Economic Myths: Miller & Modigliani Theorem

The first part of the original M&M Theorem makes perfect sense:

The Modigliani-Miller theorem (M&M) states that the market value of a company is calculated using its earning power and the risk of its underlying assets and is independent of the way it finances investments or distributes dividends.

There are three methods a firm can choose to finance: borrowing, spending profits (versus handing them out to shareholders in the form of dividends), and straight issuance of shares. While complicated, the theorem in its simplest form is based on the idea that with certain assumptions in place, there is no difference between a firm financing itself with debt or equity.

So far so good. If the value of the business is more than the outstanding debts, then the shares have value; if the debts exceed the value, then the shares are nigh worthless. The total value of debts + shares remains roughly the same. The value of the bonds can't exceed value of the business and the value of the shares can't go lower than zero.

If you aren't sure whether to buy shares or bonds in a company, the best strategy is to have a mix. For example Mike Ashley/Sports Direct spent £150 million on acquiring 30% of the shares in Debenhams. Unfortunately for him, the debts ballooned to far more than the value of the business, so the lenders took over the business and his shares were wiped out (a kind of debt for equity swap).

His better strategy would have been to spend less on shares and more on acquiring Debenhams debts pro rata (say 15% of each). If the business had done well, his shares go up in value and if it does badly, his shares are wiped out but he still ends up with 15% of the business in his capacity as lender.
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What's nonsense is the related claim that the tax system encourages businesses to borrow money instead of issuing shares:

Third, the use of debt is less expensive than the use of equity because debt is generally subsidized by the state through the tax system –since debtors can deduct the interest payment associated with the use of debt. Therefore, the use of debt may reduce the firm´s cost of capital.

That's a generalisation across many countries' corporation tax systems, but whether it is true or not depends on the rates of tax applied to corporate profits (at corporate level) and dividend and interest income at shareholder/lender level.

(I started as a tax adviser in 1989 and had to advise clients on 'what is better for tax', the answer depended on the circumstances. I later did an accounting and finance degree, and the lecturer trotted out the M&M tax drivel and would simply not listen to reason and logic.)

IIRC and generalising a bit, Singapore and Hong Kong governments get so much money from land rent, land auctions, stamp duty and capital gains on land that they barely need to bother with taxing incomes. So companies pay 15% corporation tax and individuals pay 15% income tax. If an individual gets a dividend, it is treated as tax paid, so no further income tax due. If an individual receives interest income, it is taxed at 15% so it is as broad as it is long.
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In the UK, we had a brief period in 2012 or thereabouts (before Osborne started messing things up again), when it simply did not make a difference for corporation tax/income tax (ignoring National Insurance, which clearly distorts things, the 45% additional rate and overseas stuff).

The rates were:
Corporation tax - 20%
Basic rate income tax - 20%
Higher rate income tax - 40%
Withholding tax on interest - 20%.

* If a basic rate taxpayer received a dividend, there was simply no more tax to pay (same as Singapore or HK) because the company had already paid 20%. (Ignore the bullshit with the 10% tax credit and the 10% nominal rate, it worked out at nil, unsurprisingly).
* If a basic rate taxpayer took a salary bonus, the employer took 20% income tax via PAYE and the employee had no more income tax to pay.
* If a basic rate taxpayer received an interest payment, the company paid over 20% withholding tax/income tax on a CT61 and the individual had no more tax to pay.

* If a higher rate taxpayer received a dividend, he had to pay 25% income tax on the dividend, so the overall rate was 40%. Remember - company earns £100, pays £20 corporation tax, pays £80 dividend, individual pays £20 income tax and nets £60. (Ignore the bullshit with the nominal 10% tax credit and the 32.5% nominal rate, it worked out at 25%).
* If a higher rate taxpayer took a salary bonus, the employer took 40% income tax via PAYE and the employee had no more tax to pay, net pay £60.
* If a higher rate taxpayer received an interest payment, the company paid over 20% withholding tax/income tax on a CT61 and the individual declared the gross amount and paid a further 20% of the gross amount, net interest £60.

Osborne and Hammond then busily messed up this state of affairs and now you have to do the three calculations each time to see 'what's best for tax'.
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There are lots of other wrinkles...

* Pension funds can receive interest or rent truly tax-free, but receive dividend payments out of after-tax income. It would make more sense to tax all sources at a flat, lower rate, so that they get some refund of the corporation tax on dividends but pay some tax on interest and rental income.

* Some companies have large tax losses (R&D tax credits, Film Tax Credits etc) but have distributable commercial profits, so are advised to pay dividends so that shareholders get the (slightly) lower income tax rate that applies to dividends.

* Some companies don't have distributable commercial profits, so aren't allowed to pay dividends, but can still pay salary bonuses or interest.

