Making Creditors Suffer

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.

Cowen also has an accurate read of the current situation:

This poses a very difficult public relations problem for the government, because the Federal Reserve and the Treasury do not want to discuss the importance of the creditors too publicly right now.

Why not? It would be bad precedent, and mind-bogglingly expensive, to promise to pick up all future obligations to major creditors. At the same time, any remarks that threaten to leave creditors hanging could panic the markets. So silence reigns.

Or, there’s an implicit expectation that creditors of large financial institutions will be protected, but that expectation periodically wears off and has to be bolstered by some confidence-boosting measure, but that measure can never be an explicit guarantee . . . and so on.

Cowen has some suggestions for how to fix this problem in future regulation. But what should we do right now? As long as the ongoing, ever-changing bank bailout leaves existing entities (a) under current ownership and (b) out of bankruptcy court, no force on earth can make the creditors suffer without their consent. So either we need to accept that creditors get a free pass this time, or we need to relax one of those constraints.

By James Kwak

37 thoughts on “Making Creditors Suffer

  1. James,
    I liked your last post “Be Nice”. Silencing the critics? And whats next James? Burning books? James I’m very sorry if these truths many of us tell hurt your feelings….awwww. But, they remain truths, no? Or do you feel that we should hide how we really feel about the recent collapse, AND THOSE WHO WERE RESPONSIBLE. Man up James…..grow a backbone.

  2. adios amigos: Whoa there Tex! How do you get to book burning from “be nice”? In my view it’s perfectly for James and Simon to insist that people be polite in their house, and this site is, in a sense, their house. You’re a guest, so behave accordingly.

    Back on topic: Maybe I’m deluding myself, but based on Geithner’s and Bernanke’s testimony before Congress, it’s clear to me that the lawyers have told them that they have no authority to impose haircuts on non-banks (e.g. big chunks of Citi). I’m somewhat hopeful that the administration is setting-up a bait and switch. Without the legal powers required to force receivership of the non FDIC regulated pieces of, for example Citi, the only option is to convince the world that they have a ‘get out of jail free’ card (i.e. no systemically important institution will be allowed to fail), otherwise we get Lehman, only an order of magnitude worse. Since Lehman’s blowup stopped the world economy for a week or two it’s probably not a good idea to repeat the experience on a larger scale. However, I’m hoping that once the new resolution powers are put in place, the administration will take a different tact and start imposing haircuts on creditors.

    If they get the powers and don’t use it almost immediately, then I’ll give up all hope and join Simon in the “the oligarchs have won” camp.

  3. Point of clarification: of course I meant impose haircuts on Citi’s (or whichever financial firm you want to pick on today) creditors/counterparties, not Citi itself.

  4. James:
    I am wondering why you think that remarks which remind creditors that they are responsible for the consequences of their decisions would panic the markets. To me, this suggests that the markets already have the expectation that creditors will be protected. If so, I think we should ask ourselves why as well as try to put an end to it so more creditors are forced to be diligent in making and monitoring their investments. I don’t think giving a free pass this time is a good option. This is becoming slippery slope.

  5. To the extent that the creditors are:
    1) Insurers ( We’ll bail them out )
    2) Pensions ( We’ll bail them out )
    3) Countries ( We’ll pay them much higher interest )
    4) Holders of large amount of US credit ( The might help cause a stop )
    we’re in a bind here. For now, I’ve said game over. At the very least, a huge haircut or default in the current situation would have real negative consequences.

    I’ve said we should move on and use our energy to reform the financial system going forward. If the opportunity arises, and we’re not shooting ourselves in the foot, I’d be the first person to favor the creditors eating the losses. Not because it won’t have negative consequences, but because taxpayers eating the losses has more negative consequences.

    I believe that William Gross takes the opposite view, and feels that it’s better for the taxpayers to take a hit in the long run than creditors, who are essential as investors in our markets. It’s a defensible position, but I disagree. I could also be misunderstanding him.

    Everything depends on the assumptions that you make. I assume that we can’t yet seize the large banks or put them in some kind of bankruptcy. After all, we seize banks.

    If we become majority shareholders and run the banks, I believe that we’ll then be on the hook to the creditors. I could be wrong.

    So, we’re in a bind. I’d prefer that we admit it and get on with it.

    By the way, if we’re going to have a Lender Of Last Resort, I don’t see any way to rule out intervention in a financial crisis. That’s why I favor narrow banking and a penalty for the increasing size of banks, and a very rigid application of Bagehot’s views, in which we apply moral hazard quickly and consistently. Of course, people have been saying that they’re committed to his views since he expressed them.

