Explicit and Implicit Guarantees

Note: I wrote this post on May 18 but somehow forgot to publish it; I just found it in my drafts. It’s a bit out of date, but I think the point still stands.

I’m not sure if it’s official, but it’s been widely rumored that large banks that want to repay their TARP money will have to be able to sell new debt without the FDIC guarantee they got back in October. As a result, banks are falling over themselves with new, non-guaranteed debt offerings. The idea, I guess, is that banks that can raise money without the guarantee are showing that they are sound enough to operate without government support.

But I think all we’ve done is replace an explicit guarantee with an implicit guarantee. In October, no one was sure whether the U.S. government would bail out bank creditors in a pinch; after all, Lehman creditors got back less than 10 cents on the dollar, and AIG creditors took a big haircut because the Fed’s credit line came in senior to them. So the explicit guarantee was necessary for banks to issue debt.

Since then, however, the government has shown in many ways that it isn’t going to let major banks fail or force a restructuring (indeed, it insists that it can’t force a restructuring). The message of the stress tests, ultimately, was that Treasury is standing by to provide whatever capital is needed. In that situation, what risk do bank creditors face? Virtually none, except maybe political risk (the risk that the government’s policy will change). So the banks get to raise money without the stigma of a guarantee, they don’t have to pay a premium to the FDIC, then they get to pay back their TARP money, and the government can say that the banking sector is healthy. Everyone’s happy.

And if things go badly, the taxpayer is still there to make good on all those non-guaranteed bonds – at least for the banks that are, still, too big to fail.

By James Kwak

14 thoughts on “Explicit and Implicit Guarantees

  1. Yup, the point still stands. All too firmly.

    It’s clear that a captured government has no will even to undertake the anodyne regulatory reforms which just a few months ago everyone agreed were a given, let alone to confront the underlying existential problem of the very existence of Too Big To Fail entities, which all reasonable people agree must be completely dismantled, with all deliberate speed, for the sake of economic stablity, social stability, morality itself, and freedom itself.

    It just turns out that there are far fewer reasonable, freedom-loving people than even I was naive enough to believe in not long ago. Clearly most American sheep, no matter how many times they’re kicked in the face, are willing to spend their lives under the thumb of this protection racket, and endure all the socioeconomic travail which follows from it.

    I’ve always laughed bitterly when I saw the silly argument over whether Americans more highly value liberty or the simulation of “security” (not, of course, the real thing).
    Certainly, Americans care alot more about pseudo-security than about freedom. But that’s nothing compared to how much they care about economic license, hedonist indulgence, “consumerism”.

    The scale would go something like:
    phony totalitarian security:10
    material promiscuity:100

    (And all of this doesn’t even take into account issues of debt and resource unsustainability, and that decentralization, deconcentration, and relocalization are practical imperatives as well as social and moral ones.)

  2. You are right that the government cannot completely take away the explicit guarantee until the largest banks are broken up or resolution authority is passed. (Yet, investors seem to be wary about this explicit guarantee, demanding higher yields for non-guaranteed debt.) Nevertheless, removing the FDIC guarantee, would remove much of the credit risk borne by taxpayers. Most of the banks availing themselves of TLGP debt would not be rescued by taxpayer bailouts if they were on the verge of collapse.

  3. If it works like you say why is there any spread between the explicitly guaranteed and implicitly guaranteed debt? Political risk of renegging on the implicit guarantee? Or maybe it’s factoring in the risk of government default?

  4. That’s a good question and I’ve wondered about it myself. I think political risk is the main factor – you can’t be certain that the government won’t change policies. I acknowledge that an implicit guarantee isn’t as good as an explicit guarantee. But I think there is one, and it’s certainly better than nothing.

  5. If it’s political risk this is telling you that crony capitalism has limits, or at least these market participants think so.

  6. Let’s look at China. China sold Agencies, Implicitly Guaranteed, and bought Treasuries, Explicitly Guaranteed. Now, they did this, apparently, after the way that Fannie/Freddie was bailed out, and Lehman was allowed to fail, and WaMu was seized. China immediately stated that they had previously believed that these implicit investments were really explicit. After they heard that we might haircut the bondholder’s of banks, they stated this point even louder, and threatened negative consequences.

    My answer, and Geithner’s, was to guarantee everything. Explicitly. Now, were there any negative consequences to China’s shift from Agencies to Treasuries? In my opinion, there were. For one thing, it was part of a massive deflationary flight to safety that almost led to Debt-Deflation. Had that occurred, unemployment could have doubled, from these current levels. The point is that no one knows.

    If the question is whether or not these banks are guaranteed, the answer is yes. See, we deregulated, but also guaranteed, these big banks. Does that remind you at all of the S & L Crisis, which was a bipartisan foul up, which is why it never really came up in the 1988 election. Neither party could get an advantage from the issue.

    The Federal Government will never allow Debt-Deflation, or a serious threat of it. That reality, combined with the fact that we have a Lender of Last Resort, the Fed, and, now, the Treasury and FDIC as well, mean that we will always have guarantees going forward. The answer, then, needs to be regulation. Since I’m no big fan of regulators, I prefer Narrow/Limited Banking on the one hand, and an insured Investment Industry, on the other. Either self-insured, or by government. This part of my view is very close to Gorton’s view.

    Without these kind of changes, we’ll be back here again soon. I’m sorry to have such a jaded view of regulators, but these foul ups just keep coming. Hence,although I used to favor Bagehot on Steroids, meaning a very tough regulator, I just can’t seem to believe in that possibility any longer.

  7. I think this is high-stakes chicken. Say JPMChase repays TARP funds, but conditions deteriorate further. There will be no TARP-II for them. Geithner should make this clear. The I’m sick, now I’m healthy, now I’m sick again doesn’t work. You get one shot. I do not know how the loans they picked up through WaMu or Bear will be treated, as they should get different treatment than organic JPMC loans. For that matter I don’t know how the GoldenWest -> Wachovia -> Wells assets will be treated, or the Merrill assets on BoA’s sheet.

    There are still lots more foreclosures. Case-Shiller for Miami has fallen 33% since the end of 2007 and nearly 50% since the end of 2006. For purchases from late 06 on, option arms are beginning to fully amortize, and foreclosures take a while from the point when the ‘owner’ stops paying. Have they taken the full haircut on a loan that will foreclose in mid 09 and will be REO until mid 10?

  8. Wait, the banks “get to” raise capital without the stigma of a government guarantee? Well, they also “get to” pay T+ 400bps or more.

    Is the market still underpricing the banks’ unguaranteed debt? Probably. But I assure you, paying an additional 400bps-500bps in spread isn’t exactly a treat, especially for a major investment bank. The banks “get to” get out from under the TARP restrictions, and from the threat of further Congressional shenanigans more broadly, but they’re paying a pretty penny for it. It’s probably less than they should be paying (if the risk was perfectly priced), but it’s a pretty penny nonetheless.

  9. Dear Linus,

    I am afraid you missed James’ point. The question is not whether removing the explicit guarantee is good or bad (it is unreserevedly good), but about the effects of not letting the big institutions fail policy.

    Ergo,the big ones could be inherently insolvent, but still, given the government’s basic ‘too-big-to-fail’ policy, raise capital.

    It would appear that the ‘practical’ question is whether they can raise enough capital without the explicit guarantee, but then, how would you know what is ‘enough’?

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