The Strangeness Of The Tarp Exit Bonds

When the government decided to require banks that wanted to exit the Troubled Asset Relief Program to issue non-guaranteed debt, it set the stage for one of the strangest groups of bond issuances in recent memory. The banks found themselves having to sell bonds in something akin to a distressed debt sale, yet the pricing of the debt was affected by an implied government guarantee.

Normally companies issue debt because they have a specific financial need–old debt coming due, an acquisition to fund–or they feel they have an opportunity for an inexpensive source of capital, and their debt is rich in some way. Issuers treat this decisions opportunistically. Buyers have to take this into consideration because if the sellers are right, it is a bad deal for the buyer. As the saying goes, “If Goldman is selling, why are you buying?”

But the government’s decision to require a bond sale as a condition of exiting the TARP changed this dynamic. Now the banks were motivated to sell by something the market hadn’t see before–a government requirement. It was, in a sense, akin to an exit financing that a company might do to raise money out of bankruptcy. Buyers could purchase the bonds confident that they were getting a much better deal because the sellers weren’t opportunistically entering the market.

Even stranger, many investors market continue to doubt that any of the top tier financial firms would be allowed to fail. This means that even if debt is issued on a non-guaranteed basis, it essentially enjoys a protection akin to that once enjoyed by Fannie and Freddie securities.

One key sign to watch for is whether the debt of these implicitly protected financial firms begins to be traded outside of ordinary coproate debt trading desks or by specialised sub-groups within those units. The so-called “agency debt” of Fannie and Freddie was traded by Treasury trading desks. For now, most banks still lump implicitly protected financial firm debt with ordinary corporates. But we’re told there are discussions to change this at some banks.

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