With all the material and moral support for U.S. mega-financial institutions currently on the table, why are bank holding company credit default swap (CDS) spreads at new highs? (For more on how and why you might want to think about CDS spreads, we have a basic guide.)
The most plausible explanation is that creditors – unlike equity investors – are spooked by the new resolution authority that is now sought by Treasury and the Fed. This would, after all, allow the government to manage something akin to (but potentially better than, from a social perspective) a bankruptcy process for our largest financial institutions.
These creditors are right to be worried; the authority, if granted, would almost certainly be pressed by events (and creditors’ self-fulfilling runs) into use.
But, if handled right, this authority can help solve the financial mess at minimal cost to the taxpayer (although there are no magic bullets or easy exits at this stage). The key – as always in any major crisis – is decisive action. Over on wsj.com this morning, Peter Boone and I outline one way forward.
By Simon Johnson
The Baseline Scenario 
Interesting. Assume for a moment that what you suggest — i.e., get the authority and then use it exactly once — is already, in fact, the Administration’s plan. What would they say publicly that is any different from what they are saying now?
There are three related stories that deal with the rise in CDS spreads in the past few weeks:
1) China saying that it expects the US to honor its guarantees. Many people have missed the fact that they have been claiming this about their corporate bond holdings, especially the banks. Other foreign investors have said similar things, though more politely.
2) There have been a raft of stories about insurers and pensions needing a bailout.
3) Mexico passed a law allowing the US to own more than 10% of Banamex.
These stories all have connections with the defaults of the bank’s bonds, because these are the people that hold most of them. My guess is that they would accept less money ( a haircut ), but would find a default very unwelcome, and would, at the very least in the case of foreigners, tell us to expect to pay much higher interest on loans going forward. The insurers and pensions would just send their lobbyists to the Congress. In other words, the spreads reflect the real possibility of losses and the seriousness of the issue.
Geithner has been saying all the right things about all of this, doing a good job of balancing the anger of bondholders and the need for the US to seize a few large banks. I’ve been puzzled by the criticism, since it’s too early to tell what will happen. Just like the FDIC, we’re not going to announce such a move until it happens.
Citi has been selling assets. The problem with Citi might be that investors just don’t think that they can make it, even if they sell a lot of assets. They’re a good target of a seizure or lots more money, which would be hard to get.
So, although I’ve been for the Swedish Plan since Sept. 23rd, want to seize a few banks for moral hazard reasons, want bondholders to accept their risk, this seems to me to be the best option for now. In the meantime, PPIP is simply the best hybrid that could be agreed upon. Nothing more. Until this new law comes into existence, we’re stuck with PPIP, which is simply a more politically acceptable form of the original TARP, except for the FDIC involvement, I believe. But, if you want the FDIC to be able to seize large banks in the future, this involvement should be welcome, since they’re going to need more powers, staff, and funds. Just think of the Banamex problem.
The bondholders ought to be worried — Congress isn’t going to replenish Treasury’s kitty at sufficient levels for Treasury to continue to paper over losses at Citi et al. And I agree with Simon’s take in the WSJ article that a debt/equity swap needs to be done in one fell swoop when it is done.
But I was puzzled by the following sentence buried in one of the WSJ paragraphs: “While not all creditors with the same seniority would be treated equally — this would be a major difference and potential advantage relative to bankruptcy — the benefits of rapid actions can be justified for the economy as a whole. ” Does this mean “not all creditors of the same institution with the same seniority” or “not all creditors of the same seniority of different institutions.”
The latter is obvious and doesn’t have anything to do with bankruptcy versus a new resolution regime. Differential institutional risk is what creditors take. But the former — why would we discriminate against creditors of a particular bank with the same level of seniority? What’s the benefit? Which creditors within a given seniority would we want to prefer over others? The downside of discrimination is huge. It just opens up a pandora’s box of both uncertainty going forward, which would handicap the recovery of the credit markets for financial institutions, and legal challenges.
What am I missing?
Counter-parties could be left untouched while debt-holders would be converted to equity?