In a perfect world, therefore, dividends, interest, rent and wages would be taxed exactly the same way i.e. there would simply be a flat withholding tax at the same rate on each when the company pays them out.

We used to do this for dividends (Advance Corporation Tax);
Banks used to withhold 20% income tax from deposit interest;
Non-banks still have to do it for interest payments (CT61s);
PAYE applies to wages;
CIS deductions apply to sub-contractors in the construction industry;
and tenants with non-resident landlords are supposed to, by default, pay 20% of the rent to HMRC and pay the landlord the balance of 80% (though most wriggle out of this).

You wouldn't even need to bother having special rules for foreigners and there would be no need to distinguish whether it's wages, rent, dividends, interest, sub-contractor payments etc. It could all be included on one return/reporting system and paid to HMRC in one payment. As a final flourish, dividends paid net of tax would be an allowable expense for corporation tax purposes.

Individuals who have to submit income tax returns (i.e. higher rate taxpayers) can then just enter all 'net of tax' payments in one box and pay the same tax rate on the lot, minus the credit for income tax withheld at source.

Here endeth.

Bankruptcy Of The Week

From Reuters:

German real estate company IVG Immobilien (IVGG.DE), co-owner of the landmark 'Gherkin' office building in London's City financial district, said on Tuesday it was seeking protection from creditors after failing to reach an agreement over the restructuring of its debt.

IVG has about 4 billion euros (£3.38 billion) of debt after a rapid expansion spree and had sought for weeks to agree with creditors on swapping some of the debt for equity...

Shares in IVG, which have lost 96 percent of their value this year, extended losses to trade down 8 percent at 0.077 euros by 4.30 p.m. British time on Tuesday.

One way or another this will end up with a debt-for-equity swap, as the article explains. But it's nice to see land speculators fall on their faces every now and then instead of being bailed out by the government every time. The perils of speculating abroad, I guess. Always best to speculate on land in your own country.

H/t Alan at HPC.

Debt-for-equity swap of the week

From City AM:

Yellow Pages is given to lenders in a £2bn swap

Long-suffering shareholders, who have seen shares plummet from a high of 603p in 2007 to just 0.17p yesterday, have been wiped out...

Loss-making Hibu had a debt pile of £2.3bn, equivalent to the GDP of the Maldives. Owners of the debt will take control of the business in a debt-for-equity swap.

Debts will be reduced to £580m in the form of five year senior secured debt and lenders will own a further £920m in ten year payment in kind notes, which will convert to stock later.

It's a misleading headline of course, the lenders were not "given" ownership of the business, they paid £2.3 billion for it.

It turned out the business was worth less than £2.3 billion but still appears to be viable (making the best of a bad job, I suppose), so the lenders chucked out the shareholders and took control of the company themselves. The assets side is unaffected and the book value of the debts is adjusted downwards accordingly (or converted into share capital at the stroke of a pen, plus a few forms SH01 to Companies House and so on).

It's the same general principle as the Dutch Tulip debt cancellation referred to earlier. Cancelling financial liabilities and assets has no impact on overall wealth. And it's a great pity that we didn't apply this principle to the banks (with a few notable exceptions).

Reader's Letter Of The Day

From City AM:

Re: The Co-op [Bank] rescue: There was always a better way to deal with bank failure, yesterday

Well said. It was clear, ever since trouble started at Northern Rock, that all we needed to do was look at these banks' balance sheets (rather than get hysterical) and the bail-in solution jumped off the page.

Mark Wadsworth.

The article to which I responded was a good basic article explaining debt-for-equity swaps, or bail-ins as they are now known, and is worth a read. What was unusual about it was this sentence:

This opposition to the bailouts did get some hearing in the public debate, and has spawned significant anti-bailout political movements such as the Tea Party in the US, or the Occupy movement internationally.

Indeed, that is how they both started, but the former rapidly morphed into the usual Bible-bashing, Home-Owner-Ist Republican fringe nonsense, and the latter rapidly morphed into the usual vaguely defined anti-capitalist, high tax nonsense, so nowadays most people would consider them to be polar opposites, although they're all Socialists as far as I can see.

Cyprus debt-for -equity swap: update

Mike "Mish" Shedlock in the comments at Golem XIV links to his own blog where he in turn posts an email from somebody who has done his homework:

I read with interest your article on the Cyprus bailout deal. After a quick review of the most recent financial statements of the four publicly listed Cypriot banks as shown on their websites, it is notable that a simple alternative proposal could protect the country from bankruptcy and make its depositors whole.

By wiping out 100% of the equity, 100% of the bondholders, and 17% of the banks’ liability to central banks, the Cypriots could stabilize their banking system (based on the 5.8Bn EUR figure being discussed) without penalizing local savers.

