The End of Equity?
Barry Ritholtz is blaming the falling value of bank stocks on the decision not to require mark-to-market accounting. I’m wondering whether the fall isn’t a delayed reaction to the implementation of broad safe harbors for derivatives in the bankruptcy code (which was completed in 2005).
After all, Lehman Bros. made clear that anyone who holds equity in a financial institution can expect to get nothing when the company is wound up — in fact, it looks like the unsecured creditors will get 20 cents on the dollar. What happened to the $640 billion in assets and $26 billion in shareholders’ equity that was reported for May 2008? You can be sure that a large chunk of it ended up being posted as collateral on derivative obligations and thus removed from the control of the bankruptcy estate.
Why after this experience would anyone own the shares of a financial institution that could possibly go bankrupt or be resolved?
Another concern is what will happen when some large real economy firm ends up with such big derivatives exposures that its shareholders get treated the same way as Lehman’s. Will one-time equity investors decide that, after the recent changes to the bankruptcy code, being a shareholder of a listed stock is just an option on nothing at all?
Unintended consequences, indeed.
Update 10-8-11: In case it wasn’t clear, the issue that is created by the new bankruptcy code is that is that in the months leading up to a bankruptcy (or resolution) the claims on the firm’s assets are likely to change dramatically with the result that the accounting statements don’t reflect the relevant information. So the underlying problem is that equity investors are asked to invest blindly. While this problem is worse for financial firms, it’s far from clear that the problem is limited to them.