How to recapitalize the banks October 5, 2011 at 5:20 am

Timmy did it wrong. (That is hardly a surprise.) So European finance ministers, looking to recapitalize their banks, should not take his example. First the background from the FT:

European Union finance ministers are examining ways of co-ordinating recapitalisations of financial institutions after they agreed that additional measures were urgently needed to shore up the region’s banks.

Although the details of the plan are still under discussion, officials said EU ministers meeting in Luxembourg had concluded that they had not done enough to convince financial markets that Europe’s banks could withstand the current debt crisis.

What he should have done, and what the European finance ministers should do, is buy equity. They should buy it at market – unlike the UK recapitalisation of RBS – and they should vote the stock. It is time to get some control in exchange for the cash European taxpayers will be stumping up.

Update. Carter has some good points, and some I disagree with, in the comments. To begin, where he is right:

I wholeheartedly disagree. First, let’s assume right off that you don’t mean buying equity IN the market, as this would just be a bailout of existing shareholders.

Yes, indeed. I did not mean that.

Buying “equity at market” absolutely ignores the dilution of the existing shareholders. Buying equity “at the market” price even if they are newly issued shares is a subsidy to the existing shareholders. It is paying an above-market price.

Yes again. What I was really thinking was ‘not above the market price’, as in the UK’s case. But you are right, the fair price given dilution is well below the current market price for normal market size.

You criticize the US TARP, but essentially the USG backstopped a public issuance by the banks. Banks that could effectively raise funds at a lower cost than the USG proposed did so, and the market provided the funds. Those that could not were going to be funded by the USG, the equity would have been massively diluted, and the USG would have obtained the requisite voting rights.

Um, but the US Government promised not to vote their equity where they had some, and often they took prefs or warrants where they could have taken equity. It seemed to me – and I would be eager to hear counterexamples – that they bent over backwards to be in a position where they did not have to vote stock.

But the government should not arbitrarily take control of an institution that the market is willing to fund and believes is viable.

Hmmm, I disagree. It should not do it often, that is for sure. But in the European case, where the implicit subsidy of ‘we will step in if we have to’ is worth a great deal (Haldane estimated $50B for the UK banking system, so at least $100B for the EU), taxpayers deserve something for that backstop. I would prefer a system where banks explicitly paid for this insurance all the time – similar to the FDIC model – but they should pay a market rate.

7 Responses to “How to recapitalize the banks”

  1. […] Bank recapitalisation — get it right this […]

  2. Why exactly would you want to buy an equity position in a bankrupt financial institution? Holding equity inhibits the ability to restructure, as doing so would wipe out tax payer money. Why do these banks need to be recapitalized at all? There is plenty of debt capital to protect depositors and counterparties. Wipe out the equity, haircut sub debt, and make the debt holders the new equity holders. Its quite simple, but for some reason bondholders are considered sacrosanct and apparently rank ahead of taxpayers in the capital structure.

  3. I wholeheartedly disagree. First, let’s assume right off that you don’t mean buying equity IN the market, as this would just be a bailout of existing shareholders.

    Buying “equity at market” absolutely ignores the dilution of the existing shareholders. Buying equity “at the market” price even if they are newly issued shares is a subsidy to the existing shareholders. It is paying an above-market price.

    You criticize the US TARP, but essentially the USG backstopped a public issuance by the banks. Banks that could effectively raise funds at a lower cost than the USG proposed did so, and the market provided the funds. Those that could not were going to be funded by the USG, the equity would have been massively diluted, and the USG would have obtained the requisite voting rights.

    But the government should not arbitrarily take control of an institution that the market is willing to fund and believes is viable.

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  5. Fair point on the taking of the Preferreds.

    The UST offerred firms access to “contingent capital” under its Capital Purchase Program. Specifically, firms could obtain “Mandatory Convertible Preferred (MCP) in an amount up to 2% of risk-weighted assets (or higher upon request).”

    The UST did retain the right to exercise its voting rights if and when the preferreds converted to common. Here is the relevent section of the term sheet:
    “Upon conversion of the Convertible Preferred, the UST will have the voting rights associated with the QFI’s common stock. UST will publish a set of principles governing its use of these rights prior to closing any transactions.”

    One my hypothesize that the UST did this to incent firms (or specifically management) to consider taking the needed capital. One also should consider that the authorities had other ways of influencing the firms behavior (supervision).

    To your last point, I think we actually agree. Haldane’s “if we have to” implies that the market will not provide the funds to recapitalize.

    BTW: really enjoy your posts: quite thoughtful.

  6. The probelm in the US was much more homogeneous, as a result a one size fits all solution is less problematic.

    The range of issues faced by the European banks is very wide. Some are aggressively wholesale funded with low risk weightings and bad assets. Others are well funded, well capitalised but with mark to market losses on sovereigns and uncertainty around some loan books.

    A European TARP to deal with the IMF mark to market 200bn capital hole makes no sense whatsoever. Either the losses will be MUCH bigger or they will not happen. Adding 200bn into that is nonsense. The IMF suggest it to try to stop the European banks deleveraging into this. That has already happened, Europe is about to experience a ‘sudden stop’. Any attempt to get out of this will rest with the sovereigns not the banks.

    There is a legitimate long-term issue on European banking. The leverage, even adjusted for the mortgage book and the derivative gross up is too high. There are legion examples that this is inappropriate given the large books of legacy assets and questionable marks that they have taken. This is a longer term problem. I hope it is addressed centrally- the national incentive to make their banks ‘ratioinal’ is poor. Typically they finance part of the economy in a way that damages shareholders not stakeholders. For that to happen the EBA must be changed so that it engages with banks directly rather than engaging with banks through national regulators.

    I like your posts and often learn a lot from them, best,
    John

  7. I do worry about how Europe will actually fix the problems of the banks being so indebted to insolvent states. It seems difficult to see how the IMF and the ECB will get sufficient money to bail these out particularly as Greece has effectively defaulted already.

    There are many rumours about Germany bailing out of the Euro totally. Their electorate really doesn’t want Germany to foot the bill and the courts have made it clear that they won’t let Germany spend the sorts of money that you be needed. Something althogether more radical seems to be needed, more in line with the Macarthur plan after the 2nd world war.