Recap recap June 6, 2013 at 8:17 pm

Paul Melaschenko and Noel Reynolds have an interesting idea for recapitalisation of a failing bank. The essential idea is:

  • You figure out how much equity the bank needs to be palpably and obvious solvent: call that x.
  • You seize all the existing equity and all the existing sub debt (the holders will get something for that). Say the sub debt par value is y, and the shareholder’s funds are z.
  • You seize x-y-z worth of senior debt too.
  • You set up a HoldCo. The old equity holders get equity in the HoldCo; the sub debt holders get sub debt in it; and the old senior debt holders get senior debt (to make up for their write down).
  • HoldCo has z of equity, y of sub debt, and x – y – z of senior debt as liabilities. It has x of equity in the bank as assets.
  • You sell the re-cap’d bank’s equity to the market.
  • The HoldCo now has cash as an asset. It pays off liability holders in order.

Now, this all depends on getting x right. If the market still doesn’t think the bank has positive value after the recap, you have a problem. But so long as x is big enough, the senior debt holders will get something to compensate them for the bail-in; the equity holders probably won’t, unless you had an itchy figure on the recap trigger. Still, it’s quite neat.

9 Responses to “Recap recap”

  1. The trouble is that (speaking as someone who’s been at the sharp end of this sort of thing) they’re being wildly optimistic about the prospect of IPO’ing the equity of a recently bailed-in bank, three months after the collapse and ex hypothesi in a crap market. In principle, in theory and in an efficient market, then “If the market still doesn’t think the bank has positive value after the recap, you have a problem”. But in terms of actually doing the transaction, the frictional losses are massive relative to the benefits. I think it’s a worse approach than simple bail-in.

  2. David, you’re right, it is neat. In many ways it is just like liquidation, but without closing shop: in liqudation the individual assets are sold to repay the creditors, in this proposal the whole bank is sold as a gonig-concern and the proceeds used to repay creditors affected by the write-down. Plus, it doesn’t need to be ipo’ed, it could be sold to another bank: Eg, “Barclays, we won’t provide you with any governement backstop for the takeover of Lehmans, but we will reduce its liabilities before you buy it. How much do we need to reduce its liabilties before you are interested?” If only the US had that option at the time.

    I think those that support a simple bail-in really don’t understand the needs of debt invetors.

  3. What is the benefit of bringing in bankers (ECM or M&A) to arrange a transaction that is almost certain to undervalue the bank, compared to just giving the creditors the equity and letting them decide for themselves whether they want to sell it?

  4. dsquared, the benefit of selling the bank is that you determine the market price and use this to compensate creditors fairly. This is very similar to what happens in liquidation, which would be the fate of the bank if it was not TBTF. These guys at the BIS seem to be proposing something that really does respect the creditor hierarchy, which, as their paper points out, bail-in cannot do.

    In addition, regarding your comment on transaction fees, bankers take a cut whenever shares are sold. Do you really think that the aggregate transaction cost under bail-in is lower? Bail-in could potentially involve millions of creditors selling their unwanted shares.

  5. Here’s the problem: this process proceeds to point at the beginning of step two where someone says, “You seize all the existing equity….”

    Then (let’s take Citi as an example) everyone looks around the table and says, “Who’s going to call the Saudi prince who bought $16B of C six months ago?”

    This is the operative problem with the bank recap process — no one has the cobbles to tell equity, “Remember when you read the prospectus and it said this investment was not FDIC insured and could lose all its value? Remember that? Well, this is that.”

    The Swedish government had the stones. The Japanese didn’t. When the chocolate mousse hit the fan in the US, I wondered whose model we would choose. Five years into our lost decade, it’s become blindingly clear.

    JMHO.

  6. the benefit of selling the bank is that you determine the market price

    No this is blackboard economics. You can call the price that you get in such a high-pressure, distress-seller transaction “the market price” (because it’s the price! and you got it in the market!) but really – it isn’t. Big privatisations and recapitalisations are tricky issues to manage at the best of times. In this kind of sale, your two most likely outcomes would be a) massively undervalue the business or b) couldn’t get it done at all. The BIS guys are just hugely overestimating the capacity of equity markets.

  7. dsquared – I kinda agree, but I think we need to distinguish minor, localised panics from systemic ones. Could you have got, say, Wachovia done in July 2008? I think you probably could have done. But September or October? Not so much.

  8. As you seem to acknowledge dsquared, by definition it is the market price. So please don’t say that it is not the market price, otherwise we will have a problem communicating.

    Anyway, I think your main point is that you assume the market price at the point of sale is likely to undervalue the bank. Well, maybe it will…. or maybe it won’t. In fact, maybe the market will overvalue the bank; there are certainly many providers of equity that overvalued banks during this current crisis. The fact is, no one knows whether the market will over- or under-value the bank, so it is probably best not to make assumptions in this area.

    One of the key benefits of the BIS proposal, as I see it, is that the use of the market to determine the losses to creditors is exactly what would happen if the failed bank was put into liquidation. So, creditors know that either way (liquidation or recapitalisation) the market determines their losses. What is the alternative approach to determine losses that you advocate?

  9. I think we need to distinguish minor, localised panics from systemic ones

    I would presume that most small resolutions would be handled by trade sales, but aren’t these made more problematic by the newco structure proposed? I’d be very chary of buying something like Britannia Building Society if I knew that (as well as all the other problems) there were going to be a bunch of creditors hanging around suing people.