    Also, to the extent that bondholders are people who have loaned money to US businesses, I don’t think that it’s a great idea to call for their heads. It’s enough to remind them of the risks involved in investing. Oddly, I’d like investors to keep investing in the US. Oddly.

  6. Pat,
    I do get carried away from time to time. But I feel that few if any of you are facing the reality of the situation you find yourselves in over there in the US. In short, you are borrowing yourselves into insolvency. That’s the real, reality of it all…isn’t it? Your fast headed off a cliff here, and to what end? Your country is about to undergo some massive changes, and in the end, you will come out the other side, no doubt. But you’ll be saddled with massive debt, that will be to the detriment of not only you, but your kids and their kids too. And for what? To bail out predominantly those who caused the problem in the first place? Screw them, they gambled and lost. If you lose in Las Vegas, does the Casino give you back your money? My prediction? If you continue down this path those in Washington are suggesting, you will collapse as a nation. With your GDP now headed back to reality, and your collective debt loads now pushing up past 350% of GDP (all in), are you still thinking this will actually have a happy ending…I mean…do you really think that? Your top markets are collapsing. Who knows what GDP (actual, not the nonsense from DC) will really look like in 18-months. BUT that new massive debt will still be there. Not to mention the runaway inflation that is right around the corner. Is this all really worth it to bail everybody out? What happened to doing what is right for the masses?

  7. One thing that is surprisingly not discussed is a cap on excutive pay not by fiat but simply taxing wages at a 91% plus rate. If the major Corporations want to give excessive wages to executives, fine most of the wages can go to financing the US government. wealth. Simon Johnsons article in the Atlantic was quite revealing. One likes to think as ones own state as more advanced than it is but in fact in many ways in regards to health, education, life expectancy, income distribution etc. so its not surprising that US politics is very third world in nature.

  8. Things are actually a lot better for US than most countries. The reason is the US dollar is the global currency. When the US borrow, it is in US dollar (i.e. foreigners buy US treasury bills denominated in dollar). The punch line is the US owns the printing press for US dollar.

    Besides, if you look at the US debt to US GDP ratio, it is actually way better to than European countries.

    US insolvency is not in the cards. However, there is the possibility of inflation. Here I’ll give you a philosophical answer. It is not what we know that will hurt us. It is what we don’t know. Inflation threat is well know and we are way early (at least a few years before we recover from this crisis). I am not worry about inflation. There is probably something else down the road that no one has recognized yet.

  9. Oh, once and for all, can’t America get some backbone and stop trembling before the terroristic threats of the “market”?

    It seems clear to me if people would just rediscover the old will to freedom we could solve this today by declaring that since the FIRE sector always wanted to exist outside the law, we place all of its contracts outside the law (and we’ll certainly never “bail out” any in the future).

    Then, whatever short-term economic medicine we had to take (and what we’re already taking is pretty bitter; it’s not like we could be “losing” much more), we’d be out from under the main obstacle, and we’d be assured it would not arise again in the future.

    So why not “Just Do It”, as one of their own branding ideology slogans puts it? At bottom, is it because people then still ask, where’s the next bubble going to come from to enable more debt for more SUVs and Mcmansions (maybe not in those exact terms, but that is the basic sentiment)? Other than that, I can’t imagine what anyone thinks he’s trying to prop up here.

    This is a malevolent addiction like any other, and it needs to be broken like any other.

  10. I tend to agree with Ben. There are things worse than inflation, for example: Deflation. Lets remove deflationary risk,which seems more likely during a contraction of a developed economy with an aging workforce, THEN we can worry about inflation.

    Printing a little money could do some good, despite the teleological angst it causes many people.

  11. Whoops, different Patrick’s there. I didn’t realize there was another poster using that name.

  12. Here’s a nice illustration of when creditors should get a haircut, if not the guillotine:

    “As with the phony reinsurance contracts that AIG and other insurers wrote for decades, when AIG wrote hundreds of billions of dollars in CDS contracts, neither AIG nor the counterparties believed that the CDS would ever be paid. Indeed, one source with personal knowledge of the matter suggests that there may be emails and actual side letters between AIG and its counterparties that could prove conclusively that AIG never intended to pay out on any of its CDS contracts. “

  13. And my correspondence with the author, in case you’re put off with his reference to the Takings Clause, discussed here:

    “Superb article.

    Although in a world of finite resources, giving to Peter is taking from someone, it is a stretch to call Treasury’s actions a Constitutional taking. The fact that these were sham transactions is enough for a Bankruptcy Court to void them and go for clawback of the loot. The Supreme Court has not expanded the Takings Clause to allow taxpayer class actions, although a logical case could be made. It’s up to Congress generally to police a corrupt or inept treasury department.”

    >”Good point.”
    rc Whelan

  14. A lot of the problem here, I think, is with the dependence of large pools of funds, such as pension funds, sovereign wealth funds, etc. to rely on ratings agencies for their judgments, instead of developing their own. Funds determine an asset allocation based on an historical asset-liability analysis, and use a broad index of bonds for this effort. “Risk” in this world is not the impact of holding bonds that may be downgraded or default, it is performance against a benchmark, or worse, peer groups. Financial sector bonds are a big part of the index, so not holding them in this world is risky; you can see the dangers of this approach.

    Most big banks today are investment grade because 1) the system would melt down if the ratings reflected reality, as funds strictly limit holdings of bonds in junk categories and 2) the agencies presume the government will protect unsecured creditors in these institutions. Any regulatory proposals need to consider the role of the ratings agencies; in particular their business model needs to change so that they are not paid by the entities they analyze.

    Finally, for all the focus on regulating hedge funds, this crisis has been the crisis of “real money” not the leveraged players. Bond managers to a large degree attempt to outperform benchmarks by outyielding them instead of undertaking analysis that would prevent their funds from experiencing absolute losses. A way needs to be developed to encourage them to hire more analysts to reduce their use of the ratings agencies “crutch” and changing their incentives to reflect absolute rather than relative returns.

  15. Tom,

    I think the potential for panic exists when it comes to creditors of large financial institutions. The fear is a repeat of the Lehman scenario: if one large bank goes bankrupt, its creditors and counterparties are left with losses, and some of them may go bankrupt, etc. That said, this is a problem that we created ourselves. Ever since Lehman, the “no more Lehmans” strategy has been so evident that bank creditors – who, back in September, understood that they might lose their money – now think that the government will protect them. If that overconfidence were to be eliminated, then they might panic.

    I think that the regulators who have access to the right inside information should have taken the last several months to analyze what would really be the ripple effects of a major bank going bankrupt. Who knows, maybe they have.


  16. Quite right. It’s amazing that at this point the ratings agencies are looking like they’ll come out of this unscathed. So many written contracts with ratings triggers has outsourced most of the investment judgment and provided for an amplified the cascading effect to any ‘credit event’ throughout the financial system.

  17. What is wrong with a little deflation? Prices are way too high for everything. Companies can make profits on much lower prices. Landlords can be profitable on much lower rents. Why is there always a need to have prices for everything go up year after year?

  18. Let the creditors suffer. Then you will see enormous pressure to (re)regulate, prosecute, and “throw the bums out” of Congress. And the future will be filled with people and institutions who perform adequate due diligence before becoming creditors.

    Any other avenue is immoral.

  19. Houses depreciate.

    Only inflation makes people expect a capital gain after 25 years.

  20. Again, it’s about assumptions. After Lehman, what I saw was a Calling Run, the first stages of Fisher’s Debt-Deflation Spiral. In order to stop it, the government needs to guarantee everything, hoping, of course, that the guarantees stop the panic and allow for an orderly unwinding of losses.

    As near as I can tell, the government has been doing that without saying so explicitly. But only the government can stop a Calling Run, because only the government has the resources to be believed that it could backstop the run. It’s akin to FDIC stopping a bank run.

    Short of those guarantees, investors will continue in the Flight To Safety, with no natural or predictable stopping point. Pure dread man.

  21. Things are not as bad as they seem.

    We don’t have massive bankcrupcies yet as compared to the Great Depression.

    Shall I call it YET – or are US companies actually resilient, and the economy that goes with them?

    As to government bail-outs and creditors at risk but can’t be guaranteed explicitly by the government:

    While not create an FDIC sponsored and guaranteed Public-Private Bank?

    The Public-Private Bank will provide the monetary assitance as stock investment to financially distressed companies including companies in all other sectors of the economy.

    A wholistic approach rather than the specific targeting bail-outs of the FED and Treasury that only result in public outcry and demorialize those companies that are non-bank or non-financials.

    It is a much more palatable though a dobious proposal.
    But since the FDIC is in the business of making guarantees; let them guarantee investors’ “deposits” into the bank with minimum 5 years holding period with no guarantee of profit. Some profits can be generated by buying short-term treasuries with those deposits and withdrawing them as needed.

    Likewise, any capital gains and dividend gains after 5 years that are proportionally accumulated among “depositing” investors will be exempt to any government tax or fees.

    The government will make money thru their own share of the Public-Private Bank and the resulting higher tax collection as the economy recovers.

  22. “What is wrong with a little deflation?”

