Thursday, 9 October 2008

Debt-for-equity- an alternative to the bailout

UK blogger Mark Wadsworth posted a comment in an earlier post of mine, which questioned the merits of the huge flow of central bank credit to commercial bank.

I really liked Mark's ideas. Mark offers the debt-for-equity solution to the current banking crisis:

The solution (to the banking crisis) is far simpler than that, and the State should keep out as far as possible, except to start supervising banks properly - not regulating, mind you, I mean supervising, having quiet words in ears etc.

Nobody wants to lend to banks because they are 'undercapitalised'. What does this mean in practice? It means that total liablities are perilously close total assets - especially as we know banks are overstating the value of some of their dodgier investments.

The 'capital' is just a balancing figure, really.

On the liabilities side we have customers' deposits, shorter term 'money market' stuff and longer term bonds.

To recapitalise banks, all they have to do - at gunpoint if necessary - is to cancel some of their longer term debts and replace it with share capital, a so-called 'debt-for-equity-swap'.

Hey presto, problem solved. The bondholders who get given shares can always sell their shares if they need cash - the total value of the bonds and shares, taken together, will probably be slightly enhanced by the move.

Worked example applied to Bradford & Bingley here.

As to bonuses, these are A Good Thing as far as HM Treasury is concerned - the corporation tax on negligible profits is negligible - but we know that bank managers overstated profits and then paid themselves huge bonuses taxed at effective rate 47% (including Employer's NI).

The real losers from the bonus culture are the shareholders. The problem here is that most shares are owned by 'institutions' who are in cahoots with boards of plc's and vice versa. Again, this is easily fixed - see here.

Land values can be kept low and stable by introducing land value tax (and scrapping all other property or wealth related taxes - I am a small government, low tax kind of chap).

There. All sorted.


Anonymous said...

Writing down debt in a debt for equity swap is very difficult legally speaking.

Anonymous said...

Wouldn't you need to put a bank into bankruptcy in order to restructure its liabilities.

Just a thought.

Anonymous said...

You might, I suppose, have to institute a special - and fast - bankruptcy method that can be applied to any institution with a banking licence. Would that present any difficulties?

Mark Wadsworth said...

Ta for link.

This is the oldest idea in the book. Rather bizarrely, it is only two chaps at the FT (Willem Buiter and to a lesser extent Martin Wolf) who mention this as the least-bad solution.

LFS and D make good points, but whatever the legal niceties of debt-for-equity swaps are*, it is a heck of a lot less radical than nationalising or bailing out with £50 billion or £500 billion of taxpayers' finest.

* Shareholders and bondholders just have to wrangle over the terms of the conversion - the cake is only so big and they have to share it out between themselves. If they do it properly, both parties end up slightly better off, so there is wiggle-room.

Nick von Mises said...

Just so long as we are all clear that this does not prevent the huge destruction of capital. Bookkeeping does not create wealth. All of the malinvestment from the bubble must still be purged.

Mark Wadsworth said...

NVM, step one is a write down of mortgage assets to market value - average around 3%. Step 2 is tidy things up by replacing medium term liabilities (bonds) with non-repayable claims against the bank's assets (shares).

No 'capital' is destroyed. None whatsoever. Good bookkeeping neither creates nor destroys wealth, it just records the state of play and enables people to make sensible business and investment decisions.

Nick von Mises said...

Agreed, but I wanna be clear on the nuance of your second paragraph. The capital was destroyed in the bubble - it was funnelled into unproductive enterprises that will not create wealth in the future (e.g. a kitchen remodeling via HELOC). A big piece of the financial meltdown is coming to a realisation that all that capital has gone. Accounting is just the messenger. The financial crash is not in itself a destruction of capital, it's a realignment of accounting treatments and equity valuations to reflect the sudden waking up to reality.

Therefore while the debt-to-equity is a good idea, it's not a solution in the sense of rescuing capital (not that I think you were implying that). It's about how to share the pain of the reajustment to reality.

And while a good idea, it won't make the slightest difference to lending because banks don't wanna lend and consumers don't wanna borrow.

Mark Wadsworth said...

NVM, The capital was destroyed in the bubble - it was funnelled into unproductive enterprises

90% of the credit went into inflating land values, that's not even an "unproductive enterprise". And nothing has been "destroyed", there are just people with large debts secured on depreciating assets. But for every loser there is a winner.

Whether a d-f-e strategy will "restore lending" is a moot point. At least it will make the banks creditworthy again, which is perceived to be the big issue at the moment (quite possibly rightly). And it won't cost a penny of taxpayers' finest or allow gummints to sneakily nationalise banks, that's the important bit.

Anonymous said...

Oh, I'm in favour of the plan.

Perhaps you are talking about "capital" in an accounting sense where it can't really disappear it just changes form.

In the Austrian sense, capital is a part-complete consumer good (there's a minefield of terminology there - I mean all those words in the Austrian sense). If someone invests time and resources into a process, the value is the anticipated return on the final consumer good. If that consumer good ceases to be valued in the market then the capital either disappears or must be reallocated to an alternative end product. In this sense capital does grow and contract with a changing market in a way accounting only loosely addresses. Capital built up in Quangdong to tool a factory to make kettles can evaporate completely if nobody wants a new kettle.

I'm not disagreeing with your main point, just saying the nuance of capital is different.

As an empirical fact, perhaps 90% of the MONEY went into land. The land didn't change its productivity so no new capital was created. The money was moved to the seller who then often wasted it on non-productive enterprises. So while the land with go down, capital won't be liberated. It's already been squandered by the previous seller.

Probably on a rolex and vacation.

Nick von Mises said...

That was me.

Mark Wadsworth said...

NVM, It's already been squandered by the previous seller. Probably on a rolex and vacation.

I sold all my properties in the years leading up to the crash and squandered it on National Savings & Investments, which generates the income to pay the rent.

Nick von Mises said...

Which is a pretty clear demonstration of the phrase "forewarned is forearmed".

I wasn't in the right part of the life cycle to ride the bubble up (clearing debts, building up first savings etc), but I was able to prevent wasting everything by buying the peak. Hopefully I'll do well in this downturn and ride up the next one.

The stakes have been so high it's really sharpened my mind to economics. I thank my lucky stars I devoted my attention to it before the crash rather than after.