Stuffing bondholders

Most ordinary Americans feel a certain sense of rightoues indignation about the helping hand the U.S. banking industry is receiving from government.  This sense of aggrievement is only made worse by suggestions that governemnt is not only protecting the banks themselves but their bondholders as well.  I have sympathy for this point of view because it represents a moral hazard that condones the recklessness which created this financial crisis.  However, I must confess to being a reluctant convert to the ‘save the bondholders’ movement.  Let me explain why.

But before I do, let me outline why debt holders should take a haircut.  A week ago I posted an article highlighting an Oppenheimer research piece which said the following:

To preferred and subordinated debt holders, Geithner is effectively saying the following: “If the bank holding company in which you hold capital instruments is in dire need of common equity capital, then come to terms with them or we will do it for you! You knew at the time that you purchased this paper that they were not FDIC insured deposits, but rather capital instruments of a bank holding company. If the company in which you invested is in dire trouble, you too should share some of the pain and not expect 100 cents on the dollar.”

The long and short of this comment here is that the U.S. government may finally be ready to move up the capital structure to preferred shareholders and debt holders to make sure they share some of the financial losses with equity holders before more taxpayer money is spent. Rightfully so.  Debt holders will have to lose some of their principal.  The question is how much and what will they receive in return.

My problem here is that the holders of bank liabilities – depositors and creditors – have other options. They can always withdraw their support from an institution that they feel will fail – creating a self-fulfilling prophecy. This means that taking too much of a haircut on bondholders, especially senior bondholders, will undermine confidence in the system. In the Swedish example from the 1990s, this was recognized and a blanket guarantee was given to all depositors and creditors of institutions deemed to be solvent. In September 1992, the Swedes issued a press release declaring that liabilities would be guaranteed.

The press release declared that the purpose of the blanket guarantee was that “households, enterprises and other holders of claims can feel secure.” However, the immediate reason for the press release was actually the fear of losing foreign financing facilities. Swedish banks were heavily dependent on foreign financing of their activities. Short-term foreign borrowing represented about 40 per cent of total bank borrowing. If this funding were to dry up, it would not be possible for the Riksbank to maintain the pegged krona rate.

For the policy-makers there was no alternative but to issue a blanket guarantee to support the krona. In the currency turmoil, where speculation had forced the central banks of the United Kingdom, Finland and Spain, among others, to let their currencies float, the peg of the krona came under heavy speculative pressure. The blanket guarantee – already a drastic measure in itself – was thus an attempt to eliminated foreign fears that Swedish commercial banks would not be able to meet their financial obligations. The guarantee was successful in the sense that foreign confidence in the solvency of the Swedish commercial banks remained intact.

In addition, this stop-gap measure proved highly beneficial, as it expanded the options for the Riksbank to support banks regardless of their financial position. Through the press release, the Riksbank was given the option to lend to any commercial bank operating in Sweden, even to those that were on the brink of insolvency, because the press release represented a State guarantee for the liabilities of the banks.

This is a solution that was geared to address the ‘Bear Stearns problem’, where lines of credit are pulled and a firm goes under before it is clear that said firm is actually insolvent. Bear is gone but this problem still exists. Witness GE Capital, which just a few days ago announced that it would issue U.S.-guaranteed bonds in order to avoid liquidity constraints on rolling over debt.

GE Capital, the finance arm of U.S. conglomerate General Electric Co, plans to sell more bonds under a government guarantee program, a source involved in the deal said on Monday.

The benchmark-sized offering is expected to price early this week, said the source, declining to be identified because he was not authorized to disclose details about the sale.

Benchmark-sized offerings are typically at least $500 million.

These bonds are rated AAA and have low coupons because they are guaranteed by the government. This government-insured bond program for the likes of General Electric and Goldman Sachs is the effective equivalent of the blanket guarantee given in Sweden in 1992. In essence, the government is saying, “you can issue bonds as if you were a government-sponsored enterprise. Take the free money from the lower yields and recapitalize yourselves.”

My preference is for these organizations to find funding from private investors. This will not happen, however, if those same investors are stuffed on their existing holdings. However unpalatable a senior debt guarantee might be, it seems a wise option to consider.

For an alternate take see Barry Ritholtz’s: Haircuts for Bond Holders.

Sources
GE Capital to sell U.S.-guaranteed bonds: source – Reuters
The Swedish model for resolving the banking crisis of 1991 – 93. Seven reasons why it was successful.– Lars Jonung