Garett Jones  

Bailouts are for Bondholders

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During the worst days of 2008, something strange happened.  During the Eight Days of Terror, the S&P 500 fell by 23% but there were no loud calls for the government to guarantee the value of stocks (Aside: TARP was signed into law on Day 3 of the 8).  

By contrast, about two weeks beforehand, Treasury guaranteed the solvency of many money market mutual funds, the de facto bank accounts created by investment companies.  Why the guarantee?  Because of the panic induced by one money market mutual fund (MMMF) when it announced that its value had plummeted: Instead of being able to repay 100 cents on the dollar, the Reserve Fund would only be able to pay----wait for it---ninety-seven cents.  

Yes, the Reserve Fund was an historically important MMMF--it was the first.  And surely its failure contained a signal about the health of the others.  But three cents on the dollar?  That set off a mad scramble for safety that spurred the Bush Treasury to create a new government guarantee?  

There's a lesson here. 

The lesson shows up again in the bank bailouts: Bondholders of the biggest banks never lost a penny of principal, but megabank shares lost most of their value in the crisis. 

Politicians treat depositors and megabank bondholders quite differently than they treat shareholders.  The former get bailed out regularly while the latter get...whatever is left. 

People often think of the bailouts as good news for shareholders. But it's far, far better news for bondholders.  Wisely, megabank bondholders have stayed very, very quiet about their good fortune.  

Bond and deposit promises hold a special place in people's hearts.  There's something about the line on the contract saying "You shall be repaid $10,000 on 1 December 2014" that gives people a sense of entitlement that they carry all the way to the Senator's office.  

Yet another debt externality.  

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COMMENTS (27 to date)
Daniel Kuehn writes:

But doesn't this have more to do with the difference between debt and equity than it does with the political choices being made? In other words - it's not a preference for bondholders, it's just how a bailout would of necessity work given the existing relationship between debt and equity.

That doesn't mean there isn't some "debt externality" worth speaking of, I just want to make sure I understand what the point really is.

This is one of the principle advantages of being a bondholder, regardless of whether bailouts are on the table or politicians are even involved in the discussion, right?

Greg G writes:

I think the point here is not that there shouldn't be a big difference in the risk between debt and equity but that a lot of the risk that used to be in debt isn't perceived to be there anymore.

One the other hand, the government did not guarantee the money funds because they were worried about 3% bondholder losses. They were worried about a panic in that market that would have resulted in much more than 3% losses to bondholders and others as well if it wasn't stopped.

Garett Jones writes:

In a world of politics, nothing is inherent. Everything is negotiable.

It would be easy--as law, not as politics--to require bondholders haircuts with every bailout. Why is that not the equilibrium? Why no 'shared sacrifice'?

Because mentally, politically, socially, maybe even economically, debt is different.

Shayne Cook writes:

Garett, you are quite right that "bondholders ... hold a special place in people's hearts" and that is reflected in political protections. It is much more than political protection, it is thoroughly embedded in U.S. national housing policy.

But I would submit that you are mis-labeling that protection as an "entitlement".

It has been a matter of U.S. national policy since the great depression that the U.S. financial system always supply a plentiful and low-cost supply of capital to the U.S. housing markets - in all possible circumstances of the larger U.S. economy. For the suppliers of capital (bondholders), under pure market-based supply/demand dynamics, "plentiful" and "low-cost" capital are mutually exclusive concepts.

That is why institutions such as Fannie, Freddie, FHA, Ginnie were constructed in the first place. It is also why there was also an "implied" Federal Government assurance that no capital supplier to the U.S. housing markets (remember, plentiful and low-cost) would ever have to bear, or even factor in, the costs of default risk. That "implied" assurance became "explicit" in 2008 - obviously. It had to become explicit, and serviced, in order to ensure that "low-cost" and "plentiful" capital supply would continue to be provided to the U.S. housing market!

But that is not all of the institutionalized assurances that have evolved in support of U.S. housing and housing finance policy. U.S. homeowners (debtors) never need be concerned about facing U.S. bankruptcy proceedings, due to default. U.S. homeowners are afforded automatic protections from full bankruptcy - they risk only their equity in their homes as a result of default. U.S. housing market Creditors (bondholders) are precluded by law from making any claims against any other defaulting debtors' assets, other than the home collateral.