The one problem with what is proposed is the vast discretion the federal regulators would have. For the long-term all institutions that are too big to fail should be managed with an iron-clad process that is understood by all and managed with ZERO discretion. The Citibanks of the world need to have an “on-site” regulatory office with the authority and inside knowledge required to pull the plug on them instantly under pre-defined and well-understood conditions.
Here is another theory – a little more sinister. The question is why the immediate positive response to the bank plan, followed by CDS spreads that are now as wide as during the point of maximum pessimism (so far)?
When the plan was first announced, those investors who are deeply connected recognized the potential for ill-gotten gains. Simply, create/buy holding companies (like hedge funds) with small amounts of bank capital, partner with Treasury, borrow oodles from the Fed, then buy bank assets at inflated prices (kicking back to the holding companies). It looks like banks will get to unload lousy assets onto taxpayers for a high price.
As this loophole has hit the media, perhaps Treasury has signalled that it actually intends to more actively regulate who is permitted to partner with Treasury/borrow funds to bid on the assets – to ensure that the investors are legitimate, rather than shell corporations. In other words, perhaps Treasury intends to force some legitimate price revelation through the auctions.
While it is clearly the intent of Treasury and the Fed to subsidize _risk_ (create lopsided bets), perhaps Sec. Geithner actually has the integrity to prevent outright fraud and money laundering.
What we do not know is exactly how the process to qualify bidders is progressing (although the insiders surely know this). One nice feature of Geithner’s solution is that it creates an incentive for those individuals who really want to buy cheaply discounted assets to fight a political battle to prevent the banks from artificially bidding up those assets through shell companies. If the assets are too expensive, even the lopsided bets don’t make sense. So, they will try to restrict the pool of potential bidders.
Another interesting note –
Forcible conversion of debt to bank equity has huge advantages from the perspective of a regulator. It’s an effective way to recapitalize banks while reducing outstanding assets (especially bad assets), meaning it does not require going back to Congress to get more funds.
One is how much dilution will occur. Presumably, this could depend on the price of shares. So, the more expensive the shares (on whatever time period is chosen to do the calculation), the less they are diluted.
Can someone answer this question, though: How do debt-to-equity conversions legally impact CDS contracts? The same as default?
Strictly speaking, what you describe is already forbidden by the Term Sheet, which says:
Private Investors may not participate in any PPIF that purchases assets from sellers that are affiliates of such investors or that represent 10% or more of the aggregate private capital in the PPIF.
Which is not to say there will be no way to game the system, but it does rule out the simple “shell corporation”, I think.
StatsGuy – any debt to equity conversion that is mandatory will trigger a CDS. They have to live up to the stated terms of the bond to avoid triggering the CDS.
Don’t they already have preference? I thought this was in part what AIG has been all about. And if they aren’t senior, why should they get paid out while senior debt takes the big hit?
Thank you – sincerely. That does then create problems for the regulators, who effectively own companies like AIG that back up so many of those contracts.
Two more questions please:
1) Are the CDS contracts written to cover the full value of the asset, or to cover the difference between the value of the asset and the amount recovered from a bankruptcy-like process? If so, how would this work in the context of conversion to equity?
2) What if the conversions are not “forcible”? For example, what if the govt. offers a “deal” the bondholder can’t refuse? Or tries to negotiate bilateral settlements with entities like sovereign wealth funds?
Oh yes… But let us assume the financial wizards employ some level of obfuscation. If they excel at anything, it is that.
For example, an ownership chain through off-shore financial havens with secretive financial laws.
Are hedge funds going to have to open up their books to participate? Will Treasury pursue this as aggressively as they’ve been pursuing Credit Suisse lately?
Perhaps the CDS spreads are suggesting that this is not easily done?
A shell JV should still work. Hedge fund A capitalizes a special purpose vehicle B with Bank C as its minority investor. B is an affiliate of A, but C is not an affiliate of A.
Besides, if hedge fund A has a long position in C, it might not need any collusion to overpay in the auction and loudly trumpet the results as “proof” of C’s financial health. It can do so confident that C and the Treasury will sing the exact same song.
http://tauntermedia.com/2009/03/23/gaming-the-system/
How liquid is the market/how accurate are the quotes?
