I want to pick up on a theme Simon discussed in his last two posts: the recent panic over bank debt, particularly subordinated bank debt. I’ll probably repeat some of what he said, but with a little more background.
Remember back to last September. What was the lesson of Lehman Brothers? The most important asset a bank has is confidence. If people are confident in a bank, it can continue to do business; if not, it can’t.
For the last six months, where has that confidence been coming from? Not from the banks’ balance sheets, certainly. And not, I would argue, from the dribs and drabs of capital and targeted asset guarantees provided by Treasury and the Fed. It has been coming from a widespread assumption that the U.S. government will not let the creditors of large banks lose money, out of fear of repeating the Lehman debacle.
The story goes something like this. 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?
This is why, for the last five months, the government has been doing everything it can to imply that bank creditors (at least for “systemically important” banks) will be protected, without saying so explicitly, because that would suddenly increase the potential liabilities of the government by trillions of dollars.
So what changed this week?
Simon’s theory is that the semi-forced conversion of Citigroup preferred into common shares was taken as a sign that the government may try to force creditors to exchange their bonds for common stock in future bailouts. Preferred shares are not, technically speaking, debt. But they are a lot like debt, and once you finish converting preferred into common, the next layer of the capital structure is subordinated debt. Now, Tim Geithner could come out and say, “Yes, we forced a conversion of preferred into common, but we’re going to stop there and not do the same to creditors.” But no, actually, he can’t say that, because that would constitute an explicit guarantee of all bank liabilities. So the market is left wondering, and we know by now that markets don’t like uncertainty.
Another possibility is simply that more and more people are thinking that the government may end up restructuring debt. Martin Wolf and Willem Buiter, both very serious people, both have raised the question of whether the government should be protecting creditors. Wolf, I believe, doesn’t answer the question (although he discusses the issue very well); Buiter says no.
Each time the lines on that chart above have spiked upward, the government has taken some action to imply that creditors will be protected, without making any promises. Chances are we’ll see another action along those lines. At some point, though, the government may lose credibility.
As an aside, one of the steps in Sweden’s sometimes-heralded bank rescue program was an explicit government guarantee on all bank liabilities. If any country could guarantee its banks, you would think it would be the U.S. But the real barrier to taking such a step is probably political more than anything else.
Update (3/8): Krugman says:
[S]ome decision must be reached on bank liabilities. Sweden guaranteed all of them. If forced to say, I would go the Swedish route; but of course we can’t do that unless we’re prepared to put all troubled banks in receivership. And I’m ready to be persuaded that some debts should not be honored — this is a deeply technical question.
The Baseline Scenario 
You might be interested in a parallel discussion going on at Mark Thoma’s blog which riffs on Krugman’s latest op-ed.
http://economistsview.typepad.com/economistsview/2009/03/paul-krugman-the-big-dither.html
(I added my 2 cents there, as well as citing this discussion later in the thread.)
Sir
I left a post similar to this on another article on this blog but never did get a reply.
This blog –
http://blogsandwikis.bentley.edu/themoneyillusion/
makes the argument that a bit of inflation now would be very helpful. The author is a serious man – he is not arguing for a lot of inflation – but rather for decisive action by the Fed to change the current deflationary expectations into inflationary ones. He says – and I agree – that doing this is actually more important than the bank recap – because without doing this even a big bank recap might fail again.
One does need to go so far as this to see that a bit of inflationary expectations – and really decisive statements and actions by the Fed would sure feel good just now – as we might get the idea that we are not just doomed doomed doomed – as Roubini just keeps telling us – over and over and over – with some evident pleasure.
