Fixin' the banks the free-market way

Those who object to debt-for-equity swaps as the least-bad way of sorting out the banks (and just about anything has to be better than nationalising the losses, subsidising the banks or helping them inflate their way out of trouble) seem to think that it is somehow 'unfair' to make bondholders take losses on the chin.

The point is that bondholders have already suffered losses and that a debt-for-equity swap merely crystallises those losses. The scale of the latent losses suffered by bondholders is indicated in a couple of articles on bond buy-backs or 'debt-for-debt swaps':

From The FT:

European banks are boosting their capital bases by repaying billions of euros worth of junior bonds at hefty discounts to face value and booking the difference as profits that can be added directly to core equity. Crédit Agricole offered to buy back £750m of junior debt at a 28 per cent discount on Wednesday, becoming the fourth large European bank in less than a fortnight to exploit the distressed prices of such bonds.

From The New York Times:

The Swiss bank [UBS] said last week it had bought back bonds for 537 million Swiss francs (325 million pounds) relating to a principal amount of 842 million francs, but had been prepared to buy back up to 1 billion euros of four subordinated issues.

Lloyds [Banking Group] offered between 45 percent and 80 percent of face value on a range of Upper Tier 2 bonds, denominated in sterling, euros and U.S. dollars, issued by Lloyds TSB and HBOS, for conversion into senior unsecured bonds. The bonds were trading around 20 points below the offer price, which on average is around 50 percent of face value, but are now bid around 47 percent of face value depending on the issue...

So, there are three ways of doing this; you buy back the bonds for cash for less than par value; you swap them for new bonds with a lower par value (but otherwise more favourable terms); or you can go the whole hog and replace them with new shares (thus converting a medium-term liability to a non-repayable one).

Whichever way they do it, it's all good stuff and requires no government intervention or taxpayers' money whatsoever. Were it not for government deposit guarantee schemes*, it would be more or less impossible for a bank to 'fail' - every time a bank got into trouble (i.e. its liabilities exceeded its assets), it would simply cancel some of the par value of the book liabilities so as to bring it into line with its market value and start over.

* I think that these are a good idea, actually ... provided the government actually keeps a watchful eye on the banks.