DEBT SWAPS AND DEPOSIT INSURANCE
Debt swap is a generic term for an exchange of debt with some other asset. Examples of debt swaps include the convertible bond, in which a debt–equity swap is initiated by the bondholder, and the debt–equity swap pioneered by Salomon Brothers in the USA in the early 1980s, when corporations replaced over US$10 billion of debt with US$7 billion of new equity. The latter, however, disappeared after 1984, probably because the tax-related incentive ceased to exist (Hand, 1989).
The most significant application of debt swaps has been in international finance, particularly as a mechanism for solving the debt-servicing problems of less developed countries (LDCs).
The LDC debt crisis exploded in 1982 with Mexico defaulting on its loan payments, followed by other defaults, mostly Latin American. The creditors were generally international (largely US) commercial banks. Among the various solutions proposed, the most popular were market-based strategies like debt buybacks and various debt swaps such as debt for debt and debt for equity.
In a debt for debt swap, the creditor bank exchanges its outstanding loans for US dollar-denominated bonds issued by the LDC’s central bank. These bonds are known as Brady bonds after the US Treasury Secretary Nicholas Brady, architect of the Brady Plan of 1989 to deal with the debt crisis. The Brady Plan was the first to accept debt reduction as necessary for a permanent solution; therefore, Brady bonds have longer maturities and lower coupons than the original loans. However, they have certain attractive features such as liquidity, collateralization, and rolling guarantees. The liquidity is a result of an active secondary market, with a volume of US$100 billion in mid-1994. Most Brady bonds also have collateralization of principal and immediate coupons, the collateral usually being US Treasury instruments of the appropriate maturity, and paid for partly by World Bank and IMF loans and partly from the LDC’s own reserves. The interest guarantees are rolled forward continuously. Because of this collateral backing, Brady bonds are normally senior to other LDC loans.
A debt–equity swap is an exchange of outstanding LDC debt for an equity stake in a private corporation in the LDC, as follows: LDC debt is purchased on the secondary market from the bank at the market price, usually at a discount from face value by a multinational corporation (MNC). The MNC then trades the debt claim to the LDC’s central bank for the full face value in the local currency (less the central bank’s cut), which it then invests in a local company, very often a newly privatized corporation. The investment in local equity must be maintained for a minimum number of years.
The advantage for the MNC is that the investment is made at a significant discount, since the discounts prevailing in the market can be quite high. The LDC’s advantage is that the swap reduces external debt with no outflow of foreign currency, and external debt is replaced by foreign direct investment. The swap converts foreign debt into foreign equity; this is equivalent, in a corporate finance setting, to reducing leverage and thereby improving credit rating. Another potential benefit is the increased efficiency resulting from privatization which often accompanies the debt swap. In the USA, the Federal Reserve Bank amended Regulation K in 1986 to allow commercial banks to make investments through debt swaps. This led to many banks taking equity positions in LDCs, and had a significant positive effect on commercial bank stocks (Eyssel et al., 1989).
A disadvantage for the LDC is that its liquidity position might worsen by allowing direct foreign investment through swaps instead of fresh capital inflows. The swaps may be subsidizing foreign investments that would have been carried out anyway, and not generating any additional investment. Furthermore, swaps can actually reduce investment in the LDC through their effect on interest rates, inflation, and other macroeconomic variables. For the creditor banks, there is the usual moral hazard problem; by encouraging swaps, they may be helping reduce the value of the debt by providing incentives to debtor countries to delay repayments.
There is a small theoretical literature on the analysis of debt–equity swaps. The seminal paper is Helpman (1989), which derived conditions under which a swap will not be Pareto improving (strictly preferred by all participants), and also showed that a swap may actually reduce investment in the LDC. Errunza and Moreau (1989) showed that, with homogeneous expectations, swaps are not Pareto improving even in the presence of informational asymmetries; they might, however, be Pareto improving with heterogeneous expectations.
For valuation purposes, it has been demonstrated (Blake and Pradhan, 1991) that a debt swap is equivalent to the conversion of convertible bonds to equity, with the addition of exchange-rate risk. However, the fact that the equity investment must be maintained for a number of years, significantly reduces the swap value.
Debt–equity swaps have been the most important type of debt reduction instrument, accounting for over US$35 billion (or almost 40 percent of the total volume of debt conversions of all types) from 1985 to 1993. Since the establishment of the first institutionalized debt–equity swap program in Chile in 1985, it has become an integral part of external debt management and reduction. It started slowly with conversions worth US$500 million in 1985, and peaked in 1992 with a volume of US$9.2 billion. After 1992, there was a decline in the volume, partly because market discounts on LDC debt were much smaller (Collyns et al., 1992).