That "lack of creditor right to attach other assets" within conventional bankruptcy proceedings is why U.S. national policy evolved to "imply" other assurances that preclude creditors/bondholders from ever having to price-in default risk to the capital they supply to the U.S. housing markets.

It is obvious that during the 2002-2008 period, the U.S. financial system probably supplied to much low-cost capital to the U.S housing markets. There is no doubt the U.S. financial system got a bit "carried away" with its commitment to always service the U.S. national housing policy. In the face of greatly increased global demand for U.S. dollar denominated capital - both equity and debt - from the BRIC and other rapidly growing economies, the U.S. financial system had to get creative in order to maintain the "plentiful" and "low-cost" supply to the U.S. housing market. Enter the financial innovations of CDO's, MBS, CDS, et.al., that provided leveraged returns to the capital suppliers. While U.S. national policy always warranted against default risk costs, exorbitant leveraging introduces interest rate risks and pre-payment risks - and costs. Those were not adequately accounted for, nor priced in to costs of capital supplied to the U.S. housing markets during the 2002-2008. Bad joo-joo.

It's also fairly evident that U.S. national policy regards housing might have also gotten a bit "carried away" as well. The U.S. financial system was strongly incentivized to extend "plentiful" and "low-cost" capital to U.S. folks who had not had not had access to it under normal circumstances - enter, "sub-prime", "alt-A", "no-money-down", etc. All of which increased both the probability of default, and potential costs of default to U.S. housing market credit capital suppliers....

Hence the "bailouts", and the broad bi-partisan support for the bailouts and for much of what has transpired since the bailouts. The U.S. government was compelled to "make good" its prior implied warrant to the credit markets of "no default risk" for capital supplied to U.S. housing markets. The U.S. government had to make good on that implied warrant in order to ensure "plentiful" and "low-cost" capital flows to the U.S. housing markets in the future, and in all circumstances of the larger U.S. and global economy.

In short, the "bondholders" are only receiving a warrant against default risk losses, as a matter of U.S. national policy. It is the U.S. homeowner who is the recipient and sole beneficiary of that "entitlement" aspect of U.S. national housing policy - if you choose to call it that.

E. Barandiaran writes:

Garett,

The main beneficiaries were the few shareholders controlling and managing the banks. They were the ones that could save most of what they should have lost.

MG writes:

How can government-induced moral hazard be an externality, as traditionally defined. Markets did not create this moral hazard; governments did when they co-opted reckless bank debt financing as fiscal expansion under another name.

JeffM writes:

I do not want to get in what could be a very involved debate, but there is a huge difference between insured depositors and bondholders.

The government has made an implied promise to depositors that the government insures their deposits up to the insured limit and the banks obligated by law to hold such deposits pay premiums unilaterally set by the government to support such insurance. Now we can argue all day about whether the government OUGHT to provide deposit insurance and, if so, how much and under what terms and at what cost. But GIVEN that it does provide such insurance, it is neither immoral nor imprudent for it to fulfill its advertised obligation. It is not clear to me that the taxpayers suffered any loss as a result of the government redeeming in 2008 its moral obligation to prevent loss to depositors of regulated, premium-paying banks.

What was outrageous in 2008 was the extension of protection to entities who had deliberately avoided the terms on which deposit insurance was provided, e.g., the money market funds, the AIGs, the Bear Stearns, and the Countrywides. Even if there was a practical argument that default by the AIGs of this world risked triggering a devastating chain reaction, surely the right solution would have been for the government to assume those liabilities that represented systemic risk and then to have particpated in bankruptcy as a regular creditor. The stockholders and management would properly have been wiped out, and the creditors would properly have suffered a haircut. It would have "bailed out" no one primarily responsible for the explosion in toxic securities backed by pseudo-mortgages.

Freddie and Fannie provide a problem within a problem. Here the government had made an implied promise of support for the entities' liabilities without payment of any insurance premium, pretended to regulate the entities, and let them operate as profit maximizing businesses. Given that situation, I am not sure what was ethical and prudent to do in the course of a panic. I am, however, sure that the situation should never be allowed to recur. Freddie and Fannie should be liquidated, and no such hybrid creatures should be established in the future.