The email cited in ZeroHedge alleging that AIG intentionally accepted wider-than-market spreads over the past couple of months to transfer wealth to its counterparties makes me wonder if some of what we are seeing reflects these trades working through the system.
http://tauntermedia.com/2009/03/30/scam-now-with-smoke/
All true. I was just pointing out that Treasury did include some language to imply they want to prevent such games… And many people seem to have missed this language.
Whether they are sincere about, or even capable of, preventing these games is certainly open to debate. Personally, I think Waldman paints a more realistic picture of the sinister potential, but a convoluted system of shell (or simply “you scratch my back, I’ll scratch yours”) arrangements are certainly possible.
I generally expect the financial industry to extract the maximum possible subsidy from the taxpayer. AIG, Fannie Mae, and Freddie Mac are just the beginning. But I will also give Treasury credit for trying when they appear to be trying.
The whole thing is a formula for total disaster. Haircut the bonds and get what? It will get us a run on the world wide insurance industry – as per this guy:
http://blog.atimes.net/?p=727
I simply do not believe the government would be this stupid.
Or – to put it in a different way – wee need inflation more than we need deflation. A bank recap would be profoundly deflationary -as the bank balance sheets would shrink real fast. This is a guarantee for a depression. It is nuts.
The PPIP plan essentially allows large bank bond holders, like PIMCO and Blackrock, to overbid for toxic bank assets. They put forward seven percent of the capital for a bid, and the taxpayer is on the hook for the remaining 93 percent of the risk. While Secretary Geithner is attempting to sell this plan to the public as a being a vehicle for fair price discovery, since private money is being put at risk, it is anything but that. This plan is a means for private buyers to spend a small amount of capital to overpay for bank assets in order to protect a much larger amount of capital they hold in bank bonds. In sum, the PPIP program is a way for bank bondholders to buy themselves asset protection at taxpayer expense.
Given the moral hazard this plan embodies, and the perverse incentives of the parties that will be the buyers, I am certain that this plan will cost the Treasury and the FDIC up to $450 billion dollars. Worse yet, these losses will result in the insolvency of the FDIC and may lead to loss of depositor faith and bank runs.
StatsGuy – in theory you can deliver a bond to the insurer and get principal and interest due. There is an auction procedure once the CDS are triggered that settles the cash value payment and it should roughly compensate for the true net loss of principal.
If they offer bondholders a deal that is so good they rather take it than hold the bonds, then there would be no need to make it mandatory so no need to trigger a CDS. However, could be that the resolution intervention procedure itself does trigger the CDS – like fannae and freddie conservatorship, in which case the CDS is triggered but doesn’t pay off much if the bonds are still valuable.
What is NOT surprising, is that the debate here is about how to keep Americans from stealing and cheating, or as you say “gaming” the PPIP. So, this crisis was created by people on Wall St and Washington stealing, and the “Big Solution” is: Let the same thieves who perpetrated the largest financial fraud in the history of man, solve this problem…by having access to trillions of more dollars. And spearheaded by who? Tim “I don’t pay taxes, that’s for little people” Geithner? The guy who was the head of the NY Federal Reserve when this all happened? Do any of you Americans ever sit back, and actually THINK about what your doing? I’m getting to the point where I’m no longer furious that you stole from all of our pension funds over here. I’m actually beginning to feel very bad for all of you…..are you REALLY this stupid? Apparently we all thought you were a bit smarter then this…..we were, obviously, very mistaken. Enjoy poverty after the current scam steals what little you have left.
“private” buyers can also be the banks themselves. This is disturbing:
You are right that there is a subsidy to buyers in PPIP. Yet, my research suggests at http://ssrn.com/abstract=1343625 that the insolvent or distressed banks may not accept the subsidized prices that the asset managers are offering unless they are forced to do so.
I’m more worried that P-PIP subsidies will be used to buy assets from healthy banks, enriching asset managers and banks’ shareholders without social purpose.
Personally, I think the Treasury and the Fed Reserve is likely smarter than everyone and definitely smarter than everyone give them credits for.