Instead of raising 5.8Bn EUR from depositors, it could raise 1.4Bn from combined market cap, 2.0Bn from bondholders and preferred shareholders, and 2.4Bn of the 14.3Bn in combined Central Bank loans (Cypriot and ECB) it has on its books. This assumes zero contribution from the Cypriot subsidiaries of foreign banks so it may be conservative.

If the banking system is bankrupt, anything other than an Alice-in-Wonderland recovery system suggests that the order of liquidation is shareholders, preferred shareholders, debt holders, Central Bank creditors, and THEN depositors. If 10Bn or even 17Bn EUR is truly required, then coincidentally up to 17.7Bn EUR is available from equity holders, debt holders, and Central Bank creditors without impairing a euro cent from depositors.

That's much the same picture as with UK banks. Their losses (i.e. bad debts) so far as a percentage of total assets were relatively small (certainly less than 5%, even in the case of Northern Rock) and they could have been straightened out by converting a proportion (about a quarter or a third) of the bonds they have in issue to share capital. This might or might not involve cancelling existing shares, that's a minor issue. There was no actual need for the taxpayer to pay for bank bail-outs, that was just pilfering and looting on a grand scale during the smokescreen of a recession.

The idea of cancelling loans from the government is a bit off piste, because that's effectively saying that income taxpayers should pay it. I think that the general idea here was that they didn't want Cyprus to do like Ireland, have the government underwrite the banks and then go even more horribly bankrupt itself.

Writing down deposits and/or converting them to share capital is also a kind of tax (some have described the Cyprus idea as a "wealth tax") but even then, to the extent that a share capital and bond capital write-off won't cover the losses, it is far better to have a one-off specific "tax" on depositors (or pro rata write down of deposits) and have done with it*, than it is to bail out banks via inflation, low interest rates (these two are also "wealth taxes") and taxes on earned income (the worst kind of tax), which is what they have been doing in the UK (as Philip Inman says in The Guardian).

* Or even better, convert everything back to deposits, sack the top echelons of "management" and turn the bank into a building society again.

Cyprus does debt-for-equity swaps on a grand scale

Via Little Professor at HPC, from the BBC:

People in Cyprus have reacted with shock to news of a one-off levy of up to 10% on savings as part of a 10bn-euro (£8.7bn; $13bn) bailout agreed in Brussels.(1) Savers could be seen queuing at cash machines amid resentment at the charge.(2)

The deal reached with euro partners and the IMF marks a radical departure from previous international aid packages.(3) President Nicos Anastasiades defended it as a "painful" step, taken to avoid a disorderly bankruptcy. It had, he said in a statement, been a choice between the "catastrophic scenario of disorderly bankruptcy or the scenario of a painful but controlled management of the crisis"...

Alan, a British expatriate saver in Cyprus, told BBC News: "This is robbery and we must get the EU to stop this. We retire and bring our savings to a bank in Cyprus and they can just take our money away without permission and then say we have shares in a bankrupt bank."(4)

Maria Zembyla, from Nicosia, said the levy would make a "big dent" in her family's savings and "erode the investor confidence".(5) "Russians that currently keep the economy afloat will leave the country along with their money,"(6) she added.

According to Reuters news agency, almost half of the depositors in Cyprus are believed to be non-resident Russians.(6)

1) It's not a "levy", it's a debt-for-equity swap, read the small print:

• Depositors with under 100,000 euros deposited must pay 6.75%
• Those with more than 100,000 in their accounts must pay 9.9%
• Depositors will be compensated with the equivalent amount in shares in their banks
• The levy is a one-off measure

A bank's gross assets (primarily money lent to borrowers) are worth whatever they are worth; if you deduct deposits (which are liabilities of the bank) and other liabilities (bonds etc), what you are left over with is net assets which 'belong' to shareholders and which (very broadly speaking) are equal to the value of the shares (plus or minus a bit). So all things being equal, if you cancel EUR 1 of deposits, the value of the shares goes up by (very broadly speaking) EUR 1. Nobody actually loses out from this. If the deposit cancellation is sufficiently large to turn an insolvent bank back into a solvent one, there might be a net overall gain; so you lose EUR1 of deposits and receive shares which you could sell for EUR 1.50. It all depends.

2) Clearly, you have to do these things overnight without prior warning.

3) Because this "package" is not international. It's the sort of thing which any country can do for itself.

4) Their country, their rules, Alan. Besides, the bank won't be bankrupt any more once the deposits have been partly converted into share capital.

5) "Investor confidence" evaporated years ago. And as Stillthinking says in a separate thread at HPC: "The real not nominal reduction is about the same as inflationary losses in the UK over a three year period. Personally I would prefer the "there you are we is having it sonny" approach to just cowardly underhand inflationary skanking."