    A little deflation caused by increasing productivity is not bad. A lot of deflation caused by a self-reinforcing demand crisis is awful.

    Try googling “why deflation is bad” – there are a lot of answers.

    Here is an example link…

    “If you are a borrower, you are contractually committed to making loan payments that represent more and more purchasing power — while at the same time the asset you bought with the loan to begin with is declining in nominal price. If you are a lender, chances are that your borrower will default on your loan to him under such conditions. And it’s not just debtor/creditor relationships: any long-term contract for goods or services denominated in nominal dollars will have the same problem.

    The entire economy suffers from the cascading dislocations triggered by these defaults. It’s why “bad falling prices” means monetary deflation isn’t just bad — it’s “ugly.” ”

    Gold-standard advocates often defend deflation as “normal” and “healthy”. Historically, major deflationary bouts have triggered dramatic economic dislocations, and often war. Much of the mercantilist policies (high tariffs, manufacturing protection, colonial expansionism) of Europe in the 1600s through the early 20th century was driven by a desire to preserve domestic gold supplies (to help prevent deflation) and to build captured export markets.

  23. Don is 100% right.

    The problem with a run on the banks is that they are self-reinforcing. There is _no penalty_ to a massive draw on liquid assets, and so if there is even the _possibility_ that a run might occur, every individual actor has an incentive to _get out first_.

    Banks, and any entity that “borrows short and lends long”, are inherently vulnerable to runs. No amount of market discipline solves this problem.

    The choices are therefore, allow runs and let the market discipline banks (with worldwide depressions as a normal consequences) or prevent runs through guarantees. If you prevent runs, you need to take steps (e.g. regulation) to compensate for the inevitable moral hazard.

    These, really, are the only two pure options.

    Of course there are hybrid options – our current system is one of them. Hybrid options have their own problems (e.g. failure to completely remove moral hazard). Certainly governments and central banks have tried for hundreds of years to figure this out. The problems we have today are not new.

  24. Along the lines of some what;s said above: Isn’t the extent to which creditors are exposed to systemically important firms part of what it means for those firms to be systemically important? So the magnitude of the haircut imposed on creditors will be the magnitude those creditors are weakened?

    If so, that seems to provide a reasonable explanation for why Geithner et. al. appear to be going to bat for creditors. To me, it doesn’t necessarily indicate that there might not be a balance between haircuts and systemic risk. At the least, it makes the issue trickier than merely saying that creditors must suffer.

  25. If bank creditors are not bearing greater than sovereign risk, what is the justification for them earning higher than the long-term treasury rate of return?

  26. Anybody with a 401(k) is a creditor. As I know from my own plan, anybody with a 401(k) is absolutely not able to “reduce exposure” if the portfolio does not offer cash-only or Treasury-only options. Hence for such creditors (about 1 trillion dollars worth in the 2008 losses, or 40% of then 401(k) holdings) how exactly under current law is this “cutting exposure” pipe dream supposed to be implemented? Quitting your job to roll over your 401(k) into a Traditional IRA?

    I absolutely despise sweeping pronouncements about who should suffer, having spent about 2 years leading up to 2008 lobbying my employer for a cash-only options due to some common sense numbers about the housing bubble, and ultimately being saved from the toxic waste in the least-worst choice in the portfolio by the Sep. 19 emergency insurance offered (disgustingly so) to money market funds to prevent the “break the dollar” run. I might well be the only participant in this “plan” that did not loose money in 2008.

    I am all for ending the socialization of losses, but to those who swing their Big Brush, let us see the inalienable right to in-service roll-overs of employee contributions at any time to end mandatory “exposure” first. Because the employers and fund administrators sure did nothing to reduce exposure, and could not care less about what the supposed “beneficiaries” think or want.

    And that isn’t even starting to get into the issue of pension funds, easily another trillion dollars worth of mandated exposure.

  27. Government should have the tax on creditors, like taxing on executive bonus, who get the benefits of AIG reckless actions. AIG bailout is intentionally the way to turn the loss of private investors into the loss of public that is unacceptable.

    Now the loss of US government is increasing everyday and that will cause the higher cost of living of people from the higher government debts and higher tax on taxpayers, not higher tax on private investors. Therefore, I do not understand why taxpayers should pay higher tax to support loss of private investors.

    One thing we have seen is the lower welfare of country. Now government will create higher budget deficit and will create higher uncertainty of deficit from unknown loss of bailout. FED has also intervened market by printing money and definitely will create loss from intervention and uncertainty of amount of money expansion in the future.

