Introduction.

“If I owe you a pound, I have a problem; but if I owe you a million, the problem is yours.”

John Maynard Keynes

Keynes might have added: “and if we collectively owe each other trillions, the problem is ours.”

In a previous post I discussed how the static nature of nominal debt has the perverse effect of increasing the relative debt burden in a situation of falling wages, prices and asset values: http://alejandrorivasmicoud.com/wp/cash-is-debt-debt-is-equity

The Liquidity Trap and Quantitative Easing.

The rising ratio of nominal debt in a situation of falling asset prices and incomes is far more detrimental than the liquidity trap that Keynes analyzed in the 30s.

Central banks can deal with the “zero bound” of zero nominal interest rates and positive real interest rates through quantitative easing, which has the effect of creating a “virtual” negative nominal rate.

But dealing with the liquidity trap of low nominal interest rates, as Bernanke has arguably done since 2008, does not resolve the un-sustainability of a rising proportion of nominal debt to nominal asset prices and incomes, and the associated dysfunction of the financial system.

In other words, quantitative easing, whether QE1, QE2 or a future QE3, does not solve the following conundrum: What cannot be repaid will not be.

Unsustainable Ratio of Debt to Assets and Income.

When economy wide claims become unsustainably high in relation to debtor assets and incomes, they are illusory; claims will be adjusted downwards, either through bankruptcy and restructuring, or policy induced inflation, or a combination.

In such a situation, financial entities no longer intermediate between investors and entrepreneurs; they cannot liquidate their assets at the illusory prices set in their balance sheets, and thus have no cash and become zombie banks (See experience of Japan, 1990s).

Even when quantitative easing lowers real interest rates and makes them negative, a dysfunctional financial system cannot transmit this easing to the economy at large.

This is the reason why financial crisis led downturns last so long, and why the developed world is still struggling with the downturn caused by the 2007/2008 crisis.

As a potential solution, policy induced inflation is an option. By inflating nominal values of prices, wages and assets, while nominal debt remains static, it effectively reduces the debt burden.

But it entails a large macroeconomic cost, and is not very equitable, as it affects all of society, not just specific creditors and debtors.

A second alternative is a restructuring or bankruptcy process (see: Carnegie Mellon, Secretary of the Treasury, 1929, “Liquidate everything liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate… it will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people).

But this is very inefficient, entailing a huge destruction of asset values and a significant appropriation of the remaining value of claims to liquidators, trustees and lawyers. (Over $ 170 million was paid to just one of the law firms handling the liquidators of Lehman Brothers).

In addition, the effects on the financial system when the above happens on a systemic economy-wide basis feed an accelerating feedback loop, bankrupting banks and throttling the transmission of credit to the economy, thus bankrupting companies and individuals and further damaging banks and thus turning a financial crisis into a depression.

Is there a better way?

How can we insure that nominal debt readjusts to its true market value when it becomes unsustainably high, without resorting to inflation?

How can we improve the current system whereby asset ownership passes from debtor to creditor without resorting to the value destruction of the bankruptcy process?

Can we devise a more seamless adjustment, without the very high transactional costs of bankruptcy or the macroeconomic price and inequity of inflation?

Following are a set of recommendations to allow for such a mechanism, complementing the bankruptcy code, and making its inevitable value destruction for all parties a truly “last resort option”:

Objectives of a new “Debt Conversion Code”.

In order for a new, “pre-bankruptcy” mechanism to work, the following guiding principles should be used:

-It should represent a less costly and more efficient mechanism than the current bankruptcy code in terms of transferring ownership, partially or totally, from equity holders to debt holders;

-It should be fair;

-It should be practically doable from a political, economic and societal perspective, and as market oriented as possible.

Issues:

-How to differentiate the adjustment process between corporate and personal debt loads;

-For corporate debt, how to deal with situations where the equity and/or the debt are not publicly traded;

-How to deal with suppliers and accounts payable (that are not vendor financing creditors) as well as contractual issues and contingent liabilities, such as labor force agreements, pension obligations, long-term commercial contracts, etc.

Proposal

Who should be able initiate a debt to equity conversion?

The Management and Board of a company facing a perceived unsustainable debt load could request a partial or full conversion of debt to equity, at any time, for any reason, irrespective of what the covenants of the various debt instruments stipulate, or the shareholder agreements.

Any creditor or group of creditors having greater than 25 % of total debt could at the time of a request of the company to enter bankruptcy also submit a request for conversion as an alternative to bankruptcy. Bankruptcy proceedings could not be started until 30 days had passed from a request to enter into bankruptcy to enable creditors to choose this alternative.