Norman Pfyster writes:

This has been driving me nuts every time you talk about your "speed bankruptcy" idea: the main impediment to the idea is Article I, section 10, clause 1 of the U.S. Constitution, which prevents the government from "impairing the Obligation of Contracts." Debt, bonds, loans, etc. are just contracts (unlike equity interests). The Contracts Clause was indeed put into the Constitution to prevent the government from doing precisely what you want it to do. As an aside, the bankruptcy code was drafted fairly carefully to avoid running afoul of the Contracts Clause.

Methinks writes:

There wasn't a call to guarantee stock prices outright. However, in response to the hue and cry over the market tanking, we got a short ban on "financial companies" that eventually grew to include 25% of all exchange traded companies.

We also got reg Sho rule 204 (an ad hoc rule concocted overnight and then accepted as permanent several months later without another moment's thought). So, there was plenty going on to try to prop up the equity market.

Anti-shorting rules are meant to create a positive bias in markets. They create lots of perversion instead. While bailing out the bondholders works out much better for the bondholders than the residual owners, it does to an extent bail out those residual owners as well.

Floccina writes:

So how do we encourage equity over debt? We could even make home sales more like equity than debt.

Tom West writes:

Politicians treat depositors and megabank bondholders quite differently than they treat shareholders.

Could this be because nations that don't artificially protect bond-holders and depositors suffer massive capital loss leading to much lower levels of economic growth?

It seems to me, although this is only instinct, that many, if not most, of the bond holders felt that their debt would have the same level of risk as equities in a particular market, they would abandon that market for one that credibly protected debt owners.

Are there any nations that don't privilege debt holders that one can use for comparison?

Garett Jones writes:

@Norman Pfyster:

I agree that constitutional issues are non-negligible, point well taken. Two comments:

1. In the Fall of 2008, many things were possible. I suspect top bankruptcy judges and the Supreme Court could have been persuaded that this was a reasonable way to violate the priority of claims if no bailout (or only a tiny bailout) was forthcoming.

In Swagel's paper on the financial crisis, he says they considered and rejected debt-to-equity conversions. He never claims constitutional barriers to debt-to-equity conversions (It's possible constitutional questions came up but didn't get mentioned in his paper).

http://www.econbrowser.com/archives/2009/04/phillip_swagel_1.html

2. In the future, we should write our laws and appoint our judges so that speed bankruptcy is possible. It's better than TBTF.

A third thing:

I'd recommend that countries with megabanks and massive liquid financial markets avoid writing lines in their constitutions that create stark choices between 100-cents-on-the-dollar bailouts and multi-year bankruptcy. It can create a lot of trouble down the road.

Methinks writes:

Floccina,

Why encourage anything at all? How can "nudging" (a less obvious and looser form of central planning) be good for a market?

How about just not bailing people out of consequences of their actions?

Tom West,

"...many, if not most, of the bond holders felt that their debt would have the same level of risk as equities in a particular market, they would abandon that market for one that credibly protected debt owners."

No, they wouldn't and they don't. When the risk of a company's debt approaches equity risk, creditors require an increasingly higher interest rate which approaches the required return on the equity of that firm. This is what's known as "high yield debt" or "junk bonds". The interest rate on debt balances supply and demand just as any price balances supply and demand in any market. In the debt market, the interest rate - left to its own unmolested devises - also does the important job of pricing risk.

Lenders who wish to take a lower risk (resulting from a firm's better balance sheet or some kind of government guarantee) also accept a lower return. There is no free lunch. Backstopping losses is not only completely unnecessary but also harmful to the market, as is manipulation of interest rates by central banks. And that's as true today - whether or not there is a single country on earth that doesn't engage in this foolishness - as it was true that the earth was not flat when everyone believed it was.

Methinks writes:

One more thing....

Lenders are by contract entitled to the repayment schedule in the contract. Thus, they are entitled and the borrower so entitled them in a voluntary transaction. Residual owners are not entitled to anything but the residual profits of the firm (and thus require a higher rate of return).