6) That's the interesting bit, isn't it, will the Cyprus government allow the Russians to whip out their deposits first? If they do, then the proportion of deposits of residents is going to have to double; if they don't then Cyprus' reputation as a handy little tax haven/place for Russians to hide money might take a bit of a knock. Tough call.

They're softening us up for another taxpayer-funded bank bail out

From City AM: UK banks must raise tens of billions in extra capital.

Sky News: UK's Banks 'Could Need Billions More Capital'

BBC: Major UK banks may need to raise more capital as protection against possible future losses

and so on and so forth. This all goes back to the Bank of England's Financial Stability Report:

The Committee recommends that the Financial Services Authority (FSA) takes action to ensure that the capital of UK banks and building societies reflects a proper valuation of their assets, a realistic assessment of future conduct costs and prudent calculation of risk weights.

Where such action reveals that capital buffers need to be strengthened to absorb losses and sustain credit availability in the event of stress, the FSA should ensure that firms either raise capital or take steps to restructure their business and balance sheets in ways that do not hinder lending to the real economy.

Oh dear, thinks the man in the street who only reads the headline, where are they going to get that money from? Fact is, they don't have to raise a single penny from outside the banking system, that's the bit in bold after the "or": UK banks have already raised that money, only they have treated it as bonds and not as share capital.

If the shortfall really is £35 billion, all the banks have to do is reclassify about one-tenth of the bonds (maybe it's one-fifth, who cares) they have already issued as share capital, hey presto, problem solved. The total value of all shares and bonds in issue will not change, and it might even increase slightly if you do the swap properly.

As it happens, banks bonds are trading below par and bank shares are trading at a discount to net assets, so whether you hold a £1 face value bond with a market value of 70p or shares worth 70p for every £1 of net assets is neither here nor there.

But no, the newspapers are already softening people up for the next taxpayer-funded bail out.

As to "sustaining credit availability", that is quite a separate topic. Ultimately, it is the borrower who prints the money, not the bank. Consider, if government borrowing is much the same as the government printing money printing (and it is), then so is private borrowing.

"Experts at Bank of England say 'no' to common sense"

From City AM:

CONTINGENT capital bonds risk increasing volatility in financial markets and undermining banks’ safety, rather than enhancing it as planned, a Bank of England report warned yesterday.

“Cocos” as they are commonly known, act as debt but convert into equity when a bank looks like it is getting in trouble – usually when the share price falls below a set trigger level...

As we well know, debt-for-equity swaps are the quickest, cheapest and most 'free market' way of sorting out banks which are in trouble. All this means is that some of their repayable debts get converted into non-repayable debts i.e. shares i.e. ownership. This doesn't increase their assets, but it reduces their liabilities which is as good as the same thing.

To save bickering, the idea behind cocos is to make it clear exactly whose debt will be converted into equity and under what circumstances. Common sense says that a conversion would be triggered when the bank's capital ratio fall beneath a certain figure (and there's nothing to say that the resulting shares wouldn't be converted back into bonds again if the situation improved, a kind of pre-programmed share buy back).

Clearly, The Powers That Be are against this sort of thing (presumably they think it is better for the taxpayer to bail out banks), so they worked backwards from the answer, then launched a Big Fat Lie and made the wholly unsubstantiated claim decided that the conversion would be triggered by something completely irrelevant (the bit in bold) and then applied their contorted logic (see remainder of article) to show that because this would be the trigger, then all sorts of terrible things would happen. As it happens, the rest of their logic doesn't really stack up either, but once they've got their main point across that cocos are bad, that doesn't really matter.

This is exactly the same sort of propaganda that they used when arguing against the Alternative Vote - they started off their argument by making wild claims such as AV would mean that the candidate who came third in the first round would automatically win, or that everybody would have to vote BNP, and then extrapolated forwards again to conclude that AV must therefore be a bad thing.

Barclays Bank's £100 million tax bill: Rules is rules

The Righteous are now a-wailin' and a-moanin' that this is retrospective legislation, ooh, how horrible, end of the world etc, but it is nothing of the sort, and what puzzles me is that Barclays Bank ever thought they would get away with it.

The basic rule, subject to lots of exceptions, was always that if Company A owes Company B money and does not/cannot pay up, Company B claims a deduction (bad debt relief) and Company A is taxed on the saving. So if BB owes people £2.5 billion in bonds and buys back those bonds for a lot less than £2.5 billion (and this was all public knowledge at the time) then the discount/underpayment counts as a profit for BB, shows up in BB's accounts as a profit and BB has to pay tax on that profit.

HMRC's explanatory note explains the background in more detail. It appears, that BB were trying to play clever buggers, and instead of buying back their own bonds (which would trigger a tax charge), they arranged for a friendly entity to buy it back instead. Then, under the cover of darkness and while HMRC weren't looking (they hoped) BB would obtain control of that entity and quietly cancel the bonds (you can't owe yourself money).