Of course, this has nothing to do with IQ. It is all about having a global view of all the moving parts, technical, political and legal.
I’ve posted on this site before the open question:
Will we repeat Japan’s lost decade?
I don’t think we will. For a decade Japan messed up on all the following to clean up their economy.
1. fiscal policy
2. monetary policy
3. bank clean up
This is only the 2nd month of the new administration and we already have very forceful efforts on 1 & 2. We also have a plan with credible intend, but to be determined effectiveness, on 3. I like to emphasis “credible intend”. Reasonable people can debate the effectiveness of the Geithner plan but really we should not doubt the Treasury’s understanding and desire to clean up the bank balance sheet.
If we do end up with a lost decade, it won’t be because we didn’t clean up our banks. Most likely it will be something else. This could be a good topic for this blog to cover. What other problems can bog down the recovery beside cleaning up the banks.
As a final note, to echo the sentimental in the book “the black swan”, it is what we don’t know that we need to worry about. It is good that we’ve analyzed how the Geithner plan is a one way bet that can be gamed or that it is inefficient use of tax payer money and etc. In the scheme of things these are the least of our worry.
How come we don’t ask an audit outfit to open one of these mortgage bundels? The independent audit firm’s task is to determine the real yield expectation (sum of all mortgage evaluations in the bundle) and then propose that valuation for all similar securitised bundles? We could have several such processes run in parallel with different audit firms.
Treat this as the market price indicator and have NO taxpayer’s money at risk?
This whole current scheme smells like a banker and friends enrichment sure thing with taxpayers being ripped off!
Any reason why this isn’t a better plan then Mr.Geithner’s?
“In the scheme of things these are the least of our worry.”
Ben, I could not disagree more strongly. Our financial markets have become an enormous casino where extraordinarily large bets are made at millisecond speeds and ridiculous leverage, financed by everybody else’s retirement accounts. If the masters of this casino are allowed to keep their winnings while the taxpayer absorbs their losses… If they come out of this crisis — which their gambling created! — with even more political and financial power than they had going in… Then we are guaranteeing ourselves a true catastrophe in the future.
By comparison, it is “cleaning up the banks’ balance sheets” that is the least of our worries, IMHO.
Is it really true that “authority” is necessary to unwind the ‘too big to fail’? Or, could the “authority” to do so, on a case by case basis, have been granted by Congress with the same efforts made to lobby for TARP 1 or before that, AIG ? If this power had been requested, it would have been less for counterparties and more upfront in my opinion…
I worry that the big issue to get ‘authority’ is just another way to make the jury of the public believe, that all measures taken so far, for the bank system were necessary, and the only choice other than letting the world end? Please let me know.
another theory: people want to short these banks stocks but can’t because (a) they can’t get shares to borrow and (b) given (a) they don’t want to get caught in a short squeeze.
basically they want to make a bet against the banks and shorting financials is not cost efficient now.
a cds spread of 633 bps is not particularly damaging territory by the way. what seniority is this?
To Ben–
I think even with the public’s outrage about AIG bonuses, the whole “alleged” bank bailout is a black swan to the everyday US citizen/taxpayer who in good faith places their trust in the actions taken by our government …how very sad this trust and faith has been breached in such an unfathomable and colossal way!
re: recovery What’s going to eliminate recovery is the crash in demand. Private debt, separate of the banks, is too high. China is now the #1 car market in the world, despite slipping last year, because of a wipeout in US consumer demand. This is a fundamental fact going into the future that bubble inflationist think-tankers, and academics don’t get because they make too much money. And a debt laden younger generation, blocked from career promotion by people forestalling retirement, isn’t going to help. The US consumer is dead.
1) slightly complicated, but basically they cover the difference between par value and recovery value. to determine recovery value i believe the process is that they see where the bonds are trading after bankruptcy to get the market’s opinion of the recovery value.
i don’t know the answer to 2.
simon, rather than looking at CDS spreads, which are subject to a lot of technicals, have you looked at bond yields? are you coming up with the same conclusions?
