Why do bank share prices fall when government buys preference shares?

The two main Irish bank shares fell back again today following the announcement of the details of the recapitalization — down 16 and 14 per cent respectively. There could be lots of reasons. To begin with there was the extraneous factor of the back-to-back deposits between Anglo and ILP mentioned in a previous post. ILP fell back 15 per cent as well.

Then there is the possibility that shareholders expected a more lenient deal? But how lenient could that have been? The interest rate on the preference shares is stiff enough, but not out of line with prevailing practice in other countries and anyway was well-flagged.

To all intents and purposes, however, the share prices are close to zero — down over 95 per cent on their peak.

My purpose in writing, though, is to point out that even though the preference shares are senior to equity, an injection sufficient to assure solvency going forward could nevertheless have been expected to lift ordinary share prices.

I suspect this is not a well-known effect. Permit me to present a very simple model.

Thus, suppose that there are just three periods. For convenience, assume our bank begins with zero capital.

In period 1, the government decides the amount S it will inject through purchase of preference shares.

In period 2 we discover the true state of the world, i.e. the size of the loan losses (H high in the bad state, L low in the good state). If the losses exceed the funds the government injected, then the bank is liquidated and the shareholders get nothing; If the losses are equal to or less than injection, then the bank continues in operation.

In period 3 the bank, if still in operation, earns franchise profits Z on the rest of its business. It is then wound up; the government receives its injection back if possible. Any surplus goes to the shareholders.

Clearly, if the values H and L are known and if the government injects any amount equal to or less than L, the market value of the shares at the end of period 1 is zero. (Of course, the analysis assumes rational market expectations.)

If the government injects more than that, the market value of the shares at the end of period 1 is p*max{0, (Z-L)}, where p is the probability of the good state. A longer expression gives the share value if the injection S is higher than H.

The point is that even an injection S that is only sufficient to ensure the bank’s survival in the good state will, when announced, increase the market value of the shares.

The Irish Government injection of yesterday was insufficient to do that.

10 thoughts on “Why do bank share prices fall when government buys preference shares?”

  1. You may be right (and the fact that the price actually dropped rather than merely staying static adds credence to your theory), but even if you are wrong, and the banks are indeed adequately capitalized, the share price still wouldn’t necessarily have gone up. You are assuming that investors invest primarily in the capital structure of the bank. They don’t. They might withdraw their investment on the basis that it has inadequate capital, but they will not invest in it just because it has adequate capital.

    They will only invest in a bank which they think is going to make money over and above meeting its debt obligations. The main factors in determining whether a bank is going to be able to make money in this situation is (i) the state of the economy (not good) (ii) the substantial debt obligations (getting bigger and the recapitalization makes this more acute, not less so) and (iii) the ability and track record of the management team to make the best of the adverse situation.

  2. I thought that share prices rose because non-Executive directors of banks are to have their pay cut by 25% across the board. Non-Execs are supposed to oversee the Executives and look out for the shareholders’ interests? Well, we don’t want any of that! ………Seriously though, banks and businesses need proper impartial non-Execs who take their role seriously. It is the Executives who should have have across-the-board pay cuts.

  3. “The Irish Government injection of yesterday was insufficient to do that.”

    The consensus seems to be, from listening to the three wise men on Primetime tonight, that p = 0.

    To my mind though, the current risk aversion in the market is also playing a large part.

  4. I was under the impression that the size of the capital injection — 3.5bn each — was known about already. That is, the size of the capital injections was not “new information” to the market yesterday. So, if there is, say, a 70% chance that this will be insufficient to cover expected credit losses, wouldn’t this have already been in the price before yesterday? Were there some material contract details that became known for the first time yesterday?

    The revelation of ILP’s “deposit” with Anglo can’t have helped Irish financial stocks generally — but they should have caused a bigger drop in ILP than in BOI and AIB.

  5. A good deal of the discussion about rescapitalisation has focused on credit flow. In the current environment, I continue to be sceptical that improving the capital position of the banks will do much to increase lending given the lack of willing creditworthy borrowers.

    Is it possible that that the real importance of recapitalisation has to do with its effects on liquidity rather than on credit?

    Let’s suppose for the sake of argument that that banks are modestly insolvent. With the guarantee in place, it is likely that the banks and government could muddle along until there is a global upturn. But with the government’s own solvency in question, there is a risk that the creditors will run for the exits. Liquid assets on the balance sheet could be critical to avoiding this bad equilibrium. This was why in a previous post I suggested the government be slow to commit the liquid resources of the NPRF to bank recapitalisation. However, I now think that those liquid resources could be even more useful in staving off the bad equilibrium if held directly on the balance sheets of the banks, where they give comfort to creditors. This suggests we should think twice before bemoaning the banks unwillingness to lend on the new capital. The lending conditions attached to the capital injections would also be counterproducitve when seen in this light.

  6. Three simple issues
    A) Dilutive warrant
    b) debt issue (as noted)
    c) insufficient, and probably increases the likelihood of nationalisation (aka mass dilution) as it allows the patient to zombie on until someone notices the smell

    Theres a small deadcat bounce today on low volume. Meanwhile CDS at 295 and ten year yield over bund 250. I dont think that that is panic – its rational “WTF are the paddies up to ” reaction. Oh, and stock prices generally rise on friday the 13th…

  7. It may also have something to do with the type of capital injected. A commentary by Jonathan Weil (see link below) argues that investors are not impressed by preference shares. As he puts it, “investors today are fixated on the most bare-bones measure of capital there is: tangible common equity. Investors already have figured out that preferred stock is debt by a different name.”

    http://www.bloomberg.com/apps/news?pid=20601039&sid=aQ1RyLNi6ujo&refer=home

  8. Very interesting article there Alan and makes alot of sense.

    Also there was me thinking the FASB were an indepependant body!!!!

  9. preference shares mean that if there is any upturn the common stock holders won’t get a taste of it, why would you invest in something if any profits will be taken away before you get a bite at them? So i don’t suspect there will be many jumping in to ‘participate’ as expected.

    for those who felt the 95% drop i guess its better than the option B which was ‘get wiped out totally’.

    if lending is contracting -fact- and banks are not giving out new loans at high margins -fact- yet they are still giving very generous deposit rates -fact- then where will any excess come from to reward the Ord?

    answer – there won’t be any.

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