Debt and Equity


DEBT AND EQUITY….If Uncle Sam is going to bail out America’s banks, should taxpayers receive equity in these banks in return for handing over vast piles of cash? Sure. But here’s the specific language from the Dodd “discussion draft” of the enabling legislation:

(A) CONTINGENT SHARES.—

(i) IN GENERAL.—The contingent shares to be received by the Secretary under paragraph (1) may, at the determination of the Secretary, include shares of the financial institution, its parent company, its holding company, any of its subsidiaries, or any other entity which is owned, controlled, or managed by such institution. [Details are laid out later in paragraph 2.C.3.]

(ii) DEBT INSTRUMENTS.—In the event that the equity of the financial institution from which such troubled assets were purchased is not publicly traded on a national securities exchange, the Secretary shall acquire a senior contingent debt instrument in lieu of contingent shares, which shall automatically vest to the Secretary on behalf of the United States Treasury in an amount equal to 125 percent of the dollar amount of the difference between the amount the Secretary paid for the troubled assets and the disposition price of such assets. The Secretary may demand payment of such contingent debt instrument under such terms and conditions as determined appropriate by the Secretary.

So: the idea is that the Treasury buys toxic waste from the banks and eventually sells it off. If it sells at a loss, it receives shares equal to 125% of the loss. This is based on the share price at the time it bought the assets, which means that if the bank prospers in the meantime and its share price rises, the taxpayers share in this good fortune.

Fine. But note the second paragraph: if we bail out a private firm, we get senior debt instead of equity. Fair enough: equity in a private firm is hard to value, so why add in the additional complexity of trying to negotiate a fair value?

But here’s the thing: Does accepting senior debt do the banks any good or doesn’t it? Taking debt instead of equity essentially amounts to restructuring the bank’s debt and giving it some breathing space, possibly enough to allow it raise capital privately. It doesn’t directly change the bank’s capitalization ratio, but if restructuring debt without changing capitalization ratios is useful for private banks, why not for publicly held banks too? After all, they’re both faced with borrowing money from the same people with the same concerns over possible insolvency.

Maybe I’m an idiot. It wouldn’t be the first time. But I continue to be a little perplexed by the mania for equity. The removal of toxic waste combined with a restructuring of debt either does some good or it doesn’t, and if it does, then let’s use it for publicly held banks too. If the borrowing firm eventually goes bankrupt, senior debt is better than equity anyway. If it prospers instead, equity will turn out to be the better deal, but I don’t really care about that. I don’t especially want Uncle Sam playing the market, and I don’t especially want Uncle Sam to own potentially large stakes in half the banks on Wall Street. I just want the best chance of getting our money back.

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