Tyler Cowen, co-author of a prominent independent economics blog, has an article in The New York Times explaining “Why Creditors Should Suffer, Too.”
What the banking system needs is creditors who monitor risk and cut their exposure when that risk is too high. Unlike regulators, creditors and counterparties know the details of a deal and have their own money on the line.
But in both the bailouts and in the new proposals [for financial regulation], the government is effectively neutralizing creditors as a force for financial safety.
I couldn’t agree more (except for the bit about the regulatory proposals, and that’s just because I haven’t read them closely). We need creditors who will pull their money or demand tougher terms from financial institutions that are doing things that are either too risky or just plain stupid; that’s theoretically a more efficient and cheaper enforcement mechanism than regulatory bodies.
Back in the early days of the Clinton administration, James Carville was credited with saying something like this:
I used to think that if there was reincarnation, I wanted to come back as the President or the Pope or as a .400 basball hitter. But now I would like to come back as the bond market. You can intimidate everybody.
The story back then was that bond investors, by buying or selling Treasury bonds, could lower or raise the government’s cost of borrowing and interest rates across the economy, depending on how they felt about government policy.
Today bond investors have discovered a much more direct lever over government policy. I’ve already written about the importance of bondholders in dealing with the financial sector. This week we are seeing their power over the auto industry.
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?
Posted in Commentary
Tagged banks, bonds