The only people to profit will be the first one out the door when the building starts crumbling.

1. The nation is the only institution that is too big to fail.

2. The nation has failed.

Precisely. The solution to JK’s concern (“we can’t predict in advance how much capital will be necessary to avert a bank-killing panic”) is to require that all bank debt — aside from deposits — is convertible.

‘Scuze me, wasn’t it the other way around?

;)

Not to disagree with you about hubris, but any investment in equity is a guessing game.

Now, we already have bonds that can be converted to equity — at the choice of the bondholder. They have markets and prices. People believe, rightly or wrongly, that they can evaluate them. If we have bonds that can be converted to equity at the choice of the issuer, that choice is worth something, and presumably such bonds will have markets and prices, as well. People will believe, rightly or wrongly, that they can evaluate them, too. (After all, markets self-correct in the long run, right? {hehe})

Now, CoCos are not simply convertible at the choice of the issuer, so they should be worth more than bonds that are. There should be markets and prices for them, too. :)

Consider the alternatives. First, if the issuer goes bankrupt, bondholders lose a lot of money, as a rule. They get pennies on the dollar. If their bonds have been converted to equity, they lose everything. OTOH, if the conversion of their bonds manages to save the issuer, they will do better, and may do better than if they held regular bonds and the issuer went bankrupt. Second, if the issuer is bailed out, from the point of view of the society, better that the bondholders do the bailout than the taxpayers, and if the taxpayers do a bailout, better that the bonds are converted to equity.

Yes, the buyers of CoCos may be fools, but better that they take on the risk privately than socializing it. :)

This does not work in the finanical servers sector because if a firm declares bankrupty it becomes worthless immeadiately because of the nature of how how banks work.

This puts the government is an impossible situation where they either have to bailout bond holders or let systematically important firms fail, taking out the economy with them.

Contingent capital greatly increases the government’s ability to make debt holder pay for some or all the the bailout, and really just makes bank failures equivalent to non-bank failures.

But wouldn’t it be more appropriate to take out the Too and To from the acronym to make it into…

BF = too Big to Fail

…thereby hightlight BIG and FAIL?

Just a thought…

Anyone holding the bonds of a bank holding company should be aware of this risk. It is exists now, it existed in September 2008, it existed when Continental Illinois went down. That the government refused to use an existing system of resolution designed specifically for the contingency of excessive debt should give some clarity on the government’s willingness to do so in the future.

Shareholders in big finance companies were not given billions of federal gifts because the federal government was bound to do so. They were given the gifts because the federal government chose to do so. It had plenty of other options. An alternative to the bailout regime needs to find a way to avoid the government making the choices it made, not to introduce yet another alternative it will not choose.

If Continental and LTCM were TBTF, what good would it do to break Goldman up into four separate $250 billion institutions? That “policy proposal” (and I use that phrase loosely) from Simon Johnson is based on the fact that Goldman had around $250 billion in 1998 — but he fails to address the fact that Goldman was TBTF back in 1998 too! What a joke!

Neither Kwak nor Johnson can or will address these incredibly simple objections to their so-called “proposals,” because they’re not interested in having a real debate on TBTF. They’re just interested in being quoted in the press and having the rest of the blogosphere worship them.

If you’re not willing to offer a concrete proposal, or to address blindingly obvious problems with the “break up the banks” idea, then shut up.

p.s. James — if you can’t think on a much more granular level than this, then you’re going to have a very tough time getting a job at a good firm when you graduate. Just FYI.