But, I point to the fact that there are plenty of entitlements that are carried all the way to the senators' offices. Home buyers are equity owners of their property and debtors to boot. They carried a sense of entitlement to property they have not paid for to the senators as well. This is not a debt externality but of an overactive government prone to massive overreach. You're not going to fix that by nudging this way and that.

Greg G writes:

One way to encourage equity over debt would be to lower corporate tax rates but stop allowing interest as a deductible expense.

Tom West writes:

Lenders who wish to take a lower risk (resulting from a firm's better balance sheet or some kind of government guarantee) also accept a lower return.

That's a given. However, it seems that a huge amount of capital demands a low-risk/low-return situation - think pension funds, Chinese investment, etc.

My worry would be that while increasing the amount of risk on debt would increase the return, even so, this would result in much of the capital fleeing for other more protected jurisdictions.

Of course, a case can be made that there is really no such thing as AAA debt and all debt has higher default rate than we generally acknowledge, but I would not be surprised that any jurisdiction that acknowledged that reality would be rewarded for their honesty by having their economy turned into a smoking crater as investors flee for the more comforting lies of other nations.

Shayne Cook writes:

Tom West:

Just a quick point on part of your last comment:

"... low-risk/low-return situation - think pension funds, Chinese investment, etc."

Both debt and equity investments in China are decidedly high-risk, and therefore command high returns. China is high risk due specifically to the fact its jurisdiction does not afford legal protections similar to those afforded by the U.S. jurisdiction.

Completely irrespective of China's economic growth rate, it remains a communist, commanded economy. ALL assets within China are subject to nationalization at any time and at the sole discretion of the Chinese government - with no legal recourse for recovery.

Methinks writes:

One way to encourage equity over debt would be to lower corporate tax rates but stop allowing interest as a deductible expense.

I hear this all the time, but it's not deductible. Loan servicing is an expense item. Why? Because just as a business must pay all of its vendors, it must service its debt with the same diligence to stay in business. All vendors are, in effect, creditors of the firm. The only difference between the paper supplier and the lender is the maturity of the loan.

If government decided for some odd reason to force firms to treat this particular obligation differently, the market would adjust. But you'd still have a bailout problem because the urge to bailout friends of politicians is the problem, not that they happen to be lenders.

Kevin writes:

Shayne I suspect Tom was referring to the trillions of dollars of US Treasuries owned by the Chinese.

On topic, the bailout culture also contributes to the ABC's boom/bust cycle by distorting interest rates, which of course "necessitates" more bailouts.

Shayne Cook writes:

@ Kevin:

You're probably right about Tom's meaning (although the Chinese only hold about $1 Trillion of U.S. Treasury debt.)

Methinks writes:

That's a given. However, it seems that a huge amount of capital demands a low-risk/low-return situation...

Nope. Not at all. The absolute (vs. relative) size of the loan has nothing at all to do with anything. If there's a lot of debt relative to equity, the interest rate demanded by lenders will be higher. That is not theory either but what actually happens.

You're just dead wrong about capital flight, Tom. So long as you can be compensated for the risk you're taking, you'll make the investment. Why would anyone walk away from such a deal?

Of course, a case can be made that there is really no such thing as AAA debt and all debt has higher default rate than we generally acknowledge..

No. That would only ever be true IF there's government meddling. This scenario you imagine would not happen in nature because the market is not dumb. If the default rate turns out to be higher than originally thought, then the market adjusts for that in the future. That's how markets work.

Of course, today you have the Fed actively thwarting the natural risk/reward relationship by forcing you to accept less reward for a given level of risk. That's how governments work.

Tom West writes:

Sorry for not being clearer - I was indeed talking about Chinese investment in the U.S.

The absolute (vs. relative) size of the loan has nothing at all to do with anything.

Again, I wasn't clear. It's my understanding that a number of pension funds (which are huge), and a number of other investments are simply not allowed to invest in risky assets, regardless of return. Many other organizations are highly risk averse as well.

I've heard the phrase 'world-wide shortage of AAA debt' many times, and while you are, of course, theoretically correct that a high enough rate of return will bring sufficient investment, realistically speaking, if that rate is too high, there simply won't be a market. (i.e. companies can't afford to issue debt at the rate the market demands for the risk.)

