Votermedia Finance Blog

October 14, 2008

Lehman recapitalization idea

Filed under: Uncategorized — Mark Latham @ 4:44 pm

Here’s my proposal for a better way to recapitalize troubled financial firms. For a first illustration, I’ll use numbers based on Lehman Brothers’ recent bankruptcy. In a way, it’s easier to restructure a bankrupt firm, because the old shareholders and management have already lost the battle and lost power. That gives the bankruptcy administrator more freedom to restructure claims on the firm. Later I’ll extend the idea to apply to firms that are not (yet) bankrupt.

This proposal is based on my 1998 paper “How To Transform a Failed Japanese Bank”, and has a lot in common with Zingales’ paper “Why Paulson Is Wrong”. The numbers are a very simplified version based on Lehman’s bankruptcy filing as reported by MarketWatch 2008-09-15.

Suppose Lehman has assets worth a market value of $600 billion if the firm stays in business, but would only be worth $550 billion if the firm were liquidated. Suppose they have short term liabilities of $460 bn, and long term debt of $150 bn. Suppose also that in the U.S. government’s view, Lehman is “too big to fail” because that would severely disrupt the financial system. (Evidently that was not their view at the time, since they let Lehman fail. But with the benefit of hindsight they might now wish they could go back and do a rescue. So this proposal is intended for the next case like Lehman.)

The goals are to maintain continuity of Lehman’s business while recreating it as a financially strong entity, at zero cost to taxpayers. This will require something like the combined power of a bankruptcy court and a well funded government bailout program, to take control of Lehman for a few months during the restructuring. There’s more than one way to sequence these transactions, but here’s the way I find easiest to understand:

The bankruptcy/bailout administrator announces that Lehman’s short-term liabilities will all be honored in full, the long term debt might take some loss percentage, and the old equity will be last in line for any settlement.

The bailout program gives Lehman a short term loan of $60 bn. This is used to pay down the (other) short-term liabilities from $460 to $400 bn. New long-term debt and equity are next issued, with the proceeds used to pay off taxpayers first, old long-term debtholders second, and old equity holders last. So the restructured Lehman will have assets worth $600 bn and short term debt of $400 bn.

New long term debt of $150 bn is issued to the market. Finally, 100% of the restructured firm’s equity is sold to the market in a public offering. With assets worth $600 bn and liabilities worth $550 bn, this should generate about $50 bn, but call it $40 bn to allow for some costs. Note that the equity issue uses the market to value Lehman’s distressed assets, but in the context of a well capitalized firm.

Then the $150 + $40 = $190 bn proceeds are used to pay off taxpayers first ($60 bn), the old long-term debtholders second (recovering $130 bn of their $150 bn), and old equity holders last (recovering nothing in this case).

Some of these transactions could perhaps be streamlined as exchanges, but it should be structured so as to be equivalent to the above sequence. Indeed, the initial $60 bn government loan should not be needed if the markets understand clearly how the new-issue proceeds will be used to settle old claims. The essential element of this proposal is the administrator-ordered issue of new debt and equity. Other variations of the deal could involve a small settlement paid to old equity holders; and/or losses imposed on other creditors, as long as that wouldn’t disrupt the firm’s ongoing business.

For comparison, Zingales’ proposal is: “Since we do not have time for a Chapter 11 and we do not want to bail out all the creditors, the lesser evil is to do what judges do in contentious and overextended bankruptcy processes: to cram down a restructuring plan on creditors, where part of the debt is forgiven in exchange for some equity or some warrants.”

Some may object that the capital markets will not pay fair value for new issues of financial firms’ long term debt and equity, especially right after taking losses on similar claims. But the restructured Lehman would have a stronger balance sheet than most of its competitors, at a time when market disarray is creating opportunities for those strong enough to take advantage of them.

More importantly, I would also advocate building in new protections for long term debtholders and shareowners, which I will outline in my next posts.

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