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.