Totally unrelated to the content of your post, but Simon, I have to say, I am surprised at your pop culture reference in the title.
Wow. I liked the WSJ article–and the concept of the government implementing its potential new authority on large scale all at once has appeal but months of market turmoil and substantial disruption–how much more can we take? I guess telling people in advance–to prepare–is one way. These big corrections are painful…
Simon,
The GS/AIG example (in the beginner’s guide) of CDS prices reflecting an insider’s knowledge of conditions not available to the market at large brought to my mind Roald Dahl’s story “Claud’s Dog: Mr Feasey”. A couple of small-time hustlers try to cheat the bookies at a dog track by placing small bets so as not to move the price. But the instant the bookies recognize the scam, the odds jump by 67%.
Could the sudden large movements in CDS spreads before bad news becomes public indicate a similar realization on the part of issuers that their buyers are up to something?
In the story, the would-be scammers end up with a fistful of worthless betting tickets that no one will redeem; the bettors are out their stakes, let alone their winnings. In real life, it may not be so simple to say who has been scamming and who scammed, but that may not matter if none of the bookies is *able* to pay off.
Nemo,
Since you like to look at the current crisis through a morality lens, I’ll ask you a very simple question.
What is your priority – the suffering of billions of people as a result of this global financial crisis or your concerns above?
Here is my take:
Fixing this crisis as quickly as possible is the first priority. Fixing the whole system so this crisis doesn’t repeat is important but nonetheless secondary priority.
Yup, I agreed. Our government’s monetary policies and regulatory agencies failed us very miserable. Very few foresaw this colossal failure. It is what we don’t know and don’t expect that really hurts.
On the other hand, I still have a lot of faith in this country. Just from history, this country tends to get stronger through past crisis time and again. In a way, “survivable” crises are very good to have because they expose our weaknesses. We fix our weakness and get stronger as a result.
I strongly disagree with Simon’s idea presented in the WSJ.
The global financial system is a giant domino set opaquely interlinked with derivatives. Many of the financial institutions are already significant strained. To blindly hope that knocking down a few of the main dominoes and the side affect won’t take down the massive swath the global financial system is very foolish. The only difference between this and Lehman Bros is this will many times worse.
We need to take risk, take calculated risk.
The one possibility that can lead to a lost decade is the current crisis is global crisis (unlike Japan in the 90s).
I wonder if this is actually the bigger obstacle to recovery than cleaning up the banks.
Bah. The better plan is to eliminate ALL “too big to fail” institutions. Bust the Trust and make a lot of “too small to bailout” institutions.
Ben, I reject your premise that saving the financial system requires saving its most disgusting institutions.
If I accept your premise… Well, my answer does not change. Let them fail anyway. I strongly believe in “millions for defense; not a penny for tribute”. (Inflation-adjusted millions, of course).
I recognize that not everyone agrees with me. So, when do we vote?
Sovereign Wealth Funds and non-US banks. HTH :-0
Nemo,
“If I accept your premise… Well, my answer does not change.” – Nemo
Hmm, your mindset is the suffering of billions of people is less important than retribution.
You’ve falsely conjectured my premise. What is the logical relationship with what I wrote in the previous post and your conjecture? All I cared is we make getting out of this crisis the first priority.
Lastly, if you can’t bring yourself to answer my very simple priority question, you really should look deep into yourself with your morality lens.
Helpful, thank you.
I support the GM model for the banking system. Swift, certain and decisive. Standing on the sidelines while the the market manipulators muddy the waters is only making things worse. As you have written, — and we are watching — there is an oligarchy, and they are going to win. One way or another.
Again, thank you.
Ben, if there is no relationship between your post and my conjecture, then there is also no relationship between your post and the original article, and every one of your dozen comments is off-topic.
Put another way, if you are not arguing for bailing out the existing banks — to “prevent the suffering of billions”, naturally — then you are not actually arguing with me. Or anybody else.
Feel free to have the last word.
I don’t agree with your desire for retribution trumps the suffering of billions.
Another possible interpretation for the CDS price spike could be that many CDS sellers have lost so much money that they stop selling CDS all together. This leads to drastic reduction in supply and therefore price adjusts.
