By EUGENE F. FAMA
The financial sector provides the grease that makes the transfer of savings to productive investments more efficient. This role is critical for the health of the economy.
Government injections of equity capital into financial institutions can make sense if the whole financial system is in danger. But it is important that injections are at minimum cost to taxpayers, that is, without unnecessary subsidies. Problems on this score arise when the funds go primarily to prop up the value of a financial institution's existing debt. In this case the true amount of new equity capital is less than the injection of funds by the government, and the subsidy to debt holders is a loss to taxpayers with no clear offsetting benefits. My purpose here is to describe how this problem arises and how it can be avoided.
Why Inject Equity Capital into Financial Companies?
The value of the assets of many financial institutions has fallen substantially. A fall in the market value of assets implies an equal decline in the market value of liabilities, with the big hits taken by equity and lower priority debt. The fall in the value of equity can cause a financial institution to violate its legal equity capital requirement. The first recourse for a financial institution that needs equity capital is the private market. But raising enough new private equity to meet its capital requirement may not be possible because of a "debt overhang" problem. Here's how it works.
A severe fall in the market value of a financial institution's assets raises the risk and lowers the market value of its debt, as well as its equity. Bringing in new equity capital produces an equal (dollar for dollar) increase in the market value of assets. This lowers the risk and raises the market value of the institution's debt. As a result, part of the new equity capital shows up not as equity but as a transfer to debt holders. (This is the debt overhang problem.) Who pays for the transfer? Not the new private stockholders. They will not invest unless they get stock with market value at least equal to the funds they provide. This means the transfer of wealth to the old debt holders must come from the old stockholders. They pay via the dilution of their ownership share (and the drop in the share price) caused by bringing in new equity. (The stockholders, of course, hate this transfer to debt holders.)
If the market value of the old stock before the equity issue is low, it may be insufficient to cover the transfer of wealth to debt holders that new equity capital produces. As a result, the market value of a stock issue would be less than the funds provided, and the financial institution's attempt to issue equity to meet its capital requirement will fail.
If the Treasury steps in when the private market refuses to provide equity capital to a financial institution, we are in subsidy land. Again, the subsidy arises because a large part of the equity injection by the government does not end up as government (taxpayer) equity but rather goes to prop up the financial institution's debt holders. Fortunately, at least for banks that participate in FDIC insurance of their deposits, the problem has a solution.
If a bank cannot raise private equity to meet its FDIC capital requirement, the powers of the FDIC kick in. For example, the FDIC can seize the bank and auction it off. The bidders are typically other banks. Acquiring a seized bank is often an attractive option for a strong bank since it can be a cost effective way to expand deposits and acquire links to profitable borrowers.
The details are negotiable, but when a strong bank acquires a seized bank, it often gets the seized banks assets and its deposits (which are liabilities). The maximum price the acquiring bank should be willing to pay is the market value of the seized bank's assets minus the seized bank's deposits. This net amount is then distributed to the bank's non-deposit liability holders, in order of priority. What this means is that the seized bank's stockholders and some of its lower priority debt often get nothing.
Alternatively, the FDIC may simply shut the failed bank, auction its assets, and use the proceeds to pay off depositors and other liability holders in order of priority. If the market value of the failed bank's assets is less than its insured deposits, the FDIC supplements the bank's assets to pay off the insured deposits. If the FDIC charges appropriate premiums for deposit insurance, the insurance is a fair game and does not produce losses for taxpayers, at least on average.
There are many variants of FDIC intervention, but they typically have one common property. They solve the debt overhang problem. Non-insured debtors are paid off only to the extent that the market value of the assets of a failed bank exceeds its insured deposit liabilities. This means that any new equity capital injected after the reorganization increases the market value of assets and the market value of equity capital dollar for dollar.
Can the powers of the FDIC be used when the failed bank is large? Two of the biggest banks (Wachovia and Washington Mutual) have recently been acquired in mergers more or less forced by the FDIC. Moreover, a bank is not like the typical operating company with lots of physical assets not easily moved or split up. Most of the assets of a bank, like its liabilities, are financial instruments -- entries on a computer, easy to move. A bank's relationship capital -- its private information about borrowers and depositors -- is mostly in the heads of its employees, who are also easily redeployed. In short, selling a big bank to multiple buyers is a lot easier than splitting up the typical operating company. I think the FDIC should make it clear that big banks are, if anything, more prone to the exercise of FDIC powers, to dispel the notion that any bank is too big to fail.
Suppose no private buyer steps up to buy a failed bank, and suppose, for whatever reason, the Fed and the Treasury decide they want to inject equity to allow the bank to meet its capital requirement. The FDIC approach can still be used to solve the debt overhang problem, so taxpayers get their money's worth, that is, so equity financing ends up as equity financing rather than as a shift of taxpayer wealth to the bank's debt holders. To achieve this goal, the FDIC can draw a line in the bank's liability structure, with debt holders and stockholders below the line getting nothing. The line should be drawn so that the market value of the bank's assets covers the liabilities above the line. (This is what the FDIC does when the new equity comes from a private investor.)
When this prescription is followed, the bad news is that the failed bank has been nationalized (I hate nationalization), but the good news is that nationalization is accomplished without a taxpayer subsidy to the bank's debt holders. I suspect the Fed and the Treasury think they avoid nationalization (or at least perception of it) if they inject equity capital into a bank without solving the debt overhang problem. This is an illusion. The bank has been nationalized, but in a more expensive way. The additional expense is the subsidy to the old debt holders because of the debt overhang problem.
The FDIC's powers are written so that taxpayers should not have to pay when a bank goes bad. The logic is that the bank's stockholders and its lower priority debt holders get the benefits when the bank does well so they should pay the costs when it does poorly. Stockholders and lower priority debt holders should be pushed out of the game until the value of the bank's assets are sufficient to cover its remaining liabilities. My view is that this blueprint should be followed when the subsequent injection of equity capital that a failed bank needs to survive comes from the public sector (the Treasury or the Fed), as well as when it comes from the private sector. It produces all the benefits of a recapitalization without a taxpayer subsidy.
(My colleagues, Pietro Veronesi and Luigi Zingales 2008, have a detailed paper on the debt overhang problem.)
Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP.