Behold the Powerful Swiss Approach to Convertible Debt

Minyan Peter
  AUG 20, 2009 11:40 AM

The US Treasury could learn a lot from their brilliant strategy.


Editor's note: This article was originally published on the Buzz & Banter. It's being reposted here for the benefit of the Minyanville community.

First, to my comment earlier this week on the FDIC, note that the media are already talking about additional "special assessments" from the FDIC to cover shortfalls in the insurance fund.

And again, I'd recommend that investors think of "special assessments" as recurring one-time charges. And depositors should anticipate lower yields and higher transaction fees as a result.

Second, I'd contrast the Swiss government's sale of its stake in UBS (UBS) with the US government's TARP program. Back in the dark days, the Swiss government bought mandatorily convertible debt in UBS. And this week it forced the conversion of the debt into common stock and sold it..

In contrast, the US government bought preferred stock plus warrants and then required banks to issue new common shares to replace the preferred.

As someone who advocated for the government's purchase of common stock from the beginning, I hope our team in Treasury sees the power of the Swiss approach.

Dilution risk was tackled up front when the Swiss government purchased the convert -- and it was painful, too. But there was no lingering overhang. The markets knew day one that common shares would be issued. And everyone could adjust their capital ratio projections accordingly. (And I contrast this with TARP, where the market rejected the notion that traditional preferred stock was a permanent solution and then spent months trying to determine how much common stock the government would be forced to take in exchange for the conversion of the preferred.)

But to me, that's only half the brilliance of the Swiss approach. The other half is in the government's exit strategy. Note how the shares came out -- not by the Swiss government owning them, but by new investors owning them. The benefit of government intervention without outright government ownership. And just to be clear, governments never needed ownership for intervention in the banking system. Further, the Swiss government now has a stockpile of dry powder to use again if it needs to.

Now admittedly, the US has dry powder under the TARP program, thanks to repayment of billions in preferred. But the process was cumbersome and prolonged. Further, under TARP, the US government ended up with a 40% interest in Citigroup (C) with an exit strategy that will take years to execute -- if it ever does.
No positions in stocks mentioned.