The mystery that is: Debt-for Equity Swaps

Time to do some debunking and strip out some of the obscuring lingo from Debt-for Equity Swaps.

Basically, this is a way of raising capital for banks (e.g. giving them more money so they can keep on lending/ not go bust). 

However, its advocates say that it's not at the expense of the taxpayer. Let's have a look:
Debt-for-Equity Swaps are when those who have lent to a bank agree to cancel debts owed to them in return for shares in the bank.

Very simple - but what does it mean?

Well, first of all, original shareholders in the banks lose out a bit. Because there are suddenly more shares, the overall value of each share (so the value of the company divided by the number of shares) decreases. 

For example - if bank "Hoardex" has 500 shares, and is worth about £100, then each share is 20p (100 divided by 500).But if a debt-for-equity swap happens, then the number of shares goes up to 1000, this means that shares are now only 10p - so the original shareholders lose out by losing half of the value of their shares.

How could it be implemented?

Sometimes, this happens of the banks' own accord. If they want to get their creditors (people they owe money to - sometimes called bond holders) to agree to swap that debt for shares, then they set up a ratio where the shares they get for each bit of debt is more than the amount of debt - so it could be £1 of debt for £1.01 of shares.

The problem you've now got is - just how much debt do I need to get rid of to exchange for equity? 

Here's an example - the bank "Southern Stone" owes £1000 to its creditors, it has£1000 in mortgage receivables (the amount it expects to receive), and has pretty much £100 capital. 
It emerges that £400 of its mortgage receivables is toxic - so is likely to not be repaid. Its capital is therefore not enough to make up for this imbalance, as it now owes £1000 and is expected to receive only £600.

So, it decides it will have a debt-for-equity swap, exchanging £400 of its debt to creditors for £400 worth (or slightly more) of shares in the bank.However, the price of shares will decrease dramatically, first because £300 of its mortgage receivables have to be shaved off the accounts, and then because there are more shares. Thus, existing shareholders lose out, but creditors who have now exchanged debt for equity see no change or benefit.After the swap, the bank therefore has only £600 of debt, £600 of mortgage receivables, £100 of capital, and most importantly now has no toxic assets. In fact, if they had overvalued the amount of toxic assets, when this emerges, the share prices will even rise again.

Most importantly, this does not affect the taxpayers, and need not affect governments (unless they are a major creditor of the banks - in which case they've already exerted control over them!)

If all banks with toxic debt were to do this, then confidence in the markets would finally be restored. Legislation for this is probably needed, as is perhaps the enforcement by government for banks with bad debt to go through this process immediately, with the understanding that they will not be bailed out by government.