Insolvent Banks: Why a Debt-for-Equity Swap Won’t Work

Henry Blodget has convinced himself that he’s worked out "the right way" to fix banks. It’s a big debt-for-equity cramdown, basically, which, he says, will "avoid another Lehman" and involve spending "no taxpayer money".

Which got me wondering: what do we really mean when we talk about banks being "too big to fail"? In the case of Lehman, the single biggest repercussion from the bank’s failure was not the counterparty risk in the CDS market, which everybody was worried about but which turned out not to be a problem, but rather the evaporation of $155 billion in unsecured debt, which contributed to the Reserve Fund breaking the buck and a massive spike in credit spreads.

If we enacted Blodget’s plan for, say, Citigroup, the writedown on Citi’s senior unsecured debt might well be greater than $155 billion, depending on what exactly Blodget is referring to when he talks about Citi’s "debt". He leaves the term (deliberately?) vague, but if you look at Citi’s balance sheet, it has $774 billion in deposits, $105 billion in short-term borrowings, $393 billion in long-term debt, and $646 billion in other liabilities, including $250 billion to the Fed and $118 billion in brokerage payables.

If Blodget is serious about spending no taxpayer money, that implies that the Fed should take no haircut and that the FDIC should not have to step in to guarantee deposits. (He also says that "today’s preferred shareholders would get wiped out", however, which in and of itself constitutes a loss for taxpayers, since we own a massive chunk of Citi’s $27 billion in preferred stock.) But if Blodget really wants to ring-fence not only secured creditors but also depositors, that means that the bulk of the write-downs will be inflicted on Citi’s $500 billion or so of non-depositor unsecured creditors.

Blodget wants to write down Citi’s $2.05 trillion in assets "to nuclear-winter levels". I’m not sure what he considers to be a nuclear winter, but if those assets are written down to 80 cents on the dollar, that’s a write-down of $410 billion right there, and about $285 billion of that sum would have to be eaten by Citi’s bondholders. That’s not avoiding another Lehman, it’s creating a failure significantly larger than Lehman.

Yes, those bondholders would get a bunch of equity in return for their losses, but fixed-income investors aren’t generally even allowed to own equity, and would be forced to sell those shares at fire-sale prices. The resulting valuation for Citigroup, after writing off $410 billion and swapping $285 billion of debt for new equity, would be so low that it would imply that the rest of the US banking system was also insolvent.

Alternatively, you could include depositors among the unsecured creditors — which, of course, they are. But if you even hint you might do that, you start a run on the bank, and on any other bank which conceivably might be declared insolvent. Which is substantially all banks: we might be talking about the mother of all bank runs here. And how do you start giving out equity to, say, small Polish depositors?

I’m sorry, Henry, but there are no easy answers here. Unless you consider outright nationalization to be easy, of course. Which it isn’t — but it’s a darn sight more likely to work than any of the other ideas out there, including yours.