I would have assumed that s362 CTA 2009 would have caught that anyway; HMRC seem to have admitted that on a narrow reading it didn't, but all HMRC have done is to make it clear that if it is pre-planned that the borrower is going to obtain control of the other entity, then this is sufficient to trigger a charge.

All seems fair enough to me, to the extent that you think incomes and profits should be taxed in the first place. What is spiteful is that in many cases, the creditor gets no tax relief for his loss, even though the debtor is taxed on his gain, separate topic.

Debt For Equity Swap Of The Week: Santander

From FT Alphaville:

Since Unicredit is doing this rights issue to meet the European Banking Authority’s target for banks to meet a nine per cent core capital ratio by June – it’s also worth mentioning in passing Santander’s announcement on Monday that it’s met the EBA goal. Modestly hooting that it’s "one of the world’s most solid and well-capitalised banks", Santander says it’s found €15bn of additional capital via the following:

- EUR 6,829 million through Valores Santander.

- EUR 1,943 million through the exchange of preferred shares for ordinary new shares.

- EUR 1,660 million through the application of the Santander Dividendo Elección program (scrip dividend) at the time of the final dividend corresponding to fiscal year 2011.

- EUR 4,890 million through organic capital generation and the transfer of certain stakes, mainly in Chile and Brazil.

Interesting to note that the "Valores Santander" portion is made up of converting retail bonds that were originally issued in 2007 into shares during October 2012. As the WSJ has reported, it’s been anything but “valores” for Santander retail investors who bought these securities.

Yes, it's tough, but better them than the taxpayer, eh?

Debt-for-equity swaps of the week

From today's City AM

BARCLAYS has made a £2.5bn offer to buy back its debt in order to bolster its capital levels. If taken up by holders of the bank's bonds, the move could book Barclays a profit and reduce the amount of its debt that is non-compliant with new Basel III capital rules*.

The bank is offering a price for the bonds that is above their current market price but less than the cash it raised by selling them, hence the potential for it to make a profit from the deal. (1)

The move will make concrete some of the "own credit" earnings that many banks booked in recent results statements, despite most of them having not actually realised the gain by buying back their debt. (2)

1) This is a kind of debt-for-equity swap via the back door.

At present, the bank has £2.5 billion spare cash (an asset) and (say) £3 billion in bonds it wishes to buy back (liabilities). The bonds are currently trading at (say) 68p in the £, because the bank is a poor credit risk. The bank offers to use the £2.5 billion cash to buy back (redeem) the bonds at 84p in the £, which is a good deal, from the point of view of the investors because it halves their losses.

So the bank gets rid of £2.5 billion in assets and £3 billion in liabilities (if held to maturity, the bank would have to pay £3 billion) and the balancing figure of £0.5 billion can be booked as a profit. Profits are part of a bank's equity, so hey presto, they've done a debt-for-equity swap.

2) This is the really cheeky bit, but it is actually in accordance with accounting standards and does make sense. By the logic of accounting, the fact that a bank is doing badly generates a kind of profit for them, in the same way as if you owe somebody £100 and he tells you he'll be happy to take £60 and waive the rest, he has made a £40 loss and you have made a £40 profit.
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UPDATE: I've just noticed that todays City AM covers another example of exactly the same thing:

GERMANY’S second-biggest bank, Commerzbank, said it would buy back €600m (£515m) of its own hybrid equity from investors yesterday in a bid to shore up its capital position to meet tough new Basel III capital requirements* due to take effect in 2013.

Commerzbank said it would buy back the trust-preferred securities, which are a mixture of debt and equity, at only between 40 and 52.5 per cent of their original issue price, allowing it to book a capital gain. The bank will buy back about €1.2bn of a total €2.23bn of its hybrid instruments in issue to increase its core Tier 1 capital ratio, which needs to be nine per cent by 2013.

That looks like they are using €0.6 billion cash to buy back/redeem bonds which were issued for/have a nominal value of €1.2 billion, which means investors are getting 50 cents in the €.

* The relevance of the Basel III rules is that they stipulate a certain minimum equity-to-assets ratio. Let's say that Barclays currently has assets of £100 billion and equity of £5 billion, that's a 5% ratio. Once the buy back is over, they'll have assets of £97.5 billion and equity of £5.5 billion, an equity-to-assets ratio of 5.6%, which doesn't sound like much of an improvement but these banks work on absolutely tiny equity ratios/enormous gearing; you can also express that change as a reduction in gearing of 20-to-1 down to 17.7-to-1.

In the rarified world of banking, that counts as "tough", apparently. In the real world, that means an end to 95% mortgages and borrowers being restricted to 94.4% mortgages instead.

