Explained here. Excerpt:
Let’s say that Citigroup were restructured – via bankruptcy, or via
government conservatorship – in such a way that creditors did not get
all their money back. (None of this applies to FDIC-insured deposits or
to recently-issued senior debt that is explicitly guaranteed by the
government.) They might be forced to convert debt for equity, or they
might be stiffed altogether. The first-order concern is that this would
have ripple effects that could take down other financial institutions.
According to Martin Wolf,
bank bonds comprise one quarter of all U.S. investment-grade corporate
bonds; losses would be spread far and wide, hitting other banks,
pension funds, insurance companies, hedge funds, and so on. If
Citigroup did not support its derivatives positions, then institutions
that bought credit default swap protection from Citi would face further
losses. (I believe that most U.S. banks were net buyers of CDS
protection, however.) The fear is that it will be impossible to predict
how these losses will be distributed and who else might go down.
The second-order concern is bigger. After all, Lehman did not seem
to force any major financial institution into bankruptcy, although it
may have twisted the knife that AIG had already stuck in itself. Once
investors figure out that bank debt is not safe, they will refuse to
lend to any banks, and we are back in September all over again. Or
almost: it is possible that the Federal Reserve’s massive efforts to
provide liquidity to the banking system will be enough to keep banks
functioning. But who wants to take that risk?
You're comparing that to spending a great deal of extra money on credit bail-outs; choose your poison.
Did everyone really forget that when people go bankrupt, they might not be able to pay all their bills? Or did everyone just forget that people might go bankrupt?
In either case, how do they re-learn that without getting some fingers burned?
and we are back in September all over again? Have we ever come out from that? There is a strange assumption that Lehman Brothers case was a mistake which should not be repeated. I contend that it was not a mistake and it should be repeated for others Lemon Brothers. The point is to make it orderly, systematic and in a transparent way. A kind of Euthanasia of the banking system. An induced bank run to eventually set up good banks!
No one will lend to banks?
If long term bonds are swapped for equity at a loss, then no one will buy _new_ long term bonds from banks they believe are insolvent. And no one will buy new long term bonds at low interest rates on the expectations that the banks will be bailed out in the future. Or rather, the will require higher interest rates.
If other classes of bank creditors (holders of financial paper, other banks, or whatever) should continue to lend to banks if they don’t take a loss.
Some people hold very junior debt because it is short. Their “plan” is to get out before the collapse. If I hear bad news about Bear Sterns or Lehman borthers, I just won’t buy any new overnight commerical paper. This, of course, results in a run when there is bad news. And those at the end of the line get stuck. Lehman failed, holders of commercial paper took a loss, and those lending to finanical insitutions on that foolhardy plan stopped. (Or, perhaps it all about expecting a bailout of institutions too big to fail. Bear is bailed out. People still make short term unsecured loans to simiar institutions. Lehman fails. Oops, the certainty of a bailout is less.)
But, of course, if there is always “lending to banks” by making insured deposits. If banks cannot borrow using commercial paper or bonds, then they will need to borrow by obtaining insured deposits. If investors won’t lend to banks (and fear risk generally,) what will they do with their money? Insured bank deposits are one of the few “safe” investments.
If Citibond holders suffer the loss by a debt to equity swap, (and not Citi counter parties to credit default swaps) then the counterparties have a more
secure position. If there are investors in Citibonds that take a loss do to
a equity to debt swap that have purchased a credit default swap, then it is
the sellers that will take a loss.
Still, the general notion that the govnerment should bail out sellers of credit default swaps because those who bought the swaps might lose money if
the bonds default seems crazy to me.
The direct impact is simple–people who one Citibank bonds (or any other bank
who take the loss) lose money on their bonds.
Those holding bonds in banks that are questionable, will have a lower market value of their bonds, but if it is a long term investment, they can hold them.
Why not have banks fund all their loans from insured deposits? Because insured depositors have no incentive to pay attention to bank risk. Because the deposit insurer in on the hook for all the losses. Having banks fund some loans with other sorts of debt creates a class of investors that can share losses with the government, and further, will only lend to the bank if the bank is sound enough to pay them back.
_IF_ the govenrment is going to bail out anyone who funds any bank long, then these benefits are an illusion There is no benefit.
The shadow banking system was great.. if the investors funding the loans had to take the loss.
To me, a lot of choices in this crisis are between more short-term (and probably medium-term as well) pain but better long-term capital allocation, and less short-term pain but worse long-term capital allocation and therefore lower GDP growth, worse performance of equities, etc. A lot of the choices should probably depend on the societal discount rate. IMO many politicians use an implied rate that is too high.
So you are saying that bank bondholders require a higher rate of return than treasuries, but the same level of risk? That doesn’t make any sense. It seems to me that what will happen is new lenders to banks will require a higher rate of return; that seems completely reasonable. Hasn’t the mispricing of risk been at the root of this whole problem? Of course interest rates are going to have to go up to create a healthier system.
