I've stumbled across this blast from the past illustrating how debt-for-equity-swaps work in real life:
In a move to dramatically strengthen its balance sheet, cosmetics company Revlon has brokered agreements with fund managers Fidelity Investments and MacAndrews & Forbes to swap bonds for company shares. After years of surviving on emergency cash infusions from financier Ronald Perelman, analysts say that the company may have finally found a longer-term financial solution.
The refinancing agreement will cut the company’s $1.9 billion debt load almost in half with a debt reduction amounting to $930 million...
The news is a boon for holders of Revlon’s bonds since the value of these offers either exceeds or approaches [the par value of the bonds] based on the company’s current stock price. This is reflected in the spreads on the firm’s bonds, which are no longer trading at distressed levels.
Which is exactly how the banks would have dealt with things, had the government not lumbered in with £37 billion of taxpayers' finest.
Friday, 21 November 2008
"Debt-for-equity swap boosts Revlon finances"
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13 comments:
Did you "make-up" these figures?
(I'll fetch my coat)
DfE is going to be hard for banks when they are legally required to maintain higher capital rations.
The write-off will be made against tier-1 - so more cash will be needed to be hoarded.
Oh dear, current policy will kill them. bugger.
DfE should only ever have a positive impact in terms of regulatory capital. Deposits aren't generally eligible capital. Convert them into equity and they become tier one capital at the face value of the shares, plus the difference between the original deposit and the face value of the share would be a share premium, also counting as tier one.
My only concern with DfE for banks is, would there be a danger of a run on a bank if depositors sensed that their deposits might be turned into equity?
Don't get me wrong, I think that banks which get into that kind of situation should be put into some form of administration and be restructured or broken up. DfE is a perfectly reasonable way of doing that, but if it's introduced as the default way to approach things in future, it could create some problems.
Long term bonds as a source of funding reduce the risk of liquidity crises at banks. If short term accounts become more secure than longer term deposits, due to the latter being at risk of DfE swapping, it might be harder for banks to attract longer term funding, which could make liquidity problems worse and increase the risk of bank runs.
I don't think there's a perfect solution and DfE is probably the best option we have, but it isn't problem free.
"it might be harder for banks to attract longer term funding"
Indeed it might. But is that A Bad Thing?
1. The higher risk would be compensated with higher interest rates on long term bonds, which would make the banks even keener to attract very long term funding, i.e. share capital.
2. But the correspondingly reduced risk for ordinary savers would mean that banks pay less interest on 'safe' accounts. Which is perfectly fair, the interest rate is supposed to reflect the risk. And evens things out from the banks' point of view.
3. Maybe banks would have to manage purely with customer deposits and share capital. So what? The building societies managed perfectly well without long term borrowing until the 1980s. And Nationwide is one of the few financial institutions that has not run to the gummint crying out for new money.
Sorry for the very slow reply, but I've been traveling with sporadic internet access.
Indeed it might. But is that A Bad Thing?
In terms of liquidity risk, it could be. The reason that bank runs present a problem is that banks borrow over much shorter terms than they lend. The more long term funding a bank has, the less liquidity risk it faces.
Maybe banks would have to manage purely with customer deposits and share capital. So what?
This all comes down to what you define as a customer deposit. If banks were able to define all their long term funding as a customer deposit and put that out of reach for d-f-e swapping, we'd be back to square one. That's where banks differ from other corporates, which cannot act as deposit takers in the same way.
PL, your first point on 'liquidity risk' is not borne out in practice.
In the good old days, (i.e. until about ten years ago), banks were funded almost entirely by deposits (and share capital and retained profits, of course). This made them much more cautious - it's only HSBC and Nationwide that stuck to this model and they are doing much, much better than the other banks who took out 'wholesale funding'. The banks like NR and B&B who relied most heavily on 'long term' funding were the first to get into real trouble.
Your second point is superficially good, but a bank is a business like any other - it has to balance its books somehow. It can reclassify all its loans as deposits if it so wishes - but provided it was clear that the gummint will never, ever bail out banks - but then all deposits at such a bank would be at risk of being swapped for equity. So such a bank would find it difficult to attract deposits, so the argument is self-cancelling.
The fundamental point is that in the absence of gummint guarantees, bail outs etc, free market forces would ensure that banks are much more cautious; and if they were not cautious and got into a mess, the losses would be borne by those who took the biggest risks.
Enjoy your travels, BTW.
I'm currently sat in an airport with a six hour gap between flights waiting to get home, so it's not the fun bit!
PL, your first point on 'liquidity risk' is not borne out in practice.
I think the liquidity risk that is created is fairly self-evident. If a bank were to have all it's funds in accounts which are long term, it wouldn't be at risk of a bank run. The harder it is for your funding to walk out of the door, the less risk you have of running out of cash.