You're just dead wrong about capital flight, Tom. So long as you can be compensated for the risk you're taking, you'll make the investment. Why would anyone walk away from such a deal?

Why are there different markets for stocks and bonds? Because the utility function vis-a-vis risk and return differ for different organizations and individuals.

I don't pretend any great knowledge - my only claim is that I don't think we have a good idea exactly whether the utility function of some very large pools of capital may dictate it would be better to invest outside the US than accept both higher risk and higher return.

Methinks writes:

Tom,

Pointing to specific restrictions of certain investment pools and variations in risk preferences really doesn't make your point. You and I can set up an investment pool bounded by whatever rules we want. But, since you brought it up, you're incorrect about pension funds. CalPERS, for instance, invests in risky hedge funds all the time. Pension fund managers require a certain return to meet the funds' goals and the mix of investments in the portfolio is pretty much up to them. Portfolio managers get into trouble when they manage individual investments rather than the entire portfolio.

Suppose, though, the world is brimming with irrational risk aversion. Subsidizing risk does not make it go away. It merely shifts the cost of the risk onto OTHER risk averse individuals who have no choice in the matter. How is this better?

I've heard the phrase 'world-wide shortage of AAA debt' many times,

I hear lots of silly things all the time. I just don't take them seriously. All that means is that AAA is strongly bid. The market has a way of dealing with that - eventually yield gets so low that AAA-rated firms issue more debt and sometimes use it to buy up stock. The government can relax.

And sure, sometimes the risk is so high a firm isn't able to find any capital. So what? All that tells you is that the expectancy is negative and that particular idea shouldn't be funded.

There are different markets for equity and fixed income because preferences (including risk preferences) vary. It's not just about risk. Majority equity holders often become majority equity holders to have a say in how the company is run. Lenders don't get a vote beyond whatever covenants are agreed to in the contract.

Fund managers will invest as they see fit. Sometimes that will be outside the United States even if there are great deals here if only for diversification purposes. the market doesn't pay you for taking diversifiable risk, you know. How do you propose to fix this non-issue? Do you seriously believe that transferring wealth from taxpayers to fund managers and their beneficiaries in a "heads I win, tails you lose" policy will somehow generate a benefit beyond enriching this small interest group at the expense of hapless taxpayers?

Dave Thomas writes:

This model doesn't seem to apply to the General Motors bailout. Bondholders in General Motors received significantly less than their invested dollars.

So the lesson is don't be a bondholder of anything other than a big bank.

DougT writes:

Is Lehman a "bank" in your view? Because a lot of Lehman bondholders lost a lot of money in 2008.

Are preferred stock shareholders bondholders or equity holders? Because a lot of preferred shareholders of FNMA and WaMu lost a lot of money in 2008.

It drives me crazy when people generalize about a situation they have no knowledge of. THE BAILOUTS TO THE BANKS WERE PAID BACK WITH INTEREST. Most of them didn't need the money, but we were in the midst of a systemic crisis that required an overwhelming presence. Hence the capital buy-in by Treasury, the MMF guarantee by the Fed, the other programs.

It wasn't just eight days. It started in August 2007 and continued until about June 2010.

Greg G writes:

Doug, "the other programs" were a big part of the reason that the banks were able to pay back TARP with interest. Without the bailouts of Fannie, Freddie, AIG, QEI,II,III etc. the banks would never have been able to spin this fiction that they really didn't need help.

Methinks writes:

Come on, DougT. "An overwhelming presence"? It's because of the government's "overwhelming presence" that the mess was this messy to begin with. This is what the "overwhelming presence" con game looked like:

Taxpayers backstopped loans (read: were forced to take uncompensated risk) to banks that then made back the money to "repay" their "debt" by borrowing at a below market 0% and lending out (mostly to the government - i.e. they bought a claim on our future production) at about 3%. Nice spread if you can get it. The Fed ensured they paid their debt with interest on the backs of savers and producers. And while I'm as incensed as you are about the conning of the market by forcing all banks to take bailout funds, the banks that didn't need it also benefited from charade.

I think they've overwhelmed the market to the point that it's as fragile as blown glass. Time for much less presence.

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