Banks are run badly, say bankers.

From City AM:

THE TREASURY is preparing to water down a key recommendation in the Vickers report that would protect savers in the event of a bank going bust. Investors and banks have argued that Vickers’ suggestion that retail depositors should be paid back before all other creditors if a bank collapses could risk destroying the market for bank debt and cause corporate deposits to flee the UK...

HSBC and Standard Chartered, the banks most likely to leave the UK, have lobbied against the requirement that they issue billions in bail-in bonds – bonds that can be written-down in the event of the bank’s collapse. The measure would cost HSBC $2.1bn a year, its chief financial officer Iain Mackay said recently, which he added would be "too high" to justify staying in the UK.

i. A bank holds financial assets, i.e. money lent out at interest, and all financial assets require corresponding financial liabilities, i.e. ownership. So a bank can finance itself with a mix of deposits, bonds/loans and share capital/retained profits (to use three broad categories, there are of course huge overlaps between them).

ii. In proper free market capitalism, there is a balance between risk and return. So if a bank has £20 in assets and generates £1 in gross income, the senior staff swipe 10p for themselves and the rest is dished out between the three classes of financiers (depositors, bondholders, shareholders).

iii. If the bank were funded solely by £20 in deposits, they would receive 4.5% interest and bear the whole risk; if it were funded entirely by bonds, they would also receive 4.5% and bear the whole risk etc.

iv. But people's risk preferences are different, so some are prepared to accept a lower return in exchange for bearing less risk, and 'risk' for these purposes is where they rank in priority of repayment. For example, if the bank is financed with a third from each category, the depositors are paid 1%, the bond holders 5% and the shareholders 7.5%.

v. Remember also that how a bank is financed has little impact on that £1 gross income, it's just a question of how it is split up. The whole point of Vickers is to release the taxpayer from the burden of bailing out banks.

vi. Simplest would be to increase their share capital/retained profits, either by issuing shares, paying out less as dividends or paying out less in obscene bonuses. Or we can invent a new category of finance called 'bail-in bonds' which are a hybrid of bonds and share capital. So if the bank is financed with a quarter from each category, the depositors would be paid 1%, the ordinary bondholders 1.5%, the bail-in bondholders 5.5% and the shareholders 10%. And so on; but the total cost of finance from the bank's point of view is exactly the same, it always adds up to 90p.

vii. I don't know how HSBC calculated their $2.1 bn a year cost. Using my simple examples, this would be the extra which they have to pay to those bondholders from iv. who choose to subscribe for the slightly riskier 'bail-in bonds' in vi. These bond holders receive 27.5p interest(£5 x 5.5%). But we can minus off from that the 1.7p less which depositors are getting and 25.8p less which ordinary bondholders are getting (£6.67 x 5% minus £5 x 1.5%). Whatever you do, it always adds up to 90p.

viii. Unless, of course, what HSBC are really saying is that their bank is not particularly well run, i.e. risky, and that if their bondholders are expected to bear some of the risk (clearly the share capital is not enough, or else there'd be no risk to bondholders at all), they will expect $2.1 bn more a year in interest or dividends. They could of course just run their bank properly and get the interest cost down that way or they can fob off the risk onto the taxpayer (i.e. you) and keep the rewards to themselves.

"BES plans debt-to-equity swap"

Since the 'financial crisis' of 2008, loads and loads of non-financial companies have carried out debt-for-equity swaps, most noteably the Big Three car manufacturers in the USA (Ford $10 billion; Chrysler $2.5 billion; General Motors $27 billion, possibly a bit less than that), but because banks knew that they could con governments into using taxpayers' money to bail them out*, very few banks have done so.

Reuters give us a good recent example of a bank doing a debt-for-equity swap, albeit in a very small way:

Banco Espirito Santo, Portugal's second-largest bank by assets, wants to raise up to 791 million euros ($1.08 billion) capital through an offer to swap debt for stock that could lift its core tier 1 capital ratio close to a 10 percent target...

So you see, it can be done, it's nothing dramatic or anything.

* For sure, the US government also lent/invested $80 billion, but they look set to recover over 80% of that, which by government standards was a stupendously good investment.

Excellent summary of how debt-for-equity swaps would work with banks.

Andrew Lilico has a lengthy article in today's CityAM. The idea and the justification are blindingly simple and obvious, of course, but presumably, having won the argument as to why, he has spent the last few years bogged down explaining to people how it would work in practice, so he goes into a good level of detail.

The key to it is this:

... the bank gets new capital – new shares – out of its bondholders, instead of the government injecting taxpayer funds ("recapitalisation" – or, not to mince words, partial nationalisation). So the bank isn’t shut down. The depositors can still withdraw their money. The bank carries on making loans. But it has new owners – the former bondholders – and it has fewer debts (because some of its bonds have gone, converted into equity).

