Friday, June 22, 2012

Debt equity swap explained with pie charts

In the wake of the €100B+ bailout of Spanish banks, and Michel Barnier's proposal for a banking union (WSJ), Hans-Werner Sinn (Professor of Economics at the University of Munich) recently wrote (Project Syndicate).
Debt-equity swaps would be a much better way to recapitalize the banks. Rather than imposing the costs of the ECB's and EFSF's losses on European taxpayers, the banks' creditors could give up some of their claims in exchange for receiving shares from the banks' owners. Debt-equity swaps rescue the banks without rescuing their [creditors].
An article by Nathan Lewis from last year imagines a Greek sovereign default and a debt-equity-swap (DES) in BNP-Paribas' liability (Forbes). It's a bit dated, and BNP-Paribas is not the main focus of attention right now, but it still has the merit of relying on actual data. I'm adding some pie charts to illustrate his writing and raise a few inconsistencies.

Imagine a Greek default

Here's the imagined scenario:
  1. "BNP Paribas tells us that as of the end of the first half [of 2011], it had 1,926 billion euros of assets (loans, bonds), 1,839 billion euros of liabilities (borrowed money), and equity of 87 billion euros. "
  2. "The end result [of a Greece default] is that assets would fall to about 1,625 billion by my count" [First writedown]
  3.  "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." [Second writedown]
Based on this, here's a breakdown of BNP Paribas' asset and capital structure, as of H1 2011, between what remains and what is wiped out as a result of a hypothetical Greek default:

Breakdown of BNP Paribas' H1 2011 asset and capital structure

WD stands for "write down", and HC for "haircut". Wipe outs are shown by dislocated slices. The haircut is not explicitly stated in the above scenario, but it is deduced from it.

Debt equity swap

Here's the proposed debt-equity-swap:
  1. "There are [initially] 223 billion of bonds, and another 117 billion due to credit institutions, for a total of 340 billion."
  2. "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."
  3. "Now we have 933 billion of liabilities, 1,137 billion of assets, and 204 billion of equity. "
  4. "This is a capitalization ratio of 18%, which is quite cushy, and appropriate for the sort of environment that the bank finds itself in."
From €340B to €204B, there is a €136B haircut on senior debt, as deduced above. Based on this, below is the Breakdown of H1 2011 senior debt between components, before and after the Greek default (and the DES):

Breakdown of H1 2011 senior debt

Dislocated slices are those that are affected by the debt equity swap.

The DES is further described as follows:
  1. "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."
  2. "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."
This says the haircut on senior debt is not €136B but €34B (€340B - €306B). I think there is a leap of faith with the 1.5x market-to-book-value. My understanding, instead, was that the second write down brought book value close to market value. I stand by €136B.

Incomplete picture

The article continues:
  1. "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. "
  2. "At this point there are few other options except for extravagant lying, robbing the taxpayer, and printing money. Probably all three."
  3. "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."
The whole point of a bank bailout is to keep its essential functions operating so that you and I can cash our paycheck and spend it at, say, Walmart. So while might find satisfaction in seeing parasitic functions getting eliminated that way,  the big leap of faith in the above analysis is that there is a "bank holiday" but, at the same time, "the [essential function of the] bank would continue operating". 

Some key variables were left unspecified in the analysis. Northern Rock continued to operate thanks to the central bank offering an unconditional line of credit. At the very least, that should come into play. But then, that is a form of state support. Admittedly, though, the DES can save the government the extra harship of supplying the bank with equity, which is the pattern we have observed during 2008: first emergency funding from the central bank, then the treasury writes large checks to the banks (TARP etc.).

DES, preemptively

Notice that the DES here is in a response to a Greek default. Hans-Werner Sinn's proposal is to impose a DES right now, as a preventive measure. In principle, there need not be a haircut in this scenario. If anything, the capital structure is more optimal, so that should (theoretically) result in an increase in market value.

As one recalls, banks fought tooth and nail the European Banking Authority's demand, in 2011, that they shore up their capital buffers (Voxeu). Their arguments were that the sell off of assets, the reduction in the distribution of credit resulting from increase cost of capital, and all kinds of difficulties, real or imagined stood in the way. What's the counter argument to a DES, now?

Also see:
  • Why a DES won't work, 2009 (Felix Salmon
  • A real world DES: Citibank, 2009 (Press release
  • From bail out to bail in, 2010 (Economist)
  • Recap: time for the French to swallow their pride, 2011 (Independent)
  • Struggling French banks fought to avoid oversight, 2011 (WSJ)
  • Spanish banks: recap without a bailout, 2012 (Value Walk)
  • Bail in could save Spain banks, 2012 (WSJ)
  • Spain and the Citi, 2012 (Zero Hedge)
  • Moodys downgrades BNP-Paribas credit rating (BW)


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  2. EU Commission - DG MRKT - June 2012 - Measures to avoid future bail outs


    Between October 2008 and October 2011, the European Commission approved €4.5 trillion (equivalent to 37% of EU GDP) of state aid measures to financial institutions.

  3. Rehn on 5 bailouts he implemented: 'has a good conscience'. Proof? No Lehman collapse...

    April 11, 2013 - WSJ - EU's Rehn Calls for Faster Banking Union

  4. Architect of Banking Union breaks barrier of imagination, by international bankers' standard, in solving the EU crisis: give banks a yet untapped backdoor bailout.

    May 11, 2013 - Reuters- ECB's Liikanen urges open mind on [ECB buying] asset-backed securities [from zombie banks]