How effective was the debt conversion program in resolving the debt crisis? One point of view is that it was very successful, and “Latin American borrowers have recovered from the debt crisis” (World Debt Tables, 1994–95). At the other extreme, some believe that the program has not tackled the root causes of the debt problem. A report by Larrain and Velasco 93 (1990) on Chile, which had the most ambitious swap program, suggests that the contribution of debt–equity swaps to real investment in Chile has been moderate at best. Although it did contribute to the amelioration of Chile’s debt burden, the program came nowhere near offering a permanent solution. Bartolini (1990) has concluded, based on numerical simulations with reasonable parameter values, that a much larger fraction of debt forgiveness is required (about 60 percent, instead of the 30 percent envisaged by the Brady Plan) for a sustainable long-term solution.
Although it is true that there has been substantial LDC debt reduction and credit rating improvement, it is too early to make a definitive assessment. The Mexican peso crisis of 1994 indicates that the market remains very volatile and vulnerable to shocks. Defaults do occur, albeit on a smaller scale, such as the Alto Parana corporation of Argentina in 1995. External debt has also risen to dangerous levels in many LDCs, with total debt estimated at US$1,945 billion by end-1994 compared to US$1,369 at end-1987. Debt overhang remains a serious problem for the international banking sector; however, we are likely to be better prepared for the next crisis because banks have become more circumspect in their lending activities.
Resources for Debt Swaps:
Bartolini, L. (1990). Waiting to lend to borrowers with limited liability. Princeton University Department of Economics. Working paper.
Blake, D. & Pradhan, M. (1991). Debt–equity swaps as bond conversions: implications for pricing. Journal of Banking and Finance, 15, 29–41.
Errunza, V. R. & Moreau, A. F. (1989). Debt for equity swaps under a rational expectations equilibrium. Journal of Finance, 45, 663–80.
Eyssell, T. H., Fraser, D. R. & Rangan, N. K. (1989). Debt–equity swaps, Regulation K, and bank stock returns. Journal of Banking and Finance, 13, 853–68.
Hand, J. R. M. (1989). Did firms undertake debt equity swaps for an accounting paper profit or true financial gains? The Accounting Review, 44, 587–623.
Helpman, E. (1989). The simple analytics of debt–equity swaps. American Economic Review, 79, 440–51.
Larrain, F. & Velasco, A. (1990). Can swaps solve the debt crisis? Lessons from the Chilean experience. Princeton Studies in International Finance Report No. 69, Princeton University.
Remolona, E. M. & Roberts, D. L. (1986). Loan swaps and the LDC debt problem. Research Paper No. 8615, Federal Reserve Bank of New York.
The World Bank (1994–95). World debt tables: External finance for developing countries. Washington, DC: The World Bank.
The essential functions of a bank are to loan funds and serve as a risk-less depository, paying interest on deposits. A riskless environment is particularly important to small investors, given their greater information and surveillance costs. Diamond and Dybvig (1983) show that the contract between the depository institutions and depositors is very delicate, using a game-theoretic approach to show that this contract is prone to bank runs. That is, as a depositor, there is an incentive to get in line first, even if you believe the bank to be sound, because a run by other depositors may cause the bank to become insolvent. The depositor at the back of the line is likely to lose. To be a “safe haven” for depositors, the insurance of deposits (implicit or explicit) by a third party, a guarantor, is required. To be credible, the guarantor of deposit insurance must have taxing power. Deposit insurance removes the incentive for bank runs.
There has been a dramatic increase in our understanding of the value of deposit insurance to the bank and correspondingly, the cost of deposit insurance to the guarantor (the Federal Deposit Insurance Corporation (FDIC) in the United States) in the last two decades. An important issue in deposit insurance is the ability to incorporate theoretical developments in the field to the actual pricing of deposit insurance by the FDIC. In many cases, the theoretical developments have largely been ignored by the FDIC’s politics.
Although there are still issues which remain unresolved in the theoretical pricing of deposit insurance, we understand the basic mechanics from which the ultimate model must come.
Valuing Deposit Insurance as a Put Option
The pioneering work in the pricing of deposit insurance comes from Merton (1977) who identifies an “isomorphic” correspondence between deposit insurance and common stock put options. Merton works in the Black–Scholes (1973) framework of constant interest rates and volatility for expositional convenience. In Merton’s (1977) model, a depository institution borrows money by issuing a single homogeneous debt issue as a pure discount bond. The bank promises to pay a total of B dollars to depositors at maturity. If V denotes the value of the bank’s assets, the payoff structure of the payment guarantee (deposit insurance) to the guarantor at the maturity date if the face value of the debt exceeds the bank’s assets is: – (B –V(T)) while if the value of the banks assets equals or exceeds the face value of the debt, the payoff is zero. In either case the payoff may be expressed as: max (B – V(T),0). Providing deposit insurance can be viewed as issuing a put option on the value of the bank’s assets with an exercise price equal to the face value of the bank’s outstanding debt. Assuming V follows a geometric Brownian motion, and the original assumptions of Black–Scholes, valuation of the deposit insurance as a put option follows from Black–Scholes.