Such a debt-equity conversion can be done very quickly – over a weekend, say, or certainly in no more than a fortnight. If it ends up taking any time, then there is the question of how to maintain service to depositors. That can be done by taking a distressed bank into special administration. When a normal company goes bust, it is taken over by administrators. The administrators in the case of banks would be the Bank of England or the Treasury.

Which is pretty much what I've been saying all along.

Banks and debt-for-equity swaps - good summary

From City AM:

The idea of a bail-in [another name for 'debt-for-equity swap] is that if a bank hits the rocks, rather than phoning up the taxpayer for more equity capital, the bank automatically converts a chunk of its liabilities into new equity. This recapitalises it and allows it either to bounce back – or creates time for it to be wound-down in an orderly manner.

If such a system were in place, Barclays, RBS, Lloyds, HSBC and a host of global firm such as Credit Suisse, Deutsche Bank, JP Morgan and BNP Paribas could all easily withstand losing £40bn (the biggest one-year loss inflicted on a single institution during the crisis) without any taxpayer assistance.

In fact, all of these could bear much larger losses. The entire economic and financial history of the past few years would be dramatically different had countries stopped protecting creditors and made bail-ins the norm, or acted fast and enforced one as things went bad in 2008. Taxpayers would have stood protected and real market discipline reestablished.

As part of its submission to the ICB, Barclays calculated that it had a loss absorption capacity for the purpose of a bail-in worth 47.6 per cent of risk-weighted assets in 2010 – senior unsecured debt, but also Tier 2 and Tier 1 capital on top of the Core Tier 1. Under a £40bn hit and an equivalent bail-in, its loss absorption capacity would fall – but to a still extremely comfortable 37.4 per cent.

Of course, other reforms are needed too – not least new resolution procedures for large banks for whom bail-ins aren’t enough, as traditional bankruptcy procedures don’t work for systemic banks.

What all those numbers mean boils down to this: however bad bank losses are, they will never be so bad that depositors have to lose out (or certainly not as far as UK banks are concerned) and banks will certainly never just go pop. All that happens is that bonds are cancelled and bond holders are given shares to a similar value to the bonds which were cancelled. Big deal. And no taxpayer assistance required - as I've been saying all along!

On Radio 4 this morning, they talked about the ring-fencing, and said that the total value of assets inside the ring-fence (i.e. the bits you can understand, like mortgages and loans to business) would be about £2,000 billion, which is something else I have continually pointed out - the claim that banks' balance sheets add up to £7,000 billion or something (five times UK's GDP) is complete and utter hokum as the other £5,000 billion is made up numbers which all net off to very little indeed. (i.e. Bank A lends £100 million to Bank B who lends it to Bank C who lends it back to Bank A; on a strict balance sheet basis, the total gross assets and liabilities of these three banks has increased by £300 million, in real life, nothing has happened).

Something is spot-on in the state of Denmark

Allister Heath's editorial in today's City AM explains how they are sorting out the banks in Denmark.

I'm not cutting and pasting the highlights because it is worth reading in full, all 568 words.

The Death Of Free Market Capitalism (Part 1,726,984)

From CityWire:

John Hemming, the MP who exposed Ryan Giggs’ super injunction in the House of Commons, has launched a campaign to help investors hit by Bank of Ireland’s decision to buy back its bonds for a fraction of their value. (1)

Hemming is one of group of investors (2) who bought a permanent interest bearing security (Pibs) from Bristol & West building society in 1991. The bond, which pays an interest rate of 13.375% (3) became Bank of Ireland’s responsibility when it bought Bristol & West in 1997.

Under the terms of proposals issued by the bank this week to raise €4.2 billion (£3.7 billion) these bondholders are being offered a 'haircut' of just 20% of their investments’ face value of £75 million, or the chance to swap the bonds for new shares worth only 40%. Hemming, the Liberal Democrat MP for Birmingham Yardley, said the move was unfair (4) to the bondholders, many of whom he believed were pensioners. (5)

1) Isn't it refreshing to know that there are some MPs who are prepared to make a stand? To do and say things out of principle and not just because they are tireless self-publicists or acting out of naked self-interest?

2) ... ah, right.

3) I've no idea when they stopped paying that tasty 13.375% interest, but unless it was more than ten years ago, all these investors have already had their money back!! Their original gamble paid off - not as well as hoped, admittedly, but hey.

4) And why is it not "unfair" to expect the taxpayer to chip in?

5) There's never a wrong time to play the "poor widows in mansions" card, is there?

I suppose the only glimmer here is that he wants the actual investors to be compensated, which is a far less bad way of doing it that fire hosing several £ billion at the bank itself and asking them to play nicely in future.