My point might not be relevant, but I’d like to try again. Forgetting the shareholders, etc., for a moment, what is Citi’s plan going forward? I’ve referenced a number of stories from Reuters that they plan to sell off major holdings, but keep Banamex. A figure I’ve read for Banamex is $12 to $15 Billion Dollars. How much they could get for Monex, Nikko Cordial, etc., I haven’t read. However, we are going into a depression. Many businesses might not make it. Citi’s plan, just like AIG’s, was essentially to get a bridge loan from the government to get through this crisis, and repay the money in the future when they can get a better deal for these assets. But what happens if that strategy blows up? It might be better to sell these businesses now.
What I’m asking, in other words, is whether or not Citi’s assets will ever be worth enough, going forward, for anybody to get anything from them? If the government is having to subsidize these assets, can we be sure that they aren’t already clearly a major loss?
If we are not really trying to save Citi, but insure investors or creditors of Citi, why not negotiate with them directly, acknowledging that they have us by the short hairs? It won’t be a very pleasant realization, but at least we’d be attacking the problem directly and telling the taxpayers the truth.
I believe – and I think Simon has said this on this blog or elsewhere – that a little bit of inflation, and certainly positive inflation expectations, are a good thing. So, if inflation expectations are actually negative, like they were a few months ago, then the best thing the Fed can do is to make them positive.
However, I don’t think there’s much ammunition left in that gun: I think 5-year inflation expectations are already back up to about 2% per year. So then the question becomes what level of inflation expectations you are willing to tolerate.
James, you are spot on here, but I see this playing out over a much longer time horizon. It is a lot easier for the U.S. government (politically speaking) to back all liabilities (and/or nationalize the banks) slowly and over a protracted timespan. It will definitely be worse for the economy, and will surely be the last goose flying home for the Kondratieff winter we are headed into, but for political survival it may be the only way.
Respectfully:
Against the question of “how much inflation does one tolerate?” we must also pose the question:
“How much debt can the US economy swallow to prevent inflation while stimulating the economy?”
Our GDP is 14.5 trillion in 2008. We are piling on an extra 13% of GDP onto debt (1.7+ trillion dollar deficit), when our GDP is shrinking at an annualized 6% rate. That will take our debt to GDP ratio to between 85% and 90% of GDP by the end of 2009.
That doesn’t even begin to cover demographics through 2040, private sector debt, or recent wealth destruction.
So the real question is, what are we more afraid of: debt, or inflation?
(Also, the Fed has plenty of weapons left. Simply no will to use them.)
IMO, look to the G20 in April as the last best hope. If the G20 come out with detailed targets on monetary expansion, hallelujah. We are saved.
If we get what we got last G20 – vague promises about “working together” and “consulting one another”, the market will tank and with it the global economy.
Again,
Protecting creditors leads to ex ante incentive problems for banks to make risky loans. (NINJA loans to subprime borrowers are an example of such risky lending.) This is touched on in http://ssrn.com/abstract=1321666 and http://ssrn.com/abstract=1336288. In those papers, the government bailout is why the counterparty or creditor, Bank C, lends to the bad bank, Bank B, and funds their toxic mortgage loans.
Why doesn’t anyone ever admit that un-backed fiat paper currency, a Federal Reserve Bank that has a government monopoly on the creation of money out of thin air, the clearly fraudulent fractional-reserve banking system, massive federal government intervention in the economy, and gargantuan federal debt, is the real problem in this country?
People can discuss interventionist minutia until the cows come home, but until people acknowledge that the federal government is the problem, not the solution, we will play out never-ending tweaking of various aspects of the economy forever, as we slide into oblivion.
What is keeping banks alive right now is not the prospect of a Treasury bailout. It is the FDIC guarantee on new issues of bank debt with a maturity of 3 years or less. The run on Lehman and Bear Stearns were caused by short-term creditors bolting. Market participants will continue to lend to zombies as long as their debt is backed by the full faith and credit of the United States. I am uncertain how long the government can keep extending its good credit history to insolvent banks before these liabilities become too great for even the US government. There are, of course, perverse incentives created by the FDIC guarantee also.
