Senior economist cuts through the crap!

Prof. Willem Buiter, 21 September 2008:

To get new capital into the banks, and to reduce leverage dramatically at the same time, I propose a mandatory debt-for-equity swap for all US financial institutions. For the most junior debt (subordinated or tier one debt), 100% could be swapped for equity. For more senior debt, the share of the notional or face value of the debt that is subject to compulsory conversion into equity (preferred or common stock) would be lower. Even the most senior debt should, however, be subject to a non-trivial ‘conversion ratio’ - 25 percent, say.

This form of debt forgiveness would not extinguish the claims of the current creditors, but would convert them into equity - a pro-rated claim on the profits - if any - of the banks. It would have the further benefit of diluting the existing shareholders - a desirable action both from the perspective of fairness (I was going to say equity!) and from an efficiency point of view: incentives for a repeat of past incompetence, reckless lending and mindless investment would be mightily diminished.

I am proud to say that I, humble bean counter, beat him to this by five days, although I didn't do a proper worked example, as it would apply to Bradford & Bingley, for another fortnight.