Tim Geithner did a good job on the Sunday talk-show circuit yesterday. He has survived his near-death experience of two weeks ago, and the betting odds that he’ll be ousted by June have fallen back to 10%.
But there’s one question he still refuses to answer. Why is he bailing out the people who lent trillions of dollars to our now-insolvent banks?
Each of the bailed-out institutions has tens or hundreds of billions of dollars that could be used to cover losses before the taxpayer had to cough up a dime. And with the exception of Lehman Brothers (and, now, General Motors), these gigantic pools of money have been protected to the tune of 100 cents on the dollar.
Who are these people?
In any fair world, the bondholders would lose everything before any taxpayer money was put on the line. Ever since Lehman Brothers, however, Tim Geithner & Co. have been so afraid of a Lehman-repeat that they refuse to even publicly discuss the possibility of making bondholders share the pain. Whenever anyone suggests this idea, moreover, Geithner & Co. immediately dismiss it by saying it would lead to another Lehman.
At best, this is wrong. At worst, it’s disingenuous.
The reason Lehman caused such havoc was that it was an uncontrolled and unexpected bankruptcy. No one is suggesting that AIG, Citi, et al, be forced into one of those. What LOTS of people are suggesting, including Paul Krugman, is that Citi, et al, be put into a managed receivership. This is what happened to WaMu last fall, and the process went so smoothly that few folks can even remember it.
WaMu bondholders took a hit. General Motors bondholders will take a hit. So why can’t the bondholders of Citi, AIG, etc, take a hit?
The answer, Tim Geithner would probably tell you (if he could be induced to comment on the elephant in the room) is that insurance companies, pension funds, and other companies that hold the future of Americans in their hands invest in those bonds. And if we force those companies to take a loss, we’ll hurt ordinary Americans.
Which is just another way of saying “all financial sector debt has always had a Triple A rating like Treasury bonds–you were just too stupid to notice.”
And that’s ridiculous.
The folks who lent money to AIG, Citi, etc., knew exactly what risks they were taking. It’s time to at least discuss the possibility that they should have to answer for this.
Fund manager John Hussman discusses this issue in detail in in his weekly letter. Here, in a list of the three possible approaches to bank insolvency, are his thoughts on the bondholders:
From the beginning of the recent crisis, starting with Bear Stearns, I have emphasised that nearly all of the financial institutions at risk of insolvency have enough liabilities to their own bondholders to fully absorb all probable losses without any loss to customers or the American public. The sum total of the policy responses to this crisis has been to defend the bondholders of distressed financial institutions at public expense.
Note that in the example balance sheet above [click here to read the full post], 30% of the liabilities of the institution represent debt to the company’s own bondholders. It is these individuals – not homeowners, not the American public – that are being defended by the promise of trillions of dollars in public money.
For example, while Citigroup has approximately $2 trillion in assets, those assets are financed not only by customer deposits, but also by nearly $600 billion in debt to Citigroup’s own bondholders. It is these private bondholders who provided the funds for Citigroup to acquire questionable assets.
The bondholders of distressed financial institutions – not the American public – should bear responsibility for the losses of those institutions. This can be accomplished, without harm to customers or the broader financial system, in one of two ways:
1) The bondholders could voluntarily agree to move a portion of their claims lower down in the capital structure, swapping debt for equity (preferred or common), allowing the bank to have a larger cushion of Tier-1 capital, avoiding insolvency, and hopefully allowing the bank to recover by its own bootstraps , preferably assisted by debt restructuring on the borrower side (via property appreciation rights and the like). Alternatively;
2) The U.S. government could take receivership of the financial institution, defend the customer assets, change the management, wipe out the stockholders and a chunk of the bondholders claims entirely, continue the operation of the institution in receivership, and eventually sell or reissue the company to private ownership, leaving the bondholders with the residual. Indeed, this is how the largest bank failure in history – Washington Mutual – was handled so seamlessly last year that it was almost forgettable. This is not Argentina-style “nationalization,” but receivership – a form of “pre-packaged bankruptcy” that protects the customers and allows the institution to continue to operate, followed by re-privatization. This would fully protect all of the customers and depositors at no probable expense to the public.
What should not be done is what was allowed in the case of Lehman Brothers – a disorderly failure, by which the company was allowed to fail with no conservatorship of the existing business. It was not the failure of Lehman per se, but the disorder resulting from its piecemeal liquidation, that caused distress to the financial markets.
That said, it is true that the bondholders of major banks include pension funds, insurance companies, mutual funds, foreign investors and other holders that would be adversely affected by a writedown in bond values. But this is part of the contract – when one lends money to a financial institution, one also assumes the risk and responsibility of bearing the losses. Congress always has the ability to mitigate the losses of some parties, such as pension funds, if it is agreed that this is in the public interest. But to defend all bondholders of financial institutions at public expense is to commit the future economic output of innocent citizens to cover the losses of mismanaged financial institutions. As a result of the intervention by the Federal Reserve and the U.S. Treasury, even the bondholders of Bear Stearns stand to receive 100% repayment of both interest and principal on their bond investments. This is absurd.
John Hussman’s whole letter this week is excellent. Read it here >
Graphic: The New Yorker