Bondholder Haircuts
A debt-for-equity swap may also be called a "bondholder haircut." Bondholder haircuts at large banks were advocated as a potential solution for the sub-prime mortgage crisis by prominent economists:
Economist Joseph Stiglitz testified that bank bailouts "...are really bailouts not of the enterprises but of the shareholders and especially bondholders. There is no reason that American taxpayers should be doing this." He wrote that reducing bank debt levels by converting debt into equity will increase confidence in the financial system. He believes that addressing bank solvency in this way would help address credit market liquidity issues.
Economist Jeffrey Sachs has also argued for bondholder haircuts: "The cheaper and more equitable way would be to make shareholders and bank bondholders take the hit rather than the taxpayer. The Fed and other bank regulators would insist that bad loans be written down on the books. Bondholders would take haircuts, but these losses are already priced into deeply discounted bond prices."
If the key issue is bank solvency, converting debt to equity via bondholder haircuts presents an elegant solution to the problem. Not only is debt reduced along with interest payments, but equity is simultaneously increased. Investors can then have more confidence that the bank (and financial system more broadly) is solvent, helping unfreeze credit markets. Taxpayers do not have to contribute dollars and the government may be able to just provide guarantees in the short-term to further support confidence in the recapitalized institution.
For example, one of the largest U.S. banks owed its bondholders $267 billion per its 2008 annual report. A 20% haircut would reduce this debt by about $54 billion, creating an equal amount of equity in the process, thereby recapitalizing the bank significantly.
Read more about this topic: Debt Restructuring