Wednesday, December 30, 2009
A Quick Note on Recapitalization
In November of 2008 I had a long phone conversation with the impregnable von Pepe, which clarified the typical discussions of the financial crisis in light of my hazy knowledge of accounting. In fact I was so energized after the call that I set out to do a whole series of blog posts sharing my newfound understanding.
Well that never happened. But I had another talk with von Pepe tonight and something really clicked, so I thought I would share it verbally (i.e. without coming up with a hypothetical balance sheet to illustrate the idea) while it's still fresh.
One last point before we dive in: I am going out of my way to "not get it" in the analysis below. Before my talk with von Pepe, it's not that I doubted the conventional wisdom on these matters, but I just had my doubts and wasn't sure how to dispel them.
==========
Here's the context: After the crisis, you heard many commentators say things like, "The banks took huge hits on their holdings of mortgage-backed securities and standard loans. After writing down their assets, they have very little equity remaining. They need to issue more stock to recapitalize themselves."
Now here were two vague concerns I had with this type of statement:
(1) Why did the firms need to attract new capital through the issuance of stock? If they needed to raise money, couldn't they just issue more bonds? But then that wouldn't be a recapitalization, it would be borrowing.
(2) If these firms were on the ropes because of their huge losses, how does that get magically fixed by pumping in more capital? Or to put it another way, why would investors want to buy shares in a company on the verge of bankruptcy? To put it a third way, if the company is solid and outside investors are willing to pump in more money, then who cares if they currently only have a razor-thin margin of shareholders' equity? What's a billion here or there in extra losses on MBS holdings if the underlying firm is solid?
The answer to all of the above turns out to be really elementary, but for some reason it didn't click with me until my phone call tonight. So here it is: When a corporation issues more debt, it is taking on fixed liabilities (to make periodic interest payments and eventually return the principal). If the corporation does really well and has high earnings, then it pays off the bondholders the contractual amount and keeps the rest. On the other hand, if the firm loses money, it still owes the bondholders.
In contrast, if the corporation issues new shares of stock, it isn't committing itself to future payments. If times are bad, nothing happens. If times are good, however, then the pool of available earnings to be distributed as dividend payments must be spread over a larger number of shares.
So if we're looking at a financial institution that took huge writedowns on its loan portfolio and holdings of MBS, such that there is only $1 billion in shareholders' equity compared to (say) $100 billion in outstanding debt, then that firm is incredibly leveraged. If things go smoothly and no further writedowns occur, then it will slowly climb out of its hole and the shareholders will make a killing.
However, if they lose just 1% in the value of their assets, that could wipe them out and they would have to declare bankruptcy. I.e. their liabilities would exceed their remaining assets.
So rather than remain in such a precarious position, the corporation can issue new stock and spread the potential gains and losses among a broader base of capital. If the corporation does well, it dilutes the return to the original shareholders. On the other hand, if things go poorly, the original shareholders aren't wiped out. In essence they've brought in others to reduce both the expected return and its variance.
Well that never happened. But I had another talk with von Pepe tonight and something really clicked, so I thought I would share it verbally (i.e. without coming up with a hypothetical balance sheet to illustrate the idea) while it's still fresh.
One last point before we dive in: I am going out of my way to "not get it" in the analysis below. Before my talk with von Pepe, it's not that I doubted the conventional wisdom on these matters, but I just had my doubts and wasn't sure how to dispel them.
Here's the context: After the crisis, you heard many commentators say things like, "The banks took huge hits on their holdings of mortgage-backed securities and standard loans. After writing down their assets, they have very little equity remaining. They need to issue more stock to recapitalize themselves."
Now here were two vague concerns I had with this type of statement:
(1) Why did the firms need to attract new capital through the issuance of stock? If they needed to raise money, couldn't they just issue more bonds? But then that wouldn't be a recapitalization, it would be borrowing.
(2) If these firms were on the ropes because of their huge losses, how does that get magically fixed by pumping in more capital? Or to put it another way, why would investors want to buy shares in a company on the verge of bankruptcy? To put it a third way, if the company is solid and outside investors are willing to pump in more money, then who cares if they currently only have a razor-thin margin of shareholders' equity? What's a billion here or there in extra losses on MBS holdings if the underlying firm is solid?
The answer to all of the above turns out to be really elementary, but for some reason it didn't click with me until my phone call tonight. So here it is: When a corporation issues more debt, it is taking on fixed liabilities (to make periodic interest payments and eventually return the principal). If the corporation does really well and has high earnings, then it pays off the bondholders the contractual amount and keeps the rest. On the other hand, if the firm loses money, it still owes the bondholders.
In contrast, if the corporation issues new shares of stock, it isn't committing itself to future payments. If times are bad, nothing happens. If times are good, however, then the pool of available earnings to be distributed as dividend payments must be spread over a larger number of shares.
So if we're looking at a financial institution that took huge writedowns on its loan portfolio and holdings of MBS, such that there is only $1 billion in shareholders' equity compared to (say) $100 billion in outstanding debt, then that firm is incredibly leveraged. If things go smoothly and no further writedowns occur, then it will slowly climb out of its hole and the shareholders will make a killing.
