Wednesday, February 17, 2010

Securities Fail

Felix Salmon falls for William Wild's proposal for a new form of regulatory capital for banks, which,

far from having the large potential upside of shares, has no potential upside at all. Essentially, it’s just cash, invested in risk-free assets, throwing off a very modest income stream for its owner, and which can’t be repaid or redeemed. Yet if the bank gets into trouble, all that cash would go towards absorbing losses before there’s any default.

Such capital would not be attractive to investors. But, says Wild, that’s a feature, not a bug.
There are a lot of problems with this proposed security, to the point that it becomes completely unworkable:

  1. Whether or not you call it common stock, it shares with common stock the property of being a residual claim on the assets of a firm. As such, it is first to default. It is moreover short a call to the rest of common equity at the face value of the proposed security set against the firm value. So, it provides an insurance policy to the normal common stock (but I'm assuming that as a substitute for common stock, it does not provide additional insurance for the debtholders). It will therefore have a somewhat lower value (higher discount) than normal common stock with an equivalent dividend or coupon--this means that it is somewhat more expensive than common stock from the firm's perspective. This is financial engineering at its worst.
  2. There is no adequate way to associate this security exclusively with cash, cash-equivalents or risk-free assets. The two sides of the balance sheet simply don't hook up that way. Why force an awkward fundraising process into a discussion of how much risk-free asset to hold? Why not simply have regulatory assets, rather than just regulatory capital? It's the assets that are risky as well as the current capital structure.
  3. I want stockholders to be right up against the grinding wheel--moreso than they were in the current crisis. I want them to own the consequences of their decisions, so that they're actively riding management in their own interests, rather than sitting back and letting the checks roll in.

In sum, I don't think this would work.

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