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Last week I saw this article on the Financial Post on a new approach to stabilizing Canada’s banks – it is rare that I read so many words and understand so little – so I figured we could try to unpack it.

Various regulators and government agencies are involved in managing Canada’s banks, and as of recent they have gotten pretty nervous about the amount of mortgage debt being held.

This article refers to a new “bail-in” regime – currently banks have certain levels of liquidity (that is money or near money investments) required to cover their liabilities. This bail-in plan is two fold

Change the name from bail-out because everyone hates it Provide new rules that force banks to hold more investments that count towards the capital requirement levels imposed by the government on the banks, in hopes that they will be more secure if a problem occurs becuase they now have this larger buffer

So how do they do this? Well the article mentions plenty about convertible debt – it says that certain securities will be automatically converted to support regulatory capital… uhhh okay?



A bail-what? Gaaaeargearhh

If we read further we see the following quote:

“Beginning in 2018, all unsecured long-term senior debt issued by Canada’s largest banks — those that are deemed systemically important domestically — will be convertible into equity should a bank need to be “resolved” or unwound, according to David Beattie, a senior vice-president in the financial institutions group at Moody’s Investors Service.”

Okay so that barely helps

Unsecured debt is exactly what it sounds like – debt that is owed by the bank that is not “secured” by collateral, this means that the debt is simply backed by the promise that the bank will pay you – if they don’t you don’t get to go seize their property, which you could do in the case of something like a mortgage which is secured by the home you are borrowing against.

So this means that all long-term unsecured debt (which generally means bonds issued) that a bank issues will have a clause added to the bond agreement saying that the debt the bank owes the investor can be converted from debt the bank owes the investor into equity (company shares) that the investor will hold.



Dear Mr. Bank – I have this much monies

What happens when this swap is performed? Well the bank extinguishes the debt which they owe you through the bond they issued and you as an investor bought, which is good for the bank in an emergency as the bond is a debt the bank is legally required to pay out in cash. Then the bank issues and gives to you as the bond holder an agreed upon amount of shares in the bank.

This is very good for the bank for a few reasons – one it eliminates the debt from the balance sheet which means the bank is no longer on the hook for paying the money the investor bought the bond for. For instance the bond holder gives the bank $1,000 for the bond which pays say 5% interest and will return their $1,000 in 5 years, then this bond get swapped out for 500 common shares.

Secondly the shares in the bank that the investor receives instead can be issued by the bank for very little cost – meaning the bank can swap something (the debt) which was expensive to them, for something (the equity aka common shares) which are cheap to them.

Example Time

Imagine this scenario, the bank issues a bond at 5% interest with this convertible clause for $100 and you buy it. Then there is an outbreak of meningitis because it turns out vaccines cause meningitis (who knew?), everyone runs to the bank to withdraw their money so little Timmy can fly to Mexico and get cured, the Bank needs to shore up their regulatory capital (this means money the bank must hold based on government set minimums) and so exercises the right to convert the $100 in debt (that is the bond).



A getdatmoney public services announcement – signs and symptoms of meningitis in your baby!

Notice that the article doesn’t say whether the bank or the investor has the right to exercise to the debt for equity swap. In reality the clause would have to be at the discretion of the Bank to be useful, they need it as an escape mechanism in an emergency situation. We can prove this by seeing the following quote from the article:

“We assume the newly refinanced and newly issued qualifying debt could carry a rate 50 bps (basis points) above current rates for similar debt,” Klock wrote in a note to clients, adding that this could dilute the banks’ estimated earnings per share in fiscal 2018 by 1.3 per cent to 1.5 per cent.”

This means that the new debt the Bank issues under this plan will carry a higher interest rate than debt issued without the new plan – higher interest rates means that the Bank will pay more in interest to the people who buy the debt – which is good for the debt holder and bad for the Bank.

Now we all know banks are not in the business of giving away their money, so if the investor is getting more money in interest it means they must be giving something up – that something is the option the bank has to convert the investors debt (the bond) to equity.



This ain’t monopoly pal – no freebies from the bank (also much harder to rob in real life)

So the Bank cancels your $100 bond, meaning they no longer have an obligation to pay you the 5% annual interest and the $100 principal , instead you get $100 in shares in the bank. You had debt before, now you have equity (shares are equity, as they represent ownership), from a regulatory capital position the Bank is now in much better shape! This is because the debt the bank had before counted towards a higher regulatory capital holding requirement (i.e. the more the banks owes out to people, the more money they must hold in reserve).

As we have discussed in other articles I can’t find to link here, the real losers are the existing shareholders, when the bank issues the shares to swap out for the investors $100 in debt, all the existing shareholders now own a smaller % of the bank (they have the same amount of shares, but the total number goes up – so they own less on a % basis), as you have been added as an owner of some new shares.

So the reality of the situation is that the Government has insulated themselves from the risk/responsibility of bailing out a bank by having the debt holders shoulder some of the burden in the event of a capital emergency – pretty smart huh?

And some people say politicians aren’t looking out for the little guy – getdatmoney.ca would like to take this opportunity to announce our public undying support for disgraced Italian pervert/politician Silvio Berlusconi (because why not)! Congratulations on Forza Italia’s recent success in the polls!

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