Wednesday, September 24, 2008

Whoa

The most excellent Steve Waldman blew my mind today in a response yesterday's question about whether the debt of an insolvent financial institution had any value or not.
But I am all for converting counterparty liabilities to equity (along the lines suggested in my post, define $1 stock and let the firm pay some of its obligations in stock), if necessary. I'd start with straight, long-term, unsecured debt (obviously the most-equity like), but I'd go as far as possible up the chain as necessary.
As Keanu said, "whoa".

What Steve's suggesting is that not only do the bondholders get converted to equity, but all the entire liability side of the balance sheet does (in some order)! So, going back to our hypothetical insolvent bank, GS:

--ASSETS

Good assets: $75

Assets gone bad: $0 (written off)

TOTAL ASSETS: $75

--LIABILITIES & EQUITY

Liabilities to customers/counterparties: $80

Debt to bondholders of company: $15

Shareholder equity: -$20

TOTAL LIABILITIES AND EQUITY: $75

Steve would convert all bondholders AND some liability holders to equity holders until the desired amount of capitalization was reached. Say we think 3x leverage is "right". The final balance sheet would look like this:

--ASSETS

Good assets: $75

Assets gone bad: $0 (written off)

TOTAL ASSETS: $75

--LIABILITIES & EQUITY

Liabilities to customers/counterparties: $50 (37% haircut)

Debt to bondholders of company: $0 (wiped out)

Shareholder equity: $25

TOTAL LIABILITIES AND EQUITY: $75

I have no idea what the nature of "Liabilities to customers/counterparties" is -- some might be brokerage accounts which have some government protection, so there the US Government would take the equity share and pay out the customer in cash, others may be other banks who would now own a slice of GS, etc. The Zingales plan explicitly talked about debt-for-equity swaps, not liability-for-equity swaps, so I'm pretty sure they were not talking about the entire right hand side of the balance sheet (if I'm wrong, please let me know). So I think that the Zingales plan is still a non-starter, because balance sheets are worse than they imagine, but if you're going to be open to converting *everything*, then banks can still re-capitalize themselves and yes, high leverage makes this easier (as there is more to convert).

Two additional thoughts:

1. Who the counterparties are is important. If they include the Chinese, then this could remove the last prop supporting the Greenback as China decides to stop its lender financing program for US Consumers. This would be a Significant Event as their generosity has been a powerful countervailing force against the deflation the US is currently experiencing.

2. This plan re-capitalizes banks, but it does not inject more money into the financial system. Balance sheets still shrinking, so the money supply is deflating. Paulson and Bernanke would have to inflate (if they want to do that) via another route. I would recommend mailing $1M checks to households.

As my bleg worked out so well yesterday I'll try another. Can anyone tell me who the counterparties are, and what liabilities GS might be holding?

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