Private Equity Sour Grapes Of The Week

From CityAM:

FINANCIER Guy Hands is preparing to ask his private equity backers to plough another £100m into the troubled record company EMI.

The company, whose artists include Coldplay and Robbie Williams, is close to breaching the covenants on its £2.6bn debt with Citigroup and has until May to find fresh capital. Hands has asked EMI to put together a turnaround plan that will persuade investors in his Terra Firma private equity company to stump up the additional cash.

Terra Firma, led by Hands, bought EMI in 2007 for £2.4bn, but has since written down its investment. It has been wrangling with Citigroup for some time over EMI's debt burden, and is now suing the bank, which brokered the original deal, claiming it over-inflated the price of the record company.

I would add "I hope they both lose!", but the longer such a case drags on, the more money the lawyers get. Hmmm.

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.

"Negative equity threat spreading for homeowners"

From today's Telegraph:

An estimated 145,000 mortgage holders already owe more in mortgage payments than their houses are worth ... The research company CACI analysed the 1.2 million people who bought a home since the start of last year and calculated that one in eight are in negative equity. This figure could rise to as many as 360,000 by the end of this year if house prices fall by 20 per cent, as some economists fear is now possible.

Wot?

From The Telegraph, 10 June 2008

"A leading City bank has warned that a quarter of a million homeowners have slipped into negative equity since the start of 2008 ... Michael Saunders, head economist at Citigroup ... has warned that house prices could fall by 15 per cent or more by the end of 2009, taking the number of households in negative equity over the million mark, but now says the drop could be even greater."

From The Times, 12 June 2008:

"Falling house prices have left more than 30,300 homeowners in negative equity, says the Council of Mortgage Lenders. Morgan Stanley, the investment bank, believes that a further two million households are at risk of owing more than the value of their property if house prices fall 20 per cent by 2010."

So our starting figure - those in Nequity already - could be anywhere between 30,000 and 250,000.

CACI's Nequity-o-meter suggests for every 1% fall in house prices (i.e. every month, at the speed at which prices are falling) there'll be an additional 10,000 households in Nequity. But this only relates to the 1.2 million people who have bought in the last year-and-a-half. There are about 12 million outstanding mortgages and LTV's are fairly evenly distributed (between 'nearly paid off' and '100% mortgage') - so that means the real figure is 100,000 more in Nequity for each 1% fall.

Which ties in nicely with the Nequity-o-meters used by Citigroup and Morgan Stanley, which suggest that for every further 1% fall in prices (i.e. one month's worth of falls), there will be another 100,000 households in Nequity.

My magic fag packet says for every 1% fall in prices, it might be as many as 120,000, but let's go with 100,000 as a nice round figure.

Morgan Stanley's negative-equity-o-meter

From The Times:

Morgan Stanley, the investment bank, believes that a further two million households are at risk of owing more than the value of their property if house prices fall 20 per cent by 2010

So that's about 100,000 borrowers in Nequity^TM for every 1% fall in prices; Citigroup reckoned about 70,000; and my more pessimistic fag packet said about 120,000.

So let's go with 100,000 in Nequity^TM for every 1% fall in house prices as a nice round mid-figure.