    From the uncertainty of loss of intervention and size of government deficit and size of money printing, the medium-to-long term bond yield is at the highest risk of losses from government new supply from higher deficit and the higher risk of hyperinflation of money printing. If government debt is uncontrolled and FED has to monetize debts more aggressively, the 3% 10-year bond yield is not reflecting the future hyperinflation and new supply of debts. We could not see the sharp increase in inflation in this or next year but we have the higher uncertainty and higher risk of hyperinflation and new bond supply. The medium-to-long term bond yield should move upto 5-10% and is volatile to reflect the uncertainty.

    The higher bond yield and uncertainty will create the uncertainty of economic policy and definitely deter the private investment and consumption from the higher risk premium compensation. That will create the long deterioration of growth. We could end up only the stagflation (there is some growth but low) or the depression with hyperinflation (no growth but price will increase sharply because in the long run there is no relationship of price and economic growth)


    It’s not too late to make AIG’s creditor’s suffer.

    Since the US Government effectively supports AIG and, at this point, the panic of last fall following Lehman’s collapse has subsided, it seems time to take a second look at the AIG bailout and payment of 100% on it’s counterparties claims. This could be done under the auspices of a prepackaged bankruptcy restructuring which would permit a claw back of those 100% payments to AIG’s counterparties & creditors.

    This process could be planned now that sufficient data is available on the counterparties and in most cases on the financial status of each of those counterparties. As a result this could be structured to avoid a cascading series of defaults because the US Government could at the same time, where necessary, inject selective loans to prop up essential US counterparties institutions. It could also coordinate this move with other nations to allow them to do likewise for their own essential counterparty institutions.

    This would have at lease three benefits:
    1. Make creditors & counterparties suffer to insure that going forward they do a better job of knowing their counterparties or risk suffering the consequences in a future meltdown of the financial system.
    2. Significiantly reduce the cost to the US Taxpayer of the AIG bailout.
    3. Gain political capital for the Obama administration that will be necessary when they return to Congress for more fiscal stimulus money by demonstrating fiscal prudence in light of what is now known about the use of billions given to prevent the collapse of AIG

  29. James,

    Thank you. Your explanation gives me a better understanding of the complexity of the problem. My instinct as a scientist is to “do the experiment” and not bail out the creditors, but I see the hazards of using this approach at this time. It’s a difficult call to make. I agree that the issue of creditor neutralization is important and I hope that it remains a part of the discussion as the system is rebuilt.

  30. There are many ways to present a point of view while being respectful of those who have differing perspectives. That is the point James is presenting and it is not only appropriate but in fact essential to learning and encouraging the exploration of new ideas. It has been one of the positive features of this blog as well.

  31. Isn’t the fundamental problem that market forces do not work? Continued reliance on the “invisible hand” seems excessively naive at this stage in the development of capitalism. For instance: creditors rely on credit ratings even though they know perfectly well that the rating agencies are not impartial.
    Imagine a Ponzi scheme in which investors willingly put their money, knowing that they’ll get a high return before others are subsequently ripped off. Creditors (AIG counterparties, bondholders, etc.) are either complicit or – in the case of those who did not get out in time – ill informed.

    If taxpayers are to foot the bill, it’s all right (after all, they supposedly also benefited during the fat years) provided taxation is fair. There’s the rub.

  32. Mattj:

    There is a difference between long term and short term bank creditors.

    Long term bank bonds are not inherently liquid (you can resell them, but you cannot redeem them at face value as you can a checking account). Banks do not (usually) have to repay such bonds upon request. Thus, long term bonds are not inherently vulnerable to a run. (They are still vulnerable to an asset price collapse, but this does not necessarily trigger a run on the bank.)

    Short term deposits are another story. They are inherently vulnerable to a run.

    There is a HUGE difference between these.

    A run on short term assets can cause banks to go under overnight, even if they are inherently healthy. This is disaster, but relatively easy for govts. to prevent through relatively safe guarantees. In the current environment, the govt. temporarily increased guarantees so that even holders of large cash accounts have no incentive to run.

    The long-term creditor situation is not as safe (theoretically). The govt. is not afraid of a run. The challenge here, however, is that the prospect of bank failure will cause future lenders to refuse to buy longer term bank bonds. The effects of this are not felt instantly, but can still be deadly as credit freezes up.

    It’s really in the context of these longer term bank bonds that the recent debate over bailout vs. bankruptcy has taken shape. Very few people are really suggesting that the govt. withdraw its guarantee over short term liquid deposits, particularly those made by small account-holders. Small account holders just don’t have the time or capacity to monitor their local bank; their rational response would be to pull everything out and go to paper cash. And if that happened, this is the outcome:

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