Recapitalizing troubled Banks in trouble times: deep discounts and compensating options

Various governments have to recapitalize some of their banks since 2008. The way they do it is very different across countries, and from bank to bank. The real cost to the banks and their shareholders is very different too. In some cases recapitalizations are done through the issuance of common shares, in others through the issuance of preferred shares, subordinated debt, or other quasi capital.

Quasi capital: convertible or not, some kind of junior debt or interest-bearing equity.
The interest rate on these quasi-capital instruments, and the conditions at which the bank can repay them or buy them back from the State vary greatly from one case to another; a recapitalization exercise can give an impression (to competitors at least) of very friendly terms amounting to subsidies, or inversely (at least to the bank being bailed out and its shareholders) the impression of a very harsh and unfair treatment. Sometimes even both. Of course these complicated securities issues are very popular with investment bankers and lawyers, because they justify the high fees charged on those exercises ; they might thus be promoted by some as being the best –or the only- way to go. In case the bank’s situation deteriorates following the recapitalization, the State may not even receive any proper remuneration on his investment (due to the features of non mandatory / non cumulative coupons necessary to achieve a Tier 1 treatment) and may not even be paid back. In case the bank’s situation improves, the State may be paid back and the State does not receive a sufficient remuneration for the risks it took.

Common share issues have the merit of simplicity, but the pricing can be challenging.
A common share issue is simple but difficult to price
The recap can be done through a share issue, provided of course the bank has some kind of authorized capital, which banks should have.

The bank may have to give preferential rights to existing shareholders (through the issuance of subscription rights). Some share issues have been done in difficult markets with deep discounts and preferential rights for existing shareholders, but this has often resulted in a drop in the value of the right, a subsequent drop in the share price, and a dramatic loss of capitalization for the banks concerned, leaving the shareholders who did not subscribe (often because the information they were provided was not very reliable) with large losses, and short sellers with large gains. Moreover, it is difficult to reconcile preferential rights with the timing constraints. It is in practice better to envisage an issue where the subscription rights of existing shareholders are waived.

An issue underwritten by the state, without preferential rights for existing shareholders, is still difficult to price because waiving preferential rights requires a “market pricing”. The recapitalization is often done in periods that are very critical for the bank, or the financial markets, and thus market prices can be distorted, amongst other by speculative attacks on the bank. A too high price amounts to a subsidy for the bank and its existing shareholders; it also means the government may have more difficulty and need more time to get its money back, and quit a role of shareholder it usually does not want to play. A too low price creates an exaggerate dilution that could be unfair for the existing shareholders, and anyway is an encouragement for the short sellers and other speculators who sold the shares with the hope of driving down the price and buying back at a large profit. Some banks are not listed, which can make new share issues even more difficult to price.

Hence the proposal to combine a capital increase subscribed by the State at a deep discount with an option (for the bank itself) to buy back the shares from the State, which compensates existing shareholders for the subscription rights they have to forego.

A pricing solution which limits the risk of mispricing
-the Government and the bank determine an Apparent Fair Value (AFV), based on market prices if available, or the best available knowledge of the book value and any justified corrections to this book value, as well as prospective profitability. By default, the AFV should be close to the average market price of the last few days for listed banks, and the best assessment of the book value for non listed banks.

-the issue price is set at 30% of the AFV (thus a 70% discount, in the range of observed discounts in the market for new rights issues transactions during troubled times), and the shares are bought by the State.

-the State sells to the bank an option, valid during 3 (or 5) years to buy back the shares at issue price plus an increment defined at least as the cost of equity for the period of the State investment. For example, if the State subscribed at 5 euro per share, the strike price of the option could be fixed at 6.7 euro (3 years) or 8 euro (5 years), ensuring a return of 10% p.a. for the State (in case shares are bought back). A subsidy-free level for the cost of equity can rather objectively be defined : the “expected return” for equity investment in banks in normal market conditions, possibly corrected for other objective indications (for instance a bank with an announced target of return on equity substantially higher than the expected return, might be applied a higher cost of equity). A correctly defined cost of equity thus means there is no subsidy on the option-strike level.

-the price at which the option is sold would then be the main reason to consider a subsidy is granted. The pricing of such an option in such market circumstances is very difficult. Most of the value comes from the deep discount which was set arbitrarily, and should be neutralized. In fact giving the option for free is of course a subsidy, but hardly one that distorts competition: the bank can only take advantage of it if it is able to buy back the shares, meaning that after a few years it appears either that the issue price was too low, or anyway that the bank could generate a better return than the cost of equity. Probably the best way to integrate the cost of the option is to add some percentage points to the strike price. Thereby, the cost for the bank during a crisis is very limited, but if it soon appears that the bank had been victim of a temporary crisis and is able to quickly buy back its shares, it can do so and return to normal, but the State is remunerated for the effort and the risks it took.

-It could be foreseen that the State is able to shorten the exercise period under certain circumstances (like a dramatic improvement in the share price and market conditions). Anyway, the option and its attractiveness could be an effective way to catch short sellers and speculators wrong-footed, and discourage raids on banks.
In case the bank’s situation deteriorates following the recapitalization, the State would not have overpaid (given the deep discount at which he subscribed). In case the bank’s situation improves, the State will be paid back and appropriately remunerated.

I think this scheme could have kept Fortis as an independent player, at a much-reduced cost and risk for the Belgian State, and allowed the recapitalization of Dexia at a more realistic price for the public shareholders who funded it. It could also have been used easily and effectively for ING, the English banks, etc.

Eric De Keuleneer
Solvay- ULB