The banks like NR and B&B who relied most heavily on 'long term' funding were the first to get into real trouble.
That was driven by poor credit risk management, rather than liquidity risk, but the liquidity risk did come into play afterwards. Imagine if NR had all it's funding from long term deposits; you wouldn't have seen those queues outside branches.
It can reclassify all its loans as deposits if it so wishes
To a bank, they are essentially the same thing anyway.
but provided it was clear that the gummint will never, ever bail out banks - but then all deposits at such a bank would be at risk of being swapped for equity.
I agree with that approach being the default. If you are going to swap debt-for-equity, you have to treat all investments equally, whether they are ordinary savings accounts or corporate bonds, otherwise you risk creating perverse incentives.
There might be an argument for not swapping the first few thousand held for a given depositor, just to ensure that people don't see their current account wiped out over-night, but other than that, I believe the instant access saver should be at as much risk as the corporate bond holder.
PL, your second to last paragraph, excellent stuff, but think about it - as between banks and their depositors and creditors, it is all private agreements, it is not up to you or me to lay down hard and fast rules.
Bank A might say that any d-f-e applies in priority to a defined list of bonds, and that other defined accounts would only be d-f-e'd as a last resort. This bank pays higher interest rates on the bonds and lower interest rates on the deposits.
Bank B says that in the event of a d-f-e, all deposits and bonds are affected equally. This bank pays much the same interest rate on bonds as it does on deposits.
If you have money to spare, you then choose your own risk-reward profile from the four 'products' on offer. Either way, risk and reward are matched, that's the important bit.
I was mostly following on from your comment that "swapping ordinary deposits for share capital is of course beyond the pale" when I said that all deposits should be treated equally.
If banks did what you suggest and set an order of priority (in essence defining their own list of priority creditors), that would be great and the problem would be solved, but I wouldn't expect that to happen in such an orderly fashion.
While I agree that in general "it is not up to you or me to lay down hard and fast rules" the situation we are talking about is one where a bank is essentially bankrupt. In general, it isn't for third parties to interefere when private agreements are working, but when businesses aren't able to honour their contracts, that changes and there probably do need to be hard and fast rules set out.
If a bank does tell its depositors who is first line in line for d-f-e swapping, then I'd stick with that order, but in a situation where there is no pre-defined order and d-f-e swapping is necessary, I'd say that treating everybody equally, rather than going for the corporate bondholders first is the right way to go.
PL, I agree that retrospective legislation is very tricky, it would have been much better if each bank informed its depositors and bondholders in advance. But ...
1. Politically and morally depositors ought to be d-f-e'd last. You cannot impute the same level of due diligence and expertise on somebody deciding where to open a savings account (as like as not, whatever bank is convenient on the way to work) as you can on pension funds etc who have millions and billions to invest and really ought to have looked before they leaped.
2. Under normal insolvency and banking rules, a depositor can ask to be repaid first, a bondholder who has agreed to tie up his money for six months can ask to be repaid next, and a holder of ten-year bonds can't ask to be repaid until those bonds mature. As a matter of fact, banks have plenty enough assets to repay depositors and probably enough to repay the six-month people, but seeing as the ten-year bond people were gambling on higher returns (via higher interest rate) they also ought to be the ones who now carry the can.
3. Long-dated bonds in banks are already trading under par. If your bond is trading at 80p in the £1, you have already 'lost' 20p in the £1, so it wouldn't be the end of the world to be issued with new 80p bonds and shares with a nominal value of 20p (market value unknown).
Either way, this is not a question of rules or legislation, each bank has to sort this out itself. If they get it 'wrong' (or 'wronger' than other banks) then nobody will ever deposit money with them again, so it will sort itself out.
Politically and morally depositors ought to be d-f-e'd last.
This relies on being able to draw a clear distinction between depositors and non-depositors based on term of deposit, which I don't believe could accurately be done; lot's of savings accounts are fixed term too. Your comment about pension funds is good, but that would lead me to conclude that the priority for d-f-e should be based on size of deposit rather than term of deposit.
Either way, this is not a question of rules or legislation, each bank has to sort this out itself.
In the ideal world it would be, but in reality, we need insolvency rules to deal with situations where the banks' own arrangements haven't worked. Banks could have set out d-f-e arrangements in the past, but never have, in spite of instruments, such as subordinated debt becoming common.
PL, that would lead me to conclude that the priority for d-f-e should be based on size of deposit rather than term of deposit.
OK, this is a political thing, Our benighted gummint has decreed that balances up to £50,000 per person per bank are 'guaranteed'. That's a good a place to start as any.
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