Thursday, March 12, 2009

at least it gets rid of much of the uncertainty in the system, once and for all

From Free Exchange:

"Bondholders, nervous bondholders
Posted by: | WASHINGTON
Financial markets

JAMES CARVILLE famously said that he wanted to be reincarnated as the bond market, because then he could scare everybody. Well, bond markets are looking a little skittish at the moment, and that could be cause for fear. Bloomberg reported yesterday that yields on American bank debt are soaring as concern grows that goverment officials may determine that it's time to make creditors share the pain of financial losses.

James Kwak sets the scene:

Even if the administration is wrong and the banks are not adequately capitalized, bondholders are only in danger if the administration decides not to protect them. This could happen in one of two ways. First, the administration could request, as a condition of a future bailout, that bondholders exchange some of their debt for equity. There is no law that says that bondholders have to exchange their bonds for equity just because the government asks, so the threat would be that the government would not bail out the bank otherwise (forcing it into bankruptcy or conservatorship).* Second, the administration could take over the banks; in that case, the regulator might decide not to pay back all of the bondholders - but it certainly could decide to pay them back. It’s just a question of whether losses are borne by the bondholders or the taxpayer (assuing the equity holders have been wiped out).

Movements in bond markets seem to be implying that the government will either try to force a debt for equity swap on some debtholders, or will take over some troubled banks and decline to make creditors whole. The Bloomberg story linked above continues:

Contracts on the Markit iTraxx Financial index of credit-default swaps linked to the senior debt of 25 banks and insurers were more expensive today than the Markit iTraxx Europe corporate index. That hasn't happened since Lehman Brothers Holdings Inc. went bankrupt in September and, before that, JPMorgan's takeover of Bear Stearns, according to BNP Paribas. It reflects "systemic stress" in the financial system.

What we have, then, is a situation where bond markets are beginning to suspect that debt, or some of it at least, isn't safe. This, in turn, is setting off systemic alarms last tripped when everything went south last autumn.

But the real kicker, as Felix Salmon points out, is that these movements may be self-fulfilling:

Right now, these prices represent significant unrealized losses for people who bought at par. But increasingly they're going to start representing significant potential gains for people who are buying at today's levels and hoping to be paid off at par -- paid off, that is, essentially by taxpayers. Since those people can be broadly characterized as hedge-fund managers, one can foresee a lot of Congressional pushback if a large number of hedgies start pulling in tens of millions of dollars just by playing the moral hazard trade. Or, to put it another way, it's a lot easier to impose a haircut when a haircut is priced in than when it isn't.

This is kind of hard for me to wrap my head around. Hedge funds betting that the government will be too scared to impose real losses on debtholders will swoop in and buy cheap debt. But this will irk the government, which will then be willing to impose losses on debtholders. But then the profit opportunity is gone, and hedgies run, sending debt back to the previous cheap levels? What's the equilibrium here?

What this would seem to make clear, however, is that while there is an upside to the government's wait-and-see approach—namely, so long as Treasury is relatively uncommitted, there's the chance it can avoid having to spend trillions—there is also a serious downside. Treasury may ultimately be forced by markets to play a hand that's gotten worse as additional cards have been dealt (or some such metaphor; you get the idea). Guaranteeing bank debt outright could wind up being expensive, but at least it gets rid of much of the uncertainty in the system, once and for all."

Don the libertarian Democrat wrote:
March 12, 2009 17:25

"Guaranteeing bank debt outright could wind up being expensive, but at least it gets rid of much of the uncertainty in the system, once and for all."

That's it. If you look at who the bondholders are, they are insurers and foreign investors.

Insurers. Unless I'm mistaken, these are the next group of supplicants on our list. Look at it this way: guarantee them now, or pay later when they seem unstable. Either way, pay we will.

Foreign investors. If we default, they are likely to consider us a less and less worthy creditor, at any level. If we guarantee them, we might have to spend a huge amount of money, adding to our debt. This one is also pick your poison. I say that we guarantee them, hoping that eases default worries down the road, and pray that we don't have to pay them.

Finally, guaranteeing these bondholders could make some kind of seizure possible. Who knows? I hope we can at least get that out of this mess.

As for TAs as distressed levels, who did they think would buy them?

No comments: