Will Ratchet Rights Produce Zombie Banks?

If you think the headline above is overly dramatic, BreakingViews ($, free trial) sees the possible outcome of ratchet right provisions in bank capital infusions as a “death spiral”.

This potentially ugly situation arises out of a nasty confluence of pragmatism, greed, and desperation. Anyone who invests in bank equity now has to be concerned that what looks cheap can still get cheaper. Viola! Ratchet rights!

Ratchet rights protect the investor in the event subsequent rounds of fundraising take place at a lower price. In the “full ratchet” version, the investor gets cash or shares to put his original investment on the same footing as the new money. The problem is that the repricing for the old money makes the new fundraising even more dilutive to the other shareholders.

Now consider how this plays out in our world of troubled banks. Because they need a great deal of money to shore up their balance sheets, executives are unable and unwilling to raise all the dough at once. “Unable” because the amount would be large in absolute numbers and would probably give a heart attack to existing equity owners; “unwilling” because dilutive equity raises hurt option-based management pay. The top brass has an incentive and a bias due to denial about how bad things could get to raise less and hope for the best.

But canny investors, who have a keen appreciation for the vagaries of fate, asked for full ratchet rights in some recent bank fundraisings. TPG has 18 month protection for its share of the $7 billion equity + converts investment in WaMu (the other institutional investors get nine months). National City had to give three years ratchet rights protection (cut to two in certain circumstances) on its $7 billion equity + converts deal. Merrill’s sale of $6.6 billion in mandatory convertible preferred stock to certain foreign investors also has a full ratchet provision, but it is somewhat less onerous, since it does not come into play until the conversion date three years from issuance.

However, this clever device may not prove so advantageous. The presence of ratchet rights makes fundraisings at lower prices painful and thus discourages such activity. But as Thursday’s stock market action attests, we aren’t just in a deteriorating market for banks but for shares generally. More financial firm losses are almost certain to be in the offing, and with them, the need for more capital. Deals with ratchet rights can serve as an impediment to doing what is right for the business, even if it is unpleasant for shareholders. Trying to defer a needed fundraising runs risks on other fronts, particularly with rating agencies.

Funny, when I first wrote the headline, I typed “Ratched” as in Nurse Ratched. Wonder if my subconscious is on to something.