Outbreak of common sense in Ireland

From The Telegraph:

The Central Bank of Ireland wants to force its banks to account for poor loans the way they used to under Irish GAAP and over-ride controversial International Financial Reporting Standards (IFRS). The move, which the central bank said it hoped to announce within weeks, would leave UK banks isolated in their application of IFRS. A similar overhaul in Britain would have a radical impact on the declared capital positions and profits of British banks... (1)

Yesterday investors in Irish banks were given another shock as the Bank of Ireland announced plans for a rights issue to help fund proposals to repay subordinated debt at heavily discounted prices. The bank, which is part nationalised, said the move was necessary to meet funding targets set by the government. (2)

1) The IFRS rules allow banks to do 'extend and pretend' unlike the old fashioned rule that current assets are shown at lower of cost and net realisable value, which in the case of mortgages made by banks means the lower of [the original nominal amount of the mortgage] and [the amount the bank can now hope to recover, bearing in mind the selling price of the land and buildings on which the mortgage is 'secured' etc].

2) This is yet another variation on the debt-for-equity swap. Let's say the bank intends to raise €1 billion in new shares and wants to redeem its own bonds with a face value of €2 billion for half their face value, i.e. €1 billion (let's assume that's a fair estimate of their market value).

In theory, all the bondholders could sell their bonds for a total of €1 billion and use the money to subscribe for the new shares, or the bank could short circuit this and give every bondholder a new share with a face value (and presumably market value) of 50 cents for every €1's worth of bonds the bondholder owned, hence and why it's called a debt-for-equity swap.

If you don't want the shares, well sell them for 50 cents each, that's no different to having bonds which you can sell for 50 cents in the €. Either way, it's better than expecting the taxpayer to bail out the banks - had they taken my advice and started doing this when the credit bubble first popped, then Ireland wouldn't be in the mess they are.

Spotter's badge: MBK.

Music to my ears

From page 67 of the Independent Banking Commission's Interim Report:

4.21 A bank’s loss-absorbing capacity consists of the equity of the owners of the business, and non-equity liabilities or debt, which are contractual claims against the bank.

This section starts with a discussion of equity, the most straightforward and well-understood form of loss-absorbing capacity. This includes an assessment of how much equity systemically important banks should be required to hold.

But debt also needs to be made loss-absorbing, to improve market discipline on banks’ risk taking and to ensure that creditors take losses before the taxpayer. So this section also considers ways in which the effective loss-absorbency of bank debt can be improved.

Three tools are considered:
•debt instruments that absorb loss at some point while the bank is still viable (‘contingent capital’);
•liabilities that absorb loss at the point of non-viability (‘bail-inable debt’); and
•depositor preference, i.e. ranking (at least some) depositors above other unsecured creditors in a bank insolvency, which can have the effect of increasing the loss-absorbing capacity of other parts of a bank’s liability structure.

In simple terms, the Commission suggests a kind of pre-programmed and rolling 'debt-for-equity-swap', the key to this being that depositors rank above bank bonds (quite where you draw the line is a separate issue), only I'm not sure it goes far enough.

Strictly speaking and in any logical world, any deposits covered by the FSCS guarantee (the first £85,000 per depositor, for sake of argument) would rank ahead of any bonds, whether secured, unsecured or otherwise; alternatively, HM Government in its infinite wisdom could just imply a term in its insolvency legislation saying that deposits are in fact secured, and thus are the last to bear losses*, end of discussion.

* For sure, in extreme cases (I'm not aware of any in the UK), a bank might lose so much money that it doesn't even have enough to repay all depositors, in which case the taxpayer has to chip in - with the caveat that any compensation is paid directly to the depositors (as was the case with compensation for people who lost money with Icelandic banks) and not handed over to the bank in return for the vague promise to behave in future.

Debt for equity swap of the week

From Reuters:

Bank of Ireland (BKIR.I) hopes to raise more than a quarter of the 4.2 billion euros (3.7 billion pounds) of capital it needs to find by June through a debt for equity swap, the Irish Independent said on Saturday without citing any sources.

The bank believes it can boost its capital by more than 1 billion euros by offering investors who hold 2.6 billion euros of junior bonds the opportunity to swap them for equity, the Irish Independent said...

The bank, which said it would work to raise cash through a combination of capital-management initiatives, raised 3 billion euros through similar exercises last year when its share price was at around 1 euro.

Please note, they are not raising new capital by doing this, they are cancelling EUR 2.6 billion of liabilities (whose market value is presumably somewhere in the region of EUR 1 billion) and giving the creditors new shares worth EUR 1 billion. But that's as good as raising EUR 1 billion in new cash by issuing shares and buying back the bonds at a discount.

Either way, it's infinitely preferable to expecting the taxpayer to cough up.