However, if they lose just 1% in the value of their assets, that could wipe them out and they would have to declare bankruptcy. I.e. their liabilities would exceed their remaining assets.
So rather than remain in such a precarious position, the corporation can issue new stock and spread the potential gains and losses among a broader base of capital. If the corporation does well, it dilutes the return to the original shareholders. On the other hand, if things go poorly, the original shareholders aren't wiped out. In essence they've brought in others to reduce both the expected return and its variance.
Comments:
On the first question, a bond issuance would solve a liquidity problem but not a solvency problem which would need an injection of equity.
On the second question, it's not so much of a problem convincing new investors to invest in an equity issuance. There is almost always a price at which new equity investment will be forthcoming, a recent example being the Citi issuance at a 15-20% discount.
The real problem is that the current owners of any financial institution would almost always prefer to operate on a thin sliver of equity if the regulator would allow them to. When debt issuance is explicitly or implicitly guaranteed by the govt, new debt issuance is "cheap" and increases firm value and the optimal leverage is infinite ( See Merton http://www.people.hbs.edu/rmerton/analytic%20derivation%20of%20cost%20of%20loan%20guarantees.pdf ).
The reason why we have capital adequacy standards is that creditors/depositors no longer have the incentive to monitor risk and shareholders are incentivised to operate at as high a leverage as possible.
Although given the arbitrary nature of bank bailouts and FDIC policy, bondholders still have an incentive to not invest if the bank is too thinly capitalised. Except of course if the new bond issue is FDIC-guaranteed as most bond issuances were this year.
On the second question, it's not so much of a problem convincing new investors to invest in an equity issuance. There is almost always a price at which new equity investment will be forthcoming, a recent example being the Citi issuance at a 15-20% discount.
The real problem is that the current owners of any financial institution would almost always prefer to operate on a thin sliver of equity if the regulator would allow them to. When debt issuance is explicitly or implicitly guaranteed by the govt, new debt issuance is "cheap" and increases firm value and the optimal leverage is infinite ( See Merton http://www.people.hbs.edu/rmerton/analytic%20derivation%20of%20cost%20of%20loan%20guarantees.pdf ).
The reason why we have capital adequacy standards is that creditors/depositors no longer have the incentive to monitor risk and shareholders are incentivised to operate at as high a leverage as possible.
Although given the arbitrary nature of bank bailouts and FDIC policy, bondholders still have an incentive to not invest if the bank is too thinly capitalised. Except of course if the new bond issue is FDIC-guaranteed as most bond issuances were this year.
Current creditors have a stake in this as well. If the banks issued bonds, then the current creditors would have less of a chance getting repaid if things went badly. If the banks issue sell equity, then the current creditors stand a better chance of getting their money back.
# posted by 
: December 30, 2009 at 10:54 AM
: December 30, 2009 at 10:54 AM
Very nicely done! I think you should still do the original series--to hear this explained from your angle is educational. They don't have to be too detailed--the length of this one was great.
Nice additional point, fundamentalist.
Nice additional point, fundamentalist.
# posted by : December 30, 2009 at 12:34 PM
: December 30, 2009 at 12:34 PM
Current creditors care in ordinary circumstances. They don't care if they are lending in the form of a FDIC-guaranteed deposit or bond or if they are lending to any of the too-big-to-fail entities with a "no more lehmans" implicit guarantee.
Am I really the only one to find this post to be a repetition of the obvious?
Did you all sleep through Finance and Accounting 101?
Did you all sleep through Finance and Accounting 101?
timk, It may be 'obvious' to you the same way it is 'obvious' to me you have no manners.
Even for those who understand the topic, repetition and a slightly new way to go about discussing it with other people is enlightening. This type of broad reeducation is going to be essential to the reordering of our financial and economic systems therefore we should always welcome such discussions.
BTW, whom have you taught this to lately?
Even for those who understand the topic, repetition and a slightly new way to go about discussing it with other people is enlightening. This type of broad reeducation is going to be essential to the reordering of our financial and economic systems therefore we should always welcome such discussions.
BTW, whom have you taught this to lately?
# posted by : December 31, 2009 at 3:11 PM
: December 31, 2009 at 3:11 PM
Hmmm.
2+3=5. Does it really help the discussion to say 3+2=5, as well?
It's obvious, isn't it?
Could it be that you're anti-Fed, anti-Krugman because you don't understand these basics in the "Recapitalization" post?
Just asking.
2+3=5. Does it really help the discussion to say 3+2=5, as well?
It's obvious, isn't it?
Could it be that you're anti-Fed, anti-Krugman because you don't understand these basics in the "Recapitalization" post?
Just asking.
Yes, it does.
Yes, it is to you. Educators, though, do not stop at one explanation. They shed light on the topic from several angles to give students a more stable understanding.
Nope. Now you're really getting squirrelly.
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Yes, it is to you. Educators, though, do not stop at one explanation. They shed light on the topic from several angles to give students a more stable understanding.
Nope. Now you're really getting squirrelly.
# posted by : January 1, 2010 at 12:52 PM
: January 1, 2010 at 12:52 PM Subscribe to Post Comments [Atom]
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