I think that there is a compelling case for an induced bank run on insolvent banks so that new good banks can be created. Bank runs should be a sort of euthanasia, played by market actors, for certain bankers. Provoke orderly and systematic bank runs to solve all problems and create de facto good banks.
I would be willing to tolerate inflationary expectation that are a bit higher than expected. The normal expectation – the one the Fed targets as I understand – in 3% growth + 2% inflation. The author of the blog actually wants to target nominal GDP growth – at 5%/yr. We are clearly far below that. Convert that into a price level target and target the level. Make the target explicit. Greg Mankiw put it in that way on his blog – asking for a price level target rather than a rate target – after talking to the author of the blog as I understand. In x years from now the U.S. price level will be y – and we the Fed will make sure it happens. No doubt and no fudge. Something that will make the national and local news. Something everyone knows that everyone else knows the Fed can do – even if they have to act alone. That cash in your bank account will be worth x% less in y years. Better to spend it now than to sit and look at it. Translate expectations into spending.
I would be willing to tolerate inflationary expectation that are a bit higher than expected. The normal expectation – the one the Fed targets as I understand – is 3% growth + 2% inflation. The author of the blog actually wants to target nominal GDP growth – at 5%/yr. We are clearly far below that. Convert that into a price level target and target the level. Make the target explicit. Greg Mankiw put it in that way on his blog – asking for a price level target rather than a rate target – after talking to the author of the blog as I understand. In x years from now the U.S. price level will be y – and we the Fed will make sure it happens. No doubt and no fudge. Something that will make the national and local news. Something everyone knows that everyone else knows the Fed can do – even if they have to act alone. That cash in your bank account will be worth x% less in y years. Better to spend it now than to sit and look at it. Translate expectations into spending.
Mike Woodford has made it very clear that a critical part of the work of the Fed is communications – setting expectations, I do not think they have done a good job on that at all. They should surprise people by stating that they are willing to tolerate an inflation rate somewhat higher than we had thought they were willing to tolerate – and that they are in fact determined to get that rate by targeting not a rate but a level. Too low a rate this quarter and we will redouble our efforts to make up for the slow rate next quarter. A target level – no matter what they have to do – most certainly buying long bonds or tips or foreign bonds if they have to.
Lehman crashes. Citi, in a custodial capacity, is holding $138 billion in bad Lehman paper. The NY Fed’s Geithner funnels $138 billion to JPM. JPM no longer has the $138 billion. Where’s the money?
More Americans Are Saying No to the FED & the National Debt!
Washington has bailed out the banks, Wall Street & their Washington special interests and much of the cost is added to the national debt to by paid by this and future generations while real estate and investments continue to fall. Find out what a growing repudiate the debt movement could mean for treasuries, the dollar, gold and the stock market.
The Campaign to Cancel the Washington National Debt By 12/22/2013 Constitutional Amendment is starting now in the U.S. See: http://www.facebook.com/group.php?gid=67594690498&ref=ts
Might it not be plausible that this indecision is consciously politically motivated? Nationalize (and re-privatize) now, during what seems like a period of calm (compared to September anyway), and be effectively branded a SOCIALIST (the horror), or wait until everyone, including the Republicans, are begging for it, and create the appearance (perhaps even accurate) of having been forced into the decision unwillingly.
Of course, then you have to hope against hope that the American voters can actually remember that chain of events until the next election. And you have to hope that the Republicans will buckle eventually, rather than just let the whole train wreck play out to great effect.
Is it possible to offer holders of debt a deal to switch into new debt in NuBank after taking a suitable haircut, but with some limited conversion rights into, say, equity that in time and given a fair wind might see them whole again? I’ve seen amazingly inventive schemes from VCs to suit almost any investors’ needs. Maybe such a scheme could to be proposed as the way to keep nervous creditors in play as each institution is restructured. Once the boundaries are defined and accepted the players just have to concentrate on maximising their positions which moves the game forward and removes some element of uncertainty.
