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I’ve been talking
about using a “debt/equity swap” to recapitalize
large banks in Europe or the U.S. This is actually a form of bankruptcy, but since that term
is often misunderstood, let’s call
it “receivership”
or “nationalization” instead. We will
use a real-life example,
BNP Paribas, to see how it
might work.
BNP Paribas tells us that as of the end of the
first half, it had 1,926 billion euros of assets
(loans, bonds), 1,839 billion euros of liabilities (borrowed money),
and equity of 87 billion euros. There are a number of different ways of computing capital or equity, but for now we can use the simple accounting definition. From this we
can see that the bank is levered 1,926:87 or 22:1. In
other words, it has a capital base of 4.5%.
In practice, a bank gets into trouble long before its capital officially goes to zero, as Paribas is getting into
trouble today.
The problem here is that if the bank takes a 4.5% loss on its assets
– a Greece default, for example
– then it becomes insolvent. Even before that,
its lenders and depositors will likely begin to flee. Thus, the bank enters receivership
or is nationalized.
At this point, the equity holders lose everything. Next down the chain of capital,
preferred equity and derivatives liabilities are eliminated. The subordinated debt also goes
out the window. Repurchase
agreements are canceled,
the lender taking the collateral. This would leave liabilities of 1,273
billion by my count.
This sounds promising,
but it is likely that removing
such a major derivatives and lending counterparty would also precipitate insolvency among other large banks. The most likely result
would be a “bank holiday,” in which the entire banking system enters the workout process simultaneously. The end result is that assets
would fall to about 1,625
billion by my count, eliminating
derivatives assets.
As we know, the remaining
assets are not worth as much as the bank has said they are worth. The bank takes a big write-down
on assets, of 30% or 488 billion, reflecting their fair value. This leaves assets of 1,137 billion.
Our liabilities are still
in excess of our assets, so now
the bondholders enter the picture. There are 223 billion of bonds, and another 117 billion due to credit
institutions, for a total of 340 billion. This gets converted to equity. Let’s just pick an arbitrary number and declare that for each fifty euros of principal,
the bondholders get one share of equity. Thus, there are 6.80 billion shares outstanding.
Now we have 933 billion
of liabilities, 1,137 billion of assets, and 204 billion of equity.
This is a capitalization
ratio of 18%, which is quite cushy, and appropriate for the sort of environment
that the bank finds itself in. We will assume that the bank trades at a modest
premium to book value on the stock market, of 1.5x
book. Thus, the equity market cap is 306 billion euros
and the price per share is 45 euros.
Note that the bondholders
didn’t actually lose much money. They started with 340 billion of bonds, and ended
with 306 billion euros of equity.
Not a bad trade, all considered.
Admittedly, this process is very
dramatic. By way of the
“bank holiday,”
we have effectively eliminated the entire outstanding derivatives book
– which, I would
argue, is a good thing. At this point there are few other options except for extravagant lying, robbing the taxpayer, and
printing money. Probably all three.
The bank would continue
operating. This whole process
amounts to taking a red pencil to the balance sheet, and doesn’t inherently require any liquidations or mass layoffs.
From this we can also
come to a few conclusions regarding how things should be done in the future. I
support some form of the
Glass-Steagall Act, which separates commercial banking from broker/dealer operations. In other words, large deposit-taking banks would not engage in derivatives dealing and investment banking business, which is at
the core of many of the problems facing these giant money-center banks today.
Second, it would be worthwhile to define a more detailed hierarchy of seniority for
commercial bank lenders. Demand deposits would be senior to time deposits and bondholders. Also, there would
be a requirement that demand deposits
constitute no more than
70% of liabilities. This would
provide a clearer sequence of seniority, as opposed to my somewhat arbitrary example, which would allow the process to be much more forthright.
We can also see from
this why taxpayer-funded “bailouts”
are not likely to be very successful. They would have to fill the huge 488 billion euro hole, plus add some additional equity of perhaps 100 billion
euros, for a total of 588 billion euros. That doesn’t
include any nasties hidden in the derivatives book.
For just one bank. The taxpayer would likely get some
pathetically small slice
of equity, perhaps 20% of
the total, amounting to a direct ripoff.
The time for kicking the can
is about over in Europe. We
can only hope that leaders there do something sensible.
Nathan Lewis
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