Convertibles: Collateral Damage of the Shorting Ban

It seems a long time ago now, but back at the beginning of the credit crisis, when US banks were being bailed out recapitalized by foreign governments rather than their own, one of their favorite methods of raising new capital was to issue convertible bonds.

Here’s a measure of how bad things have gotten since then: in pressuring the SEC to ban short-selling, the likes of John Mack have implicitly conceded that there’s simply no way they’ll be able to issue any kind of convertible bond for the foreseeable future.

How’s that? Investors in convertible bonds are perfectly happy to put up new money, but they invariably short the underlying stock at the same time. It’s called convertible arbitrage, and it’s popular enough that there’s almost no room in the convertible-bond market for anybody else. Any bank trying to issue a convertible bond into a market where short-selling is banned would be doomed to fail.

I’d be interested to see how the prices of various banks’ public convertible bonds are doing today. I doubt there’s a panicked attempt to dump them all immediately, now that hedging them has been banned. But I also suspect that there’s a huge overhang of bonds waiting for any buyers to come along.

Not that you can short the converts — that’s been banned, too, at least in the UK, and probably in the US too, before long. The main effect of that, I suspect, will be to simply drive volumes and liquidity in the convertible-bond market down to zero. Which is fine if the only source of capital right now is the US government. But if other people are interested in putting up money too, the ban on short-selling might, ironically, make it that much more difficult for them to do so.

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