The Treasury Department is rightfully seeking private investors to recapitalize sick but viable banks. Private investors are, however, unlikely to invest in troubled institutions under current conditions, despite having the interest and capacity to do so.
Early abortive attempts by sovereign wealth funds and private-equity firms to invest in Citigroup, Washington Mutual and National City are sobering and highlight the impediments facing investors. They go beyond the traditional bank holding company ownership restrictions. Resolving the impediments is important to entice private investment, which can break the inefficient and unpopular government bank bailout cycle.
Distressed banks' assets have fallen in value and can no longer support their liabilities. Despite $1 trillion of charges, there is still $2 trillion of impaired assets on bank balance sheets. The specific location of the losses is less well known. Consequently, confidence in bank solvency has fallen.
Regulators have been reluctant to force realistic markdowns to 5%-30% of par, from 50%-60% of par carrying values at many institutions. This reflects the mistaken belief that toxic assets reflect a liquidity issue instead of a solvency problem. Bankers are unwilling to record true losses, which may exceed their artificial regulatory capital levels.
Public investors' concerns are reflected in the depressed stock prices at institutions that trade at a discount of more than 50% to tangible book value. Uncertain and opaque asset values complicate the determination of capital needs and earnings potential. This problem plagued investors in the failed recapitalizations of Wamu and Nat City.
Government assistance, not funding, is required to close this gap. The Treasury can use its stress test framework to encourage bankers to write down toxic assets to realistic market levels. The resulting losses would be covered through new capital injections or debt conversions. Rather than subsidizing investors through an expensive public-privative partnership, the emphasis would be on marking assets to market and recapitalizing firms with private funding.
The writedowns and capital injections can occur simultaneously, as in a prepackaged bankruptcy, with new private funding supplemented by debt equity swaps.
Many troubled institutions are effectively insolvent; liabilities exceed asset market values. Under these circumstances, it is difficult to attract private investors. It is similar to a homeowner whose mortgage exceeds the home's depressed market value. Any payments result in a value transfer directly to the existing debtholders. Thus, removal of this overhang becomes a critical component of efforts to attract private investment.
Large institutions use holding company-issued debt to support up to 50% of their assets. The four largest institutions have over $1 trillion of outstanding debt instruments. Converting a portion of this debt into equity through a swap can be an effective way to remove the overhang. Unlike in the Lehman Brothers collapse, debtholders would receive shares as compensation for their claims.
A current nonbank example is provided by General Motors, which is seeking to convert a portion of its debt into equity.
Regulators can force the conversion to expedite a process similar to the forced conversion of Citi's preferred stockholders. Creditors facing the choice of a potentially valuable equity claim or nothing are likely to be flexible. The current drop in bank senior debt prices and widening credit spreads suggest bond investors are beginning to notice this possibility. This requires ending the existing Treasury support of bondholders, which in effect reflects a disguised subsidy for bond funds.
Outmoded, ad hoc and inconsistent governmental and regulatory actions inhibit private investors. Restrictive holding company rules block efforts to initiate needed management and strategic changes by new investors. This frustrates investors, who fear being trapped in a deteriorating situation without the ability to respond. Private investors, not Congress, are better able to evaluate management and compensation plans.
Furthermore, investors will not invest today if they could get a better deal from the government later. And the rules of the game must be written in pen, not pencil. Investor interest is hampered if they believe their economics can be retroactively changed concerning, for example, dilution, clawbacks, onerous lending requirements and taxes.
A large pool of private capital is waiting for the banking industry. A prerequisite to investment is a governmental mindset change away from being the investor of first resort to being the investor of last resort. This entails reducing asset uncertainty by encouraging realistic valuations.
Next, the debt overhang must be eliminated by converting a portion of bonds into equity. Finally, a stable legal framework is needed to ensure investor benefits are maintained.