What does the trading volume look like for the last 6 months? What is a good way to determine the supply of CDS?
Just wanted to add that CDS requires sellers to put up collateral when bond price drops. This has to tie up a lot of capital that in normal times would have went into writing more CDS.
Lost in all the erudite econospeak, are the social implications. You do not need to be a London School of Economic’s doctorate to recognize that Geithner, Summers, Bernake and the entire Obama economic team are Wall Street insiders largely responsible for conjuring, cloaking, and profiting from the economic crisis. Further it is glaringly obvious to anyone who bothers to make even cursory examinations into these complex issues, that the Giethner plan, the PPIP is an overt heavily onesided give away to the thieves and swindlers on Wall Street who are responsible for the worst economic crisis since the great depression. The “Black Swan” should be essential reading for every American, and every economist. What you are failing to factor into your calculus is the human element of this crisis.
While hedgefund managers, bankers, and bondholders would be forced to put off that second yaught or villa purchase if the FAILED banks were nationalized and the criminal oligarchs disbanded in an orderly manner, – the rest of society is facing the harsh reality of informing your 17 year old daughter that affording a college education is simply no longer an option, or worse for many of us in the lower economic strata, adequate food, clothing, and housing are no longer a certainty, and the entire family could end up homeless living in a tent city. As these brutal realities become more pervasive (and they are every single day as the Obama government bailsout FAILED banks and FAILED managements bruting FAILED models with our taxdollars) ever expanding populations of people grow more desperate. Desperate people do desperate things.
There comes a time, and this moment is perilously near, – when the abused (poor and middle class Americans) are pushed a point of such dire desperation by abusers, (the finance oligarchs, the socalled regulators, and thier enablers and apologists in the government) that desperate and violent actions are the only viable options left for the abused.
There will be blood, a reckoning and a balancing. Factor that calculated risk into your baseline scenario.
Yoo Hoo !!!!!! Ben, Nemo!!! I lost my entire pension over here – Norway – over this nonsense…I actually have a chip in the game. I would like BOTH…retribution and suffering. I would like the americans to suffer their way over to their bank and wire me the money that was stolen from my pension fund. A lot to ask, I know. I shouldn’t feel so bad I guess, at least i’m not a 9-year old child laying dead in the street in Baghdad. I guess I should stop complaining, huh? At least the americans spared my life. I guess i’m fortunate that all they did to me was steal 30-years worth of pension savings. I should proably start looking at it that way….at least they didn’t kill me….ya know? Hey, did they ever come across any of those WMD’s over there in Iraq?
Finally, a clear thinker (but not much of a speller)
AA
Market Failure for lack of regulation, Invisible hand blamed for financial crash and spiraling death of a star
An unregulated business cycle falls on a pattern of steep booms or expansion,growth and proportionally equivalent steep busts or contraction ,recession, that can lead to a deep depression, the recovery cycle being directly proportional to the size of the initial boom. The final result of the end cycle of the boom is a shift of market power balance, the rate of change in capital accumulation, a shift of purchasing power because of the shift of wealth ,a redistribution of wealth, a concentration of aggregate supply and financial assets in a few hands and an equally inverse diminishing of aggregate demand that is worsened during the bust by a shift in value, assets lost value, fall in real estate prices, salaries ,etc. lost value of Bank financial assets freezes Banks, that increases more the concentration of aggregate supply and financial assets and catastrophically worsened by a government supply sided financial bailout that increases even further the concentration of aggregate supply and financial assets therefore exterminating aggregate demand , creating a freezing or stagnation because the falling rate of profit begins at the lower end of the market distribution chain therefore crashing distribution by finally exterminating aggregate supply also and eventually forcing government to finish the cycle according to the Eisenhower complex scheme or Spiraling death of a star. In order to avoid this a government demand sided approach should be used.
The problem is fictitious capital if it never existed and is the result of over valued assets because of a market manipulation by speculative gambling strategies that artificially inflated and drove up the price or value, inflating the bubble, you cant restore its original value unless you repeat the same cycle that pushed their false value during the boom.