Speed saves: How to instantly stop the next banking crisis
if people had listened then, the idea would have saved taxpayers untold billions today — the government’s bailout of the two mortgage agencies is unlimited, with the Congressional Budget Office estimating it could cost $373 billion by 2020.
The "trigger" for conversion from debt to equity would be a decline in the company’s regulatory capital ratios, as disclosed in its quarterly earnings reports. If these ratios dropped below "well-capitalized" levels (typically defined as equity equal to about 8% of assets), then each dollar of the contingent capital debt would be changed into common stock, based on a fixed conversion ratio.
Everyone loses — except taxpayers
The debt holders would lose, but at least they wouldn’t have to wait for bankruptcy to determine their recoveries. Shareholders would lose too — but without the conversion, they would need to raise emergency capital at a depressed share price, leading to much worse dilution, assuming the company could raise any capital at all. (Remember when Citigroup traded for $1 per share?).
Not only would conversion be speedy, but it would protect the taxpayer. Government-guaranteed deposits (and other debt that might need to be guaranteed) would be protected from losses by the new equity.
Given the severity of the recent crisis, systemically important financial firms ought to hold contingent capital equal to their normal equity requirement, effectively doubling taxpayers’ protection.
In normal times, issuing this special kind of debt should not be expensive. Firms that look systemically dangerous might face higher costs. To avoid these costs, risky firms could shrink their balance sheets or rethink their business models. In this way, the contingent capital requirement would brake the growth of large, risky financial firms, another goal of regulatory reform. And if we’re not truly preventing systemic failures with our reform plans, it’s worth asking whether they’re worth pursuing at all.
Kenneth A. Posner is the author of Stalking the Black Swan: Research & Decision-making in a World of Extreme Volatility