $371 billion to squeeze out of
the innocent taxpayer -- for just one bank!
What does the taxpayer get for his $371 billion? Nothing!
This is essentially what has happened in Ireland. You have to admit
that is a really impressive level of theft. Because that's what it
is -- pure criminality.
However, what is supposed to happen is that the bank enters the
bankruptcy process. In this process, there is a hierarchy of
seniority. Some people get paid, and some people don't get paid.
First, the equity (the shares traded on the stock exchange) goes to
zero. Next, the trading account liabilities would probably be
eliminated -- that's how it should work, anyway. Trading assets are
liquidated, and become cash. Derivatives counterparties don't get
paid. Strictly speaking, depositors and senior bondholders are
probably equal in seniority, but for our example we will make
depositors senior. (In practice, this would be something to discuss
in detail.) Fed funds purchased -- short-term collateralized lending
-- will probably have the collateral sold, so that disappears along
with an equivalent amount of assets. Brokerage payables and other
liabilities we will assume are senior for now, although that might
not actually be the case.
When the smoke clears, we have liabilities including $844 billion of
deposits, $123 billion of payables and other liabilities, $78
billion of short-term debt and $381 billion of long-term debt.
We also have assets of about $1,530 billion minus the assets sold as
collateral, leaving $1,341 billion of assets. Liabilities total
$1,426 billion.
The old equity holders are gone, so who owns the bank? Normally, the
bondholders become the new owners, in some form. We will formalize
that here with a debt/equity swap. The $78 billion of short-term
borrowing and $381 billion of long-term borrowing get converted to
equity. This leaves liabilities of $1,426B - $78B - $381B = $967
billion.
So, now we have assets of $1,341 billion and liabilities of $967
billion, leaving equity of $360 billion. That's a capital ratio of
$360B/$1,341B or 27%. Now the bank is recapitalized. We now have
plenty of equity, and it didn't cost the taxpayer anything.
How did the bondholders do? We had $78B+$381B or $459B of debt that
was converted to equity. After the debt/equity swap, we have
$1,341B-$967B=$374 billion of shareholders' equity or book value.
So, bondholders went from $459 billion of debt to $374 billion of
equity. Which sounds like a loss, but it isn't that big of a loss.
However, a bank has some franchise value, so it would probably trade
at a premium to book value on the stock market. Let's say the new
bank trades at 1.3x book. That would mean an equity market cap of
$374 billion * 1.3x or $486 billion. The bondholders thus started
with $459 billion of debt, and ended with equity with a market value
of $486 billion. Which is not a bad trade, when you think about it.
The losers, of course, were all those junior in the bankruptcy
process, including shareholders, preferred shareholders, trading
counterparties, and so forth. However, the depositors are 100% OK.
In practice, a bankruptcy of this size would probably disrupt the
entire financial system, not because of "contagion," a metaphor of a
healthy person becoming sick, but because all the banks are as
sickly as Citibank. The government would declare a "bank holiday,"
figure out which banks need restructuring via a debt/equity swap, do
it, and then reopen a few weeks later with healthy banks across the
board. It wouldn't cost the taxpayer anything. The banks would then
have a clean balance sheet -- assets have been marked to their true
value, no more fudging -- and ample capitalization.
The bank continues to function. It has the same offices, the same
employees, the same services. Probably some operations would be
eliminated -- derivatives -- and the whole banking system should be
reregulated to more of a 1960s standard. The whole process is really
just a red-penciling of the liabilities side of the balance sheet.
It's just a reorganization of who gets paid what. Not that
complicated, really. This is how capitalism is supposed to work.
In fact, we already did this once before, in the "bank holiday" of
1933. Worked fine.