James,
Are you starting to worry about the effects of all this on insurers? David Goldman thinks that the insurers could take a huge hit if the preferred’s are nuked by the govt. See:
http://blog.atimes.net/?p=675
http://blog.atimes.net/?p=669
http://blog.atimes.net/?p=661
He thinks the capital structures are too tied up to separate them. I had always thought that insurers were restricted to safer investments (er, how ’bout them muni’s?) than that, but perhaps I’m wrong?
Thoughts?
Cheers,
Carson
There seems to be the beginning of a shift in Fed thinking–or at least a public outlier. See this speech by Thomas Hoenig, President, FRB/Kansas City, entitled “Not to Big to Fail”:
Click to access Omaha.03.06.09.pdf
There seems to be the beginning of a shift in Fed thinking–or at least a public outlier. See this speech by Thomas Hoenig, President, FRB/Kansas City, entitled “Too Big Has Failed”:
Click to access Omaha.03.06.09.pdf
See correction in title below. Sorry for the duplicative post.
Excellent post, James. Question: are there data that support your conviction that banks are net purchasers of the CDSs? This seems plausible to me too, but I’d like to back that up with numbers. Thanks.
A lot of the movement in banks’ CDS spreads this week was due to technical factors. The major dealer banks will start novating CDX contracts onto ICE’s CDS clearinghouse (called ICE Trust) on Monday. The clearinghouse will require higher margin levels, which will reduce the dealer banks’ available cash, in some cases not-insignificantly, as certain dealers carry large inventories of index contracts for their basis trading operations.
The banks are essentially preparing for a large one-off margin call as they move to a clearinghouse next week. This predictably drove up CDS spreads on the dealer banks.
No real mystery here. Don’t read too much into the CDS spread movements.
Buiter also takes on the Lehman Brothers analogy today. (Second half of the post.) Short summary is that he doesn’t buy it.
Obviously Thomas Hoenig has been reading my comments on this blog (smile). He is absolutely right.
“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.”
Bank debt is not safe until the large banks are adequately capitalized. They will not be adequately capitalized until subordinated debt is converted to equity. For the long term, investors SHOULD demand a higher risk premium for subordinated bank debt. The worst thing we could do is have the government in effect guarantee bank debt. We will have metastasized the Fannie/Freddie problem to encompass the entire financial sector.
Who should bear the costs of this debacle? In principle, the issue is settled. First common shareholders, then preferred shareholders, then holders of subordinated debt, then holders of large deposits and last the US Treasury for FDIC guaranteed deposits. What we need is a fast-track, efficient process to make this happen.
The financial markets will behave erratically until what the government will do becomes clear. And the way to assure a healthy financial sector in the future is for the government to do the right thing.
Would Mr. Kwak please identify the sources of evidence from which he draws his conclusions.
“losses would be spread far and wide, hitting other banks, pension funds, insurance companies, hedge funds, and so on.” – how does he know that this will be “far” and “wide” – based on what reports? Are these liabilities published in order to verify this claim?
“The fear is that it will be impossible to predict how these losses will be distributed and who else might go down.” – how can this be verified?
“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. ” – why wouldn’t investors be more confident in lending to the remaining banks if the bad banks were restructure?
For weeks I have been struggling with Geithner’s refusal to reorganize troubled banks and replace existing officers. Other than banks stuffing his pockets, what would explain Geithner’s bizzare handling of the banking crisis?
Today everything became clear. Geithner CAN’T allow BOA, C and others to be reorganized because that would expose the horrific financial condition of these institutions. Once assets are re-valued and derivatives are charged off, there will be little left to break up and reorganize. I truly hope I’m wrong about this, but my gut says otherwise. It’s the only explanation that makes any sense.
Thank you for these links.
Nevertheless, I continue to come across these posts that claim an interdependence among banks and between banks and other financial instutions without any published evidence for their claims to size or scope.
