All About the Bondholders

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March 9, 2009 1:59 p.m.

In all the debates we’re having about what to do about the banks we don’t seem to focus enough (at least not in the popular press) on the fact that almost all the questions come back to a single question: what to do about the bondholders. As that J.P.Morgan report we referenced this morning put it, government policy to date has largely been focused on making sure that bondholders do not lose any of their money.

So let’s draw back and consider what this all means and whether it makes sense.

If you’ve got a big insolvent bank and you need to make up a big hole on the balance sheet you’ve got, broadly speaking, four groups of people you can get the money from, or put a different way, who can take the hit: shareholders, depositors, bondholders and taxpayers.

Now, for most of these banks the stock price has essentially fallen to zero. So they’re pretty much already wiped out. Not much to be accomplished there, although those folks want to hold on to their equity in the hopes that they may recover on the upside. Then you have the depositors. But in FDIC insured accounts, they’ve got a federal guarantee up to $250,000. And presumably those with really big sums on deposit have been proactive enough to spread their money around several institutions. So not much luck there either.

Which leaves you with bondholders (the companies creditors rather owners) and taxpayers. Now, on the one hand, this sounds like a no-brainer. If you lend money to a company that goes bankrupt, that’s tough luck. Maybe you recover a percentage on the dollar of what you were owed. But too bad. Why taxpayers should cover those loses is really hard to answer. But let’s try it.

The counter-argument is that if bondholders, especially the most ‘senior creditors’, take a big hit it, will create a big shock to the financial system worldwide, making bond-investing money extremely risk-averse for a long time and making the credit markets seize up again on far worse a scale than happened last fall in the wake of the Lehman bankruptcy.

A second issue is that a lot of these bondholders are other financial institutions, so you create a cascade of failure.

(ed.note: as I spoke to economists who are extremely knowledgeable and I think not at all inclined to be carrying the water of the bondholders, what became clear to me is that it’s not just a question of our having no good theory of how to unwind a crisis like this, ‘we’ also don’t have a good handle on the facts of the situation, which makes everything much more perilous. Sort of like defusing the time bomb without having put the bomber on the rack long enough to have him tell you how it works. As one of them told me a few moments ago, the only people who really know where the bodies are buried are the folks who buried them. So as we’re trying to come up with some global fix, the people who screwed everything up won’t tell us where they put everything or what’s connected to what.)

I come into this extremely suspicious of arguments for why taxpayers need to cover the bondholders’ losses. Yes, those bonds are held by pension funds and insurance companies. In broad terms they’re held by very, very wealthy people. But I’ve talked to different economists who I think are pretty on the level on this and they think the systemic risk is very real. And not just huge shocks to the credit markets. The losers aren’t just guys in Monopoly suits who hold these bonds. It’s your insurance company, your state pension fund, etc. So there’s potentially a lot of collateral damage.

So where does this leave us? What’s the risk of having the bondholders take a big part of the hit? A lot of it depends on whether the issue with Lehman was just letting it go under or letting it go under in a totally uncontrolled way. It seems to me that what you need is a controlled and orderly process for unwinding all of this and some equitable and reasonable system for determining who takes what hits. Then again, since I don’t really know much about this how it seems to me doesn’t really count for much.

Whatever else, when we talk about AIG or what to do with Citibank or Bank of America, this is the essential issue — does the government protect the bondholders? And if we don’t, is the damage so great that we’re better off just covering these folks’ losses? Meaning, as one of these economists I just spoke to said, at this point, in this bad a situation, stability is more important than fairness.

Saying you’ll take the banks into receivership doesn’t answer the question. It’s a just a way of approaching it. The economists I spoke to for this both believe in nationalizing the big insolvent banks. They just also think we’ll likely have to do it with blanket guarantees for their obligations — even though it’s a big giveaway to the people now holding the banks’ debt.

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