Geithner's "Nuclear Option" Should Scare Bejesus Out Of Bondholders


From the beginning of the bailouts, we’ve been appalled by the willingness of Messrs. Paulson and Geithner to protect most financial-firm bondholders to the tune of 100 cents on the dollar while socking it to taxpayers. 

Geithner suggests–we think disingenuously–that this is because the government lacks the legal authority to ding the bondholders (the real reason is presumably that he’s scared of triggering another Lehman Brothers).  But in any event, Geithner has now requested access to this “nuclear option”: The ability to seize and restructure any financial institution that the government deems insolvent.

Simon Johnson (MIT professor, ex- IMF banker) and Peter Boone (Chairman of Effective Intervention) explore the ramifications of this in an essay in the WSJ. 

The bottom line? 

If Geithner’s going to go through the hell of having this authority granted, he’d damn well better use it.  He’d better use it intelligently, moreover (all at once), and not in a random bank-by-bank fashion that will trigger runs on healthy banks.  And he’d also better keep in mind that the mere existence of this authority will, finally, put the fear of God into bondholders who heretofore have been given the distinct impression that bank bonds would be kept as safe as Treasury bills.

Simon Johnson and Peter Boone:

If passed by Congress, these powers would allow the governments to treat nonbank financial institutions more like regulated deposit-taking banks. This authority offers a clear path to recapitalize institutions without using taxpayer money and therefore avoiding some dimensions of moral hazard but, if implemented poorly, the existence of this “nuclear option” can cause panic in financial markets and substantially delay recovery. This fear may be with us already — despite all of the material and moral support already on the table, the market is pricing in the highest ever risk of default for Citigroup senior debt, i.e., about a one in three chance over the next five years…

[T]oday these powers don’t exist, and none of us know exactly how this authority would be used if it ever lands on Mr. Geithner’s desk. We’ll now have a healthy debate in Congress and then see revised versions passed and signed into law. But as this debate proceeds, creditors and shareholders in all such institutions will be nervous. We’ll be giving the Treasury a “nuclear option” and no one can be sure who is safe. A natural reaction by clients and investors of these banks will be to edge towards the exit immediately and to stay away until the dust has settled. It won’t matter whether institutions are solvent: Due to the uncertainty and risk of losses, investors and clients may run.

Read the whole thing >

See Also:
The Question Geithner Refuses To Answer
Protecting Bondholders Will Sock Taxpayers With A $10-$14 Trillion Loss


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