From what published figures are these claims originating?
It seems to me that the giant in the closet that no one wants to discuss is the counterparty risk flowing from randomized derivatives contracts, which may amount to as much as a notional $1,028 Trillion Dollars. The great unknows is who is obligated and how large will the volume of losses actually be. While the CDS market is a part of this, it is actually much smaller level of risk to evaluate.
I work in pension investing, so let me add my two cents about the impact of a debt-to-equity conversion.
Most pension plans are about 60% equity, 40% fixed income. They had drifted up to about 65% equity in the last decade, but had started to edge back in the last few years. By equities, I mean not only stocks, but private equity and hedge funds, too. Of the fixed income, most–not all–assets were managed relative the Barclays Capital Aggregate Bond Index or a similar long investment grade index bond index if they were hedging against their liabilities (which only a minority do). There are some high yield and international bonds in this mix, but probably no more than 7% or 10%, so lets’ say about 33% to 30% of pension assets are investment grade bonds. This index is heavily Treasuries, GSE mortgages, and agencies. No more than a 30% is corporate. I guess that the financial sector is 33% of the corporate market. A conversion of equities to debt would involve about 0.4 x 0.3 x 0.33 = 0.04 of the total assets. Thus, my quick guess is that the direct effect on pension plans would be about a 4% to 5% of assets. This is a bad loss, but since they are unlevered, it’s not catastrophic. The equity market has done far more damage.
The indirect effects could be as large. For example, the cash market would be roiled again. Plans involved in securities lending would be hammered in their cash collateral accounts and cause another round of headaches. There could be other losses I haven’t thought about.
The bottom line: don’t worry about a debt-to-equity conversion destroying pension plans. They are already in trouble.
To return to Kwak’s remarks, “If any country could guarantee its banks, you would think it would be the U.S.” Any idea what the risk to the taxpayer would be of doing this? I suppose the answer depends on whether it restores confidence or whether the current deflation continues. Still, it is worth asking: if marked to market, how many banks are currently under water, and by how much?
I take it that your solution would be to abolish government.
There are three possible situations. No government, totalitarian government, and a mix of government and private sector.
I don’t believe that there has ever been a documented society without some form of government, and I’m quite sure you’re not advocating totalitarianism. So if you choose to deal with reality, and not some utopian dreamworld that human nature can’t handle, you’ll need to figure out how much government we want. And as time change, we’ll need varying amounts of it. Hence the “never-ending tweaking.”
i made the following comment at the article where mr. johnson made the point about a junior debt/stock swap:
terrific commentary. all very, very valuable.
however, the issue raised was what the cds market was saying. simply put, mr. johnson suggested [that the cds market] implied a forced trade from banks’ junior debt into common shares.
I don’t think markets are that precise, esp. when the two objects of the forced trade are in tatters already. both are essentially worthless.
i think we need to look for the message elsewhere, in a less precise, more all-encompassing way.
the broad message, given the nature of mr. johnson’s intoductory remarks concerning the governmental backstop, in my estimation is that the backstop is itself in doubt, that we are in a much more serious situation than even the gloomiest can imagine, perhaps even that a crash is imminent.
and how, do you suggest, do we achieve this?
Well, well, let me see, if only governments would like…:
Besides hitting banks in the stock markets, market participants could stop lending to insolvent banks and depositors start transfer their funds. A kind of collective action which will signal to governments that time is over…If then public and private investors will set up in parallel brand new banks or strengthen existing good ones, business will move from the insolvent banks “too big too fail” very rapidly here you get a run on them…
sodhi
Mark,
How right you are that no one will acknowledge the elephant in the room that you call attention to. Notice how there are no replies to your post other than the one giving three false choices.
People simply continue to discuss the minutia, as in all the following posts; much as generals plotting with their war toys, missing the big picture.
It is just not much fun being reminded that the game being played is nothing but a game, an end in itself.