Time for Bank Creditors to Share the Pain?
The big debate about President Obama’s financial rescue plan has centered on whether he’s been right to avoid nationalizing the country’s biggest banks. But there is another, more pressing question about the plan that has received considerably less attention.
After the Federal Reserve’s stress tests identify the country’s sickest banks next week, who will bear responsibility for shoring up their balance sheets?
Will it be solely the government? Or will the government force institutions that lent money to sick banks in better times — their creditors — to take a hit by forgiving some of the loans?
Timothy F. Geithner, the Treasury secretary, and other officials are reluctant to force losses, often called haircuts, on banks. They worry that haircuts could create a cascade, in which some of the creditors that take losses become insolvent, while creditors of healthier banks begin wondering whether they will be subject to future haircuts. In the ensuing panic, financial markets could freeze up, as they did last fall.
But relying on the government alone to shore up the banks brings risks, too. In the long term, it could leave taxpayers with an enormous bill. In the short term, it could destroy the already thin political support for the rescue plan.
Recently — and, I’d argue, fortunately — the Obama administration seems to have become more open to the idea of encouraging loan forgiveness in certain situations. Beyond those situations, officials hope that no others are needed.
Yet that may turn out to be wishful thinking. The Treasury Department has only about $130 billion remaining in its Troubled Asset Relief Program, or TARP, fund. By comparison, American banks are probably facing an additional $1 trillion in losses over the next two years, the International Monetary Fund projects.
The gap between those numbers means that the debate over haircuts could be with us for a while.
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The case against haircuts starts with Lehman Brothers. When Lehman collapsed into bankruptcy on the night of Sept. 14, its creditors were left with billions of dollars in loans to Lehman they would never recover. Needing to conserve capital and fearful that other firms might collapse soon, they largely stopped lending.
“That’s when this crisis took a quantum leap up in terms of seriousness,” as Janet Yellen, the president of the San Francisco Fed, recently said.
So imagine that on Monday, when releasing the results of its stress tests, the Fed says that several banks need more money to survive a deep recession. Assuming private investors are not willing to put it up, the government will then have two options.
It can increase the banks’ assets, by giving them more taxpayer money in exchange for an even greater ownership stake. Or the government can reduce the banks’ debts, by using its influence to encourage, or even demand, loan forgiveness.
Debt reduction, in exchange for an equity stake, is a standard strategy for dealing with failing companies. It’s what the Obama administration is trying to do with Chrysler’s and G.M.’s creditors. Under the tentative deal worked out on Tuesday, Chrysler’s creditors would receive about 28 cents in stock for every dollar of loans they forgave.
But banks aren’t like other companies. Like it or not, they are the heart of the credit system and thus the economy. No matter what happens to Chrysler’s creditors, Honda won’t stop making cars, and people won’t stop buying them. Imposing losses on Bank of America’s creditors, though, has the potential to freeze the financial markets.
One sign that such concerns are legitimate is the fact that they’re shared by some economists who saw the financial crisis coming well before Fed officials or Mr. Obama’s current advisers. At a Fed conference in 2005, Raghuram Rajan — then the director of research at the I.M.F. and now a University of Chicago professor — criticized Alan Greenspan for turning a blind eye to risk (and was in turn criticized by Lawrence H. Summers, now Mr. Obama’s lead economic adviser). Today, Mr. Rajan says that haircuts really do have the potential to make some financial firms insolvent and cause worldwide problems.
Yet he also says that the government should study whether it can sensibly impose any losses on creditors, rather than unquestioningly accepting Wall Street’s self-interested view that haircuts would be bad for the economy. “We constantly have to question the arguments the Street puts forward,” he said, “and ask whether they are really these holy cows who can’t be touched.”
Ever so gradually, the administration may be moving toward this more skeptical position.
In February, the Treasury began twisting the arms of some holders of Citigroup preferred stock to get them to convert it into common stock. (Preferred stock, despite its name, is something between a loan and stock.) The credit markets hiccupped, but quickly returned to their previous state. In the wake of the stress tests, the Fed and the administration may well push for more conversions along these lines.
The trickier issue is what to do with holders of so-called subordinate debt. In the spectrum of investments, subordinate debt is considered safer than preferred stock and tends to be subject to haircuts only when a company slides toward bankruptcy. Pushing a bank to the brink of bankruptcy would raise the specter of Lehman Brothers.
Now, some debtholders may be fearful enough of bankruptcy that they would willingly accept haircuts, figuring they are better than the alternative. On “Meet the Press” on April 19, Mr. Summers said one option for increasing the banks’ capital was “asset liability swaps,” by which he meant a voluntary exchange of loan forgiveness for equity.
The government’s main role would be to force existing equity holders to offer the swaps to creditors. Equity holders often oppose such swaps because their own stake is diluted. But government regulators could insist that the offer be made and then allow debtholders to accept or reject it. If the offer were, say, 60 cents on the dollar and the market price of the debt only 50 cents, the creditors might accept.
If steps like these, along with TARP, are enough to repair the financial system, haircuts won’t be needed. If not, the only remaining options will be more taxpayer money, more haircuts or both.
We already know what the bankers will say about haircuts, regardless of how carefully they’re devised: that they’ll end up hurting the rest of us. Remember, though, they said the same thing about stronger financial regulation, and they turned out to be spectacularly wrong. Stronger regulation would indeed have hurt many bankers. It would have benefited the rest of us.
This month, I interviewed Mr. Obama for a Q. and A. to be published Sunday in The New York Times Magazine, and I asked him why his economic inner circle was dominated by protégés of Robert Rubin. These protégés, like Mr. Geithner and Mr. Summers, are deeply thoughtful people, just as Mr. Rubin is. But in retrospect, they all gave too much deference to Wall Street.
Mr. Obama replied that his economic team also included people from outside the Rubin circle, which is certainly true. Still, Mr. Geithner and Mr. Summers remain the dominant forces in the team.
When they — and the president — consider Wall Street’s warnings about haircuts, I hope they also consider its track record. Lately, taxpayers haven’t done very well when they’ve listened to Wall Street’s advice.
E-mail: leonhardt@nytimes.com"
FIRST, let me thank The Economist for hosting this debate and the many commentators who offered very useful thoughts on the ideas in my piece. Second, I would like to thank colleagues in the Squam Lake group (two of whom, Martin Baily and Hyun Shin, added their comments), with whom I have had enlightening exchanges on regulation. Finally, I should give credit to Mark Flannery of the University of Florida for first proposing the notion of contingent capital. 
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