Why a debt-for-equity swap WILL work

NVM alerts me to an article entitled Insolvent Banks: Why a Debt-for-Equity Swap Won't Work.

The author has at least used the real life example of Citigroup, which appears to be deeply in the mire. He points out that if assets were written down by 20% (a reasonable guess), not only would all bonds have to be converted to equity, but (1) some ordinary deposits as well, which would of course trigger a run on the bank, and (2) a lot of those bonds represent money invested by the government on the taxpayers' behalf, so the taxpayer still has to take a loss on the chin.

Problem (1) has only arisen because banks were allowed to move away from the good old-fashioned model whereby they are financed solely by deposits and share capital/retained profits. This keep a tight lid on the lending side, as funding is by definition restricted to 'spare cash' in the economy, which is of necessity a fairly stable amount.

Problem (2) arises because governments have been steering the wrong course for the past year; once you start bailing out banks, it is difficult to know when to stop - the UK government invested £5 billion in RBS preference shares two months ago and is now about to swap this for equity worth about £0.5 billion.

Be that as it may, and as painful as a debt-for-equity swap may be, it is best to get it done and over with as soon as possible - a year ago would have been better than now, but doing it now is better than letting things drag on for another year. Most governments guarantee ordinary deposits (probably rightly so), but clearly they have been undercharging banks for this implicit insurance and not supervising banks closely enough to minimise the risk that it will have to pay out.

Using the author's figures, and assuming that the government guarantees deposits, there would still be an immediate cost to the taxpayer, but at least the loss would be capped once and for all and The Black Hole would be shut.

I did similar workings on the Bradford & Bingley last September, with a 10% write down and it worked just fine - even with a 20% or 30% write down, that bank would not have to eat in to ordinary deposits, so it all depends on the numbers.

There is another cunning way of doing what is effectively a debt-for-equity swap, and that is the New Bank/Good Bank model.

Just sayin', is all.