As Simon wrote this morning, the administration strategy is to wait and see if the economy turns around, lifting banks out of the mess they created. How can you tell if this is working? One way is to look at bank bonds.
If the administration is right and the banks are healthy (and to the extent they aren’t healthy, their capital will be topped up with convertible preferred shares), then bank bonds are safe. Even subordinated bonds (the ones that get paid off after senior bonds and insured deposits) are protected by the bank’s capital – both common and preferred shares. So if the administration is correct that the banking system is adequately capitalized, and will be even more adequately capitalized after the stress tests and capital infusions, then banks will be able to pay off all of their bonds.
Even if the administration is wrong and the banks are not adequately capitalized, bondholders are only in danger if the administration decides not to protect them. This could happen in one of two ways. First, the administration could request, as a condition of a future bailout, that bondholders exchange some of their debt for equity. There is no law that says that bondholders have to exchange their bonds for equity just because the government asks, so the threat would be that the government would not bail out the bank otherwise (forcing it into bankruptcy or conservatorship).* Second, the administration could take over the banks; in that case, the regulator might decide not to pay back all of the bondholders – but it certainly could decide to pay them back. It’s just a question of whether losses are borne by the bondholders or the taxpayer (assuing the equity holders have been wiped out).
So what does the bond market think?
According to a Bloomberg article this morning, the bond market is scared. Yields on bank debt overall are 3.6 percentage higher than for industrial companies (before August 2007 they were lower); Citigroup’s subordinated debt due in October 2010 has fallen from 95 cents to 77 cents on the dollar in the last three weeks; Bank of America’s subordinated debt due in January 2011 is down from 99 cents to 80 cents. Here is some color:
“The bond market is getting more scared every day,” said Gary Austin of PDR Advisors in Charlotte, North Carolina, who manages $450 million in fixed-income securities. “At some time, the government is going to say enough is enough, the only way we will give you more cash is if the bondholders have to be hit.” . . .
“The current prices imply that the companies’ equity is worthless, the government’s investment is worthless and subordinated debt holders will lose some of their investment,” said David Darst, an analyst at FTN Equity Capital Markets in Nashville, Tennessee.
In other words, the bond market isn’t buying the administration’s story, and thinks there’s a pretty hefty risk not only that some banks will be taken over, but that bondholders will be made to suffer in the process. Correct or not, this perception decreases confidence in the banking sector as a whole, because of the potential ripple effects of shorting creditors.
Maybe Treasury or the Fed will start buying subordinated bank bonds in order to project confidence. That would be putting its money where its mouth is. Of course, that would also guarantee that the taxpayer will suffer any potential losses, one way or the other.
* The government tried this with GMAC back in December, with only partial success. Some bondholders, including PIMCO, refused to convert, betting that the government would bail out GMAC anyway, which it obligingly did. Felix Salmon covered this extensively (short version and long version). This means that the government may not be able to go the voluntary route in the future.