What amount or ratio would be converted?

The proportion of debt to be converted would be applied on a pro-rata fully diluted basis when applicable and any individual creditor would be able to choose to have a higher proportion of its debt converted at the same terms as offered by the company in its offer.

Suppliers that were not vendor finance creditors, for example accounts payable, would not be obliged to convert, but could choose to be included, at the proposed proportion of debt or higher.

Conversion Rate & Valuation

If both debt and equity are publicly traded, then the conversion of debt to equity would be set automatically at the average market price of both debt and equity, calculated over a period of 60 days after the announcement of the offer by the company.

Creditors would be able to exercise a right to a conversion of a higher proportion of their claims than the pro-rata proportion of liabilities included in the offer by the company, within 30 days after the announcement of the offer by the company.

When all or some of the debt or equity is not publicly traded, the conversion valuation would be determined by a committee formed by:

-The company auditors, a rating agency that had previously covered the company, and a valuation firm chosen by the former, or;

-If no ratings agency had covered the company, the auditors and a valuation firm agreed on by the company and the largest creditor, or;

-If no auditor exists, a valuation firm selected by the company and the largest creditor.

Failure to agree on any of the last two options between the company and its largest creditor within 15 days of the company offer would trigger a selection of a valuation firm by an arbitrator selected by a bankruptcy court.

Upon request of company or creditors representing 25% of liabilities, the net present value of contingent liabilities, except for pension obligations, also would be converted into shares at the specified proportion offered by the company, and the valuation of the contingent liabilities and contractual obligations would be determined by the same valuation procedure described above.

Governance Post Conversion

After conversion, pre-conversion equity would have the same voting weight as converted shares and vice versa and all voting power discrepancies between classes of shares would disappear until changed by a majority of shareholders, or until new classes have been issued by the new board.

A shareholders meeting would be held within 60 days of conversion to elect a new board. Any shareholder or grouping of shareholders (old or new) with greater than 5% of shares could propose an individual board member.

Senior management contracts of the CEO/President and all direct reports and existing board members, including “Golden Parachutes”, would be suspended until the new board was elected, which would have the power to confirm, terminate, or modify the terms of said agreements.

Individual Debt Adjustments

In the case of individuals facing unsustainable mortgage debt loads related to owner occupied housing, they could at any time ask for conversion of their mortgage debt, whereupon the home ownership would pass to the lender, and the previous owner would turn into a renter, obliged to pay market rates to the new owner if they choose to continue using the home as their residence.

The new owner/old lender could evict the previous owner only upon the sale of the home, as long as the previous owner was current on his/her new rental obligations.

In the event the home is sold, the previous owner would receive a proportion of the proceeds. This proportion would be calculated as the result of the sale minus the net present value of the debt (without penalties) at the time of conversion, plus the net present value of the proceeds from the rent to previous owner or others from the time of conversion up to the time of sale. To calculate the net present value the inflation rate over the period would be used.

Conclusion

The current system for adjusting nominal debt to its market value and/or transferring ownership to creditors in the face of falling GDP, wages or asset prices is extremely costly to society, to debtors, and to creditors.

It is inefficient; the value of a company or neighbourhood (in the case of foreclosed homes) is destroyed by the process of bankruptcy and foreclosure.

It is inequitable; the remaining value is largely appropriated by intermediaries such as liquidators, lawyers and trustees.

It is illusory; it postpones the recognition of reality that creditors must face when confronted with a claim that has become unsustainable, whether due to mismanagement, the economy or other factors.

The above Debt Conversion Code enables a smoother and less costly adjustment of nominal debt values to real market values, and a more seamless transfer of ownership to creditors.

The process entails a big benefit to debtors, but at a significant risk to management and existing shareholders; the former may be booted out and their contracts rescinded, and the latter may suffer massive dilution. Therefore the incentives are balanced for both the debtor and the creditor.

Creditors may request a conversion when a bankruptcy has been requested by a company, and thus have an implied warrant. But they face the uncertainty of what the conversion rate will be, and how they will monetize their resulting equity, so they will choose to take an action of this nature only when it is clear that it is beneficial both to themselves and the company.

For society, the Debt Conversion Code would help companies and individuals escape the debt trap that the current system imposes in an asset led deflationary environment such as the one currently being experienced in the United States, and especially in Europe.

It would also allow for a more seamless adjustment of the balance sheets of financial entities and their related recapitalization, thus restoring them to their true societal utility function of intermediating between investor.