Stochastic Interest Rates and Volatility
Although we have come a long way in the pricing of deposit insurance, there are still many issues which are unresolved. An important consideration is the value of extending Merton’s (1977) model to a stochastic interest rate environment. Duan et al. (1995) have empirically tested the effect of stochastic interest rates on deposit insurance using Vasicek’s (1977) model and find that the inclusion of stochastic interest rates has a significant impact on deposit insurance. Au et al. (1995) directly incorporate the bank’s duration gap into the put option’s total volatility. They price the deposit insurance put option following Merton’s (1973) generalization of Black–Scholes and model interest rate dynamics following the no-arbitrage-based Heath et al. (HJM) (1992) model. The HJM paradigm provides a number of important benefits for modeling interest rate dynamics, as it avoids the specification of the market price of risk, allows a wide variety of volatility functions, and easily allows for multiple factors for interest rate shocks.
Another important issue in deposit insurance pricing is the ability of the bank to change the volatility of its assets over time. For instance, as a bank approaches failure, bank management may have incentives to increase the riskiness of its portfolio because bank management reaps the rewards of a successful outcome, while the FDIC pays for an unsuccessful outcome.
Recent papers, such as Boyle and Lee (1994), have developed theoretical extensions to the model to account for stochastic volatility.
FDIC’s Closure Policy and Non-Tradable Assets
Additionally, the Merton (1977) model does not account for the closure policy of the insuring agency. Ronn and Verma (1986) alter Merton’s (1977) model to allow for forbearance on the part of the insuring agent. Forbearance essentially allows the bank to operate with negative net worth. However, the exact amount of forbearance is debatable. Moreover, although some forbearance may be granted, there is some limit at which the FDIC will close the bank.
Therefore, perhaps a more appropriate method of modeling the deposit insurance put option is to value it as a down-and-out barrier option, wherein, once a certain level of asset value is exceeded, the bank is closed. Recent papers have begun to examine this question.
Finally, and importantly, an unresolved issue is the appropriateness of Merton’s (1977) model in light of the fact that the assets of the bank are non-tradable. For the isomorphic correspondence between stock options and deposit insurance to hold, one must be able to achieve the risk-less hedge, which requires the ability to trade in the underlying.
FDIC and Continuing Developments
Though there are currently limitations in the theoretical pricing of deposit insurance, our knowledge is much greater than it was twenty years ago. Such a guarantee is costly, as is obvious from the failure of FSLIC, the Savings and Loan deposit-insuring agency. The cost of the guarantee is increasing in the debt level of the bank and the riskiness of the bank’s assets. However, the FDIC has largely ignored theoretical developments, maintaining a constant premium of deposit insurance (per dollar of deposits) regardless of individual bank characteristics. Kendall and Levonian (1991) show that even a dichotomous grouping of banks on individual characteristics improves upon the FDIC’s current policy. It is therefore troublesome that the FDIC would continue to ignore the developments in the area.
Resources For Deposit Insurance:
Au, K. T., Dennis, S. A. & Thurston, D. C. (1995). The deposit insurance fund and the
regulation of interest rate and credit risks at depository institutions. University of New South Wales. Working paper series.
Boyle, P. & Lee, I. (1994). Deposit insurance with changing volatility: an application of exotic options. Journal of Financial Engineering, 3, 205–227.
Diamond, D. & Dybvig, P. (1983). Bank runs, deposit insurance, and liquidity. Journal of Political Economy, 91, 501–19.
Duan, J. C., Moreau, A. F. & Sealey, C. W. (1995). Deposit insurance and bank interest rate risk: pricing and regulatory implications. Journal of Banking and Finance, 19, 1091–108.
Heath D., Jarrow, R. & Morton, A. (1992). Bond pricing and the term structure of interest rates: a new methodology for contingent claims valuation. Econometrica, 60, 77–105.
Kendall, S. & Levonian, M. (1991). A simple approach to better deposit insurance pricing. Journal of Banking and Finance, 15, 999–1018.
Marcus, A. & Shaked, I. (1984). The valuation of FDIC deposit insurance using option-pricing estimates. The Journal of Money, Credit, and Banking, 16, 446–60.
Merton, R. (1977). The analytic derivation of the cost of deposit insurance and loan guarantees: an application of modern option pricing theory. Journal of Banking and Finance, 1, 3–11.
Ronn, E. & Verma, A. (1986). Pricing risk-adjusted deposit insurance: an option-based model. Journal of Finance, 41, 871–95.