It seems to me that the bondholders that we as a nation would not feel obligated to bail out are trying to hide behind the ones they think we will. If forcing Citi, WFB, BOA, etc. to recognize their losses causes them to go bankrupt, and threatens insurance companies and pension funds; then we can deal with those damages. Maybe we will want to make annuity holders whole, but not the stockholders and bondholders of those insurance companies. Maybe we will want to cover the pensioners with the PBGC and recapitalize that, forcing them to accept lower benefits, but not bailing out the pension fund employees and stockholders.
By trying to bail out the insolvent banks, we are covering at par all of their creditors, which almost has to be more expensive than bailing out only their sympathetic creditors.
The thing with Lehman was the fear of contagion. But after Lehman, aren’t we somewhat inoculated? Of course, people had months to get Lehman notes off their books and didn’t, so who knows.
What do you think of rather than setting a 100% max of $100k or $250k for FDIC, we set an 80 cents (or whatever) on the dollar up to, say, $300k, to capture some depositor incentive to check on their counterparty. Sort of like medical co-pays. Maybe even make it progressive because the fat cats are more likely to have the wherewithal to do it and broadcast it. Now, you would have an incentive to “run” to the bank to save your 20%, but there could be a 20% minimum on the account.
What if banks raised all their capital by bonds? We wouldn’t need the FDIC, we’d have time horizon’s matched up, and a strong incentive to keep an eye on the bank’s operations.
Curt, that is an excellent point. According to what I’ve heard, many PE people and other private investors want to start up banks (just look at Dell/Paulson’s purchase of IndyMac). However they are encountering very long “delays” and other barriers at FDIC-level. My guess is that the FDIC wants to try to help current banks as much as possible and not allow startup banks to “steal” deposits from Citi, BoA, et al
I’ve got a dumb question… If the government had “lent” all the TARP funds and bailout money to homeowners who wanted to “borrow” it, and some significant fraction of people who wanted to stay in their homes took them up on the offer, how much would money would we be talking about? Would this have not headed off the housing crisis, which precipitated the collapse of the mortgage backed securities, which precipitated the near collapse of the banking system, and so on?
Given that no one knows how much more will be needed, might this still be an option worth considering?
I may be missing something but it seems to me that the government could manage the risk in conservatorship by choosing to make bondholders whole. Aren’t the debt markets already discounting the debt of the banks? The stock price is certainly reflecting a possible conservatorship
This is the issue I had earlier asked Tyler to address (when he fielded requests for what he and Hanson should talk about). But–as others have noticed–this doesn’t give us the tradeoff. Of *course* it’s true that if the gov’t did nothing, then people who were exposed to bad mortgage derivatives (directly or indirectly) would take some big hits.
But the crucial question is, would those hits have been larger than what the taxpayers will ultimately end up paying? If Tyler linked to someone who argued, “By making taxpayers eat $2 trillion over the next 10 years in bailouts, we are preventing idiot bankers from losing $20 trillion,” then maybe that would be a good argument. But I have seen no actual estimates like this, I’ve just seen Vietnam-type “we can’t let the dominoes start falling with AIG”-type statements.
It’s particularly ironic that this guy is saying, “We would be back at September.” Didn’t Tyler a few days ago link to a piece saying we already ARE back to September, despite the trillions in handouts and guarantees?!
The difficulty is that the market is uncertain as to which banks hold toxic assets and how much they hold.
How do market participants obtain the information necessary to discriminate between good and bad banks? Clearly, the best source of information would be the market process itself. Those banks that go bankrupt are bad. Those that survive without bankruptcy or that are cleansed by a true bankruptcy process are “good”. Clarity results. The market can have confidence in the result of bankruptcy processes because investors (such as potentially other banks) that purchase either the toxic assets or the cleaned-up bank do so voluntarily by putting their own money at risk. The FDIC process, as I understand it, is essentially a bankruptcy process, with the add-on that depositors are protected.
The other mechanisms being proposed to provide the necessary clarity would be government administered to a greater extent and appear to involve government identification of toxic assets, subsidized pricing for the toxic assets in various forms and estimates of fair value for other assets. What could possibly go wrong? I would suggest that anyone who thinks that the market is going to place a great deal of confidence either in government’s competence or its good intentions in the context of such a process is dreaming in technicolor.
As a side point, it seems that a lot of people are suggesting that it’s OK for government to intervene because there is currently no market for the toxic assets or that prices are unreasonably low because they are illiquid. My understanding is that the vulture funds, i.e., the guys whose business is buying distressed debt, would be happy to buy these assets, but only at market value. The market value is far below face value, not because of nasty artificial stuff like market “illiquidity” or “adverse feedback effects” but because we now know that these assets have a very high risk of default and no sane person (enter the government) would pay face value or anything approaching it. This debt is no more illiquid than the distressed debt of any particular insolvent corporation and that stuff gets bought up all the time. Market liquidity is not a guarantee that market prices will always equal face value or that market prices will never fluctuate, it simply means that the process of selling the asset won’t by itself significantly depress the current market price. If anything, the expectation of government bailouts probably discouraged banks from selling these assets early, i.e., before the full extent of the problem and of the recession became known, when they might have obtained a higher price.
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