Basel Committee proposal: Convert bonds to stock when a company goes bankrupt

[yllus]

I'm surprised that what's proposed here this isn't already how the system works. I imagine this means that corporate bond rates will increase to some degree as the amount of risk taken by private investors will be upped (however slightly).

Basel watchdogs back Canada's banking scheme

The Basel Committee on Banking Supervision is proposing that debt counted as bank capital should be converted to stock or written off in a crisis, forcing bond investors to bear some of the cost of future bailouts.

Stakeholders have until Oct. 1 of this year to respond to the proposal. But on the surface this represents a major victory for Canada -- which pushed hard for such a scheme, deemed contingent capital, as an alternative to a global bank tax as advocated by European economies.

According to documents released by the Swiss-based group, all regulatory capital instruments sold by banks should be capable of absorbing losses if the company can’t fund itself, the committee said in a consultative paper Thursday. Before taxpayers’ cash is used to rescue a lender, so-called contingent capital should be converted to equity or written off.

The committee, which sets international banking rules, wants to avoid a repeat of the financial crisis when government assistance to failing banks helped holders of some subordinated bonds dodge losses. Banks’ cost of capital may rise as investors demand compensation for the increased risk they won’t be repaid.

“It looks like the banks are going to be paying more for regulatory capital,” said John Raymond, an analyst at credit research firm CreditSights Inc. in London. “They’ll also have to look for a different investor base.”

The proposals will reduce moral hazard and excessive risk-taking by discouraging investors from buying securities with the assumption they will avoid losses if a bank fails, the committee said. It would also make private investors the first source of new equity to rescue a bank when it nears collapse, cutting down on the need for government rescues.

 

[PokerGuy]

I'm not an expert on this, but wouldn't that essentially remove a major benefit of bonds over stocks, that you are not subject to the same risks because your bonds are backed by more than the stocks? Wouldn't that create a massive exodus from bonds and thus raise bond rates a lot? Wouldn't that make it a lot more expensive for companies to raise capital?

 

[yllus]

I don't think bond rates would go up that significantly. Whether this change happens or not, you're still gambling on whether or not that company can pay on its debts. I think this just puts bondholders at the back of the line with equity investors if it comes to bankruptcy.

 

[Fern]

That's crazy.

And why should bondholders be at the back of the line stockholders?

These two types of investments are so fundamentially dissimilar that to treat them similarly in bankruptcy is insane.

Bondholders are subject to the risk of rising interest rates (pricipal loss as bonds' value will be less than face if rates rise), stockholders are not. In fact, the stockers benefit from the bond holders' risk (lower cost of borrowed capital increasing stockholder value). Stock holders share in banks profits (via dividends), bondholders do not. Stockholders share in company appreciation (higher stock price/value), bondholders do not. Bondholders have no say in running the bank, stockholders do. Etc.

Bondholders are already subject to being wiped out in a bankruptcy, so this looks like some gov type plan to sacrifice bondholders yet avoid bankruptcy in a bailout plan. I.e., a benefit to gov at the cost of bondholders.

I would think this would greatly damage the bank bond market etc. You'd be crazy to buy bank bonds if you were treated this way. Bank bonds would probably have to be insured for a bank to sell any. Maybe this is a proposal actually pushed by financial institutions selling bond insurance?

Fern

 

[alphatarget1]

The common shareholders will probably get wiped out first and the bondholders will probably get stocks for their bonds afterwards.

 

[Blackjack200]

The Basel Committee on Banking Supervision is proposing that debt counted as bank capital should be converted to stock or written off in a crisis, forcing bond investors to bear some of the cost of future bailouts.

Just guessing, because I don't know all the accounting rules, but I would assume that "debt counted as bank capital" refers to insturments like preferred stock and convertable bonds. Non-convertible debentures would not be impacted.

LegeandKiller would probably know.

 

[Fern]

The common shareholders will probably get wiped out first and the bondholders will probably get stocks for their bonds afterwards.

What?

If the shareholders get wiped out then the stock is worthless. Giving bondholders worthless stock makes no sense.

And I strongly suspect they wanna wipe out the bondholders in order to avoid bankruptcy. I.e., wiped out before bankrutcy to avoid causing the gov to step in before bankruptcy with a bailout plan.

Fern

 

[Blackjack200]

What?

If the shareholders get wiped out then the stock is worthless. Giving bondholders worthless stock makes no sense.

And I strongly suspect they wanna wipe out the bondholders in order to avoid bankruptcy. I.e., wiped out before bankrutcy to avoid causing the gov to step in before bankruptcy with a bailout plan.

Fern

Or maybe they're just explicity putting the bond investors behind the financial counterparties?

i.e., the point of bailing out Bear Sterns was not to make sure that the investors holding Bear Sterns bonds recovered their principal, it was to prevent other financial institutions from failing as a result.

 

[Fern]

Just guessing, because I don't know all the accounting rules, but I would assume that "debt counted as bank capital" refers to insturments like preferred stock and convertable bonds. Non-convertible debentures would not be impacted.

LegeandKiller would probably know.

Link:

http://en.wikipedia.org/wiki/Capital_requirement

Tier 2 (supplementary) capital

There are several classifications of tier 2 capital, which is composed of supplementary capital and are called temporary capital unlike, tier 1 which is permanent capital. In the Basel I accord, these are categorized as undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated term debt.

Preferred stock should be Tier 1 capital (along with common stock).

Convertable bonds aren't mentioned. But since the conversion is typically at the bondholders election (not the bank company) I suspect they are classified as senior or subordinated debt based upon their other characteristics.

Fern

 

[Jhhnn]

The article really doesn't go into enough depth to enable solid judgement. OTOH, I think that the principle that bondholders should take the hit before the taxpayers seems entirely valid on the surface, something that didn't happen wrt the recent bailout at all. GSE bondholders are apparently being made whole w/o a haircut of any kind, courtesy of the taxpayers, for example.

I'd hope that the proposal really means that the highest level of stakeholders, bondholders, would still maintain their stake in a bailed out and reformed company as stock while the common stockholders would simply be wiped out as in the current system. When and if the company emerges from bankruptcy, bondholders would emerge with as much of their original stake intact as possible w/o mooching off the taxpayers... their stock would essentially be part of the stock offered in the new IPO...

Derivative counterparties probably need to be treated in a similar fashion, as well... they take the haircut, not the taxpayers...

This is, of course, all consequential to allowing companies to get TBTF in the first place. If that weren't a factor, the whole discussion would be meaningless. Normal bankruptcy proceedings would be entirely adequate.