Thursday, August 19, 2010

Yes, Of Course Bank Bond Investors Should Absorb Losses!

The first story I read this morning was "Basel Committee Says Bank Bond Investors Should Absorb Losses."

"The Basel Committee on Banking Supervision is proposing that bond investors should help bear the cost of future bank bailouts as it seeks to reduce moral hazard and the burden on taxpayers. 

All regulatory capital instruments sold by banks should be capable of absorbing losses in the event that a bank is unable to fund itself in the private markets, said the committee, which sets international banking rules, in a consultation document. The securities could either be written off, or converted to common equity, the committee said. 

“A public sector injection of capital needed to avoid the failure of a bank should not protect investors in regulatory capital instruments,” the committee said in the report, published on its website today. 

The committee is seeking to redress the situation during the financial crisis, when holders of Tier 2 capital instruments, such as subordinated debt, benefited alongside depositors from government assistance and avoided losses. The committee is reviewing the role that contingent capital and convertible capital instruments could play in the regulatory capital framework. 

The committee, which represents central banks and regulators in 27 nations and sets capital standards for banks worldwide, was asked by Group of 20 leaders to draft rules after the worst financial crisis since the 1930s. The committee said it will welcome any comments on the proposals until Oct. 1."

But it's not just subordinated debt - it's all debt.  As we've said many times - stockholders should get wiped out, bondholders should have their obligations restructured, take haircuts, and become the new equity owners of the company.  I even asked Barney Frank this very question back in May, 2009 at a Town Hall Q&A session - "Why were auto bondholders and shareholders asked to make concessions during their bailout negotiations while bank bondholders and shareholders did not have to make concessions - and how do you justify the massive transfer of wealth from the taxpayer to both bank bondholders, and bank shareholders in the form of common stock dividends which are STILL being paid by Citi and BankAmerica?"

I can't help but think of the movie Usual Suspects - do you remember the scene where Kevin Pollack's character (Tom Hockney is being interrogated?):

Cop:  "I can put you in Queens on the night of the hijacking."

Hockney: "Really?  I live in Queens. Did you put that together yourself, Einstein? What, do you got a team of monkeys working around the clock on this?

In other words, it shouldn't take a committee of central banks and regulators in 27 nations two years to come up with the most obvious solution of all.   But hey - at least it's a start!

Edit:  Commenter Greycap notes that I misinterpreted this article (which has since been expanded and elaborated on in the Bloomberg link).  His point is that the Basel committee is not talking about who should take the pain in bankruptcy, but rather, how to avoid bankruptcy in the first place by regulating the quality of capital.  So, read this article as a condemnation of the bailouts that subsidized bondholders who should have taken the losses, and not as a condemnation of the Basel Committee taking 2 years to state the obvious - since that's not what they're doing here.



Greycap said...

You have missed the point. Anything can take a loss when you bankrupt the obligor, but the whole issue is about setting capital high enough to avoid bankruptcy. The committee would like to encourage banks to avoid bankrupting themselves because it is not really possible for a financial institution to continue operations while bankrupt.

So take as big a loss on bonds as you like - nobody cares. But you can't count your bonds as capital if defaulting would trigger legal consequences that impair your operations.

Kid Dynamite said...

ok Greycap - good clarification - let's talk specifics (and I see that it may be a slightly different "point"...

I'd start with BSC. What should have happened with BSC's failure was that instead of the Fed guaranteeing $30B of liabilities, BSC's bondholders should have taken haircuts - do you disagree? Weren't they made whole?

Next would be Wachovia - the initial deal was for the FDIC to take them over and sell them to Citi, with massive gov't guarantees. of course, that's not what ended up happening, WFC stepped in, but it never should have been on the table - the WB bondholders should have taken those losses before the government.

no? that's my point.

i understand your last sentence with respect to not-yet-bankrupt institutions: "But you can't count your bonds as capital if defaulting would trigger legal consequences that impair your operations." thanks for the concise explanation.

Greycap said...

I agree that rescuing bond holders was a bad idea. But so would a lot of BCBS members.

I just don't think its very helpful to use Basel's concern with the quality of capital - which is actually an important issue - as a springboard to go off on a tangent about bailouts. Its sort of like the guy who says "buy gold!" and "disband the Fed!" when the subject of discussion is farm subsidies.

Kid Dynamite said...

i misread the initial bloomberg article (which i c&p'd in its entirety), which has now been expanded and elaborated on (if you click the link).

so, read this instead as having nothing to do with Basel and instead being about how the bailouts could have been improved upon.

Greycap said...

On re-reading, I see that some of my language has been inflammatory, which I regret. I apologize for causing offense. Rest assured, that I have no quarrel with the substance of your rant.

What I am saying is that this capital issue deserves a different, special rant of its own. The Bloomberg article seems misleading to me. Under the Basel II regime, banks were allowed to count certain very special debt instruments as tier 1 capital. These instruments had no fixed maturity, but had a step up in coupon after a fixed term, usually 10Y; at this point, they were callable by the bank. Neither principal nor coupons were guaranteed, and coupons were not accrued if skipped. You can see that this structure was designed to absorb losses when the bank was in trouble without exposing the bank to the IR duration of a perpetual bond; when healthy, the bank would roll over the debt rather than pay the penalty rate.

But this is not what happened in practice. The buyers of this capital debt were the same institutions that bought subordinated bank debt. When the crisis hit, banks continued to call their "capital" debt even though the options were out of the money. They were afraid to call because they thought that would tank the market for their sub debt, which is much more important to them. A few regulators forced their banks to call but most did not have the power or will to do so.

A moment's reflection shows that this capital debt ought to trade much wider than sub debt, to which it is junior. It has all of the risks of equity without the upside, and when fairly priced should be expensive. That it was not raises the suspicion that banks were privately assuring buyers that they would always call; in effect, doing an end-run around regulations. This is what the committee is now trying to fix.

Kid Dynamite said...

greycap - are you talking about trust preferred? plus - they (the banks) all owned each others TruPs, right? it was a big circular reference ponzi scheme....

Greycap said...

KD, so far as I know, TPS are long-dated but not perpetual. That would make them eligble for tier 2 but not tier 1 - see Having said that, different national regulators have materially different interpretations of the rules, making direct comparisons of capital ratios meaningless.

Qualifying tier 1 debt instruments have different names in different countries because they have to be tweaked for different regulators. So far as I know, the main demand was from asset managers, not other banks. I could be wrong about that.

Of course, this issue is just scratching the surface of bogus capital. E.g. sub debt was routinely issued with a call date 5Y before the legal maturity to avoid the 5Y amortization rule for tier 2 debt. And why should tax credits deferred to future years have counted as capital? To be worth anything, they require going concern operation + future profits. Isn't that the same as assuming there will be no problem?

Kid Dynamite said...

Greycap - changing topics a bit, back to your initial few comments - a firm can restructure debt (with debtholders taking haircuts) without declaring bankruptcy. Was your point that with financial companies although this may be true in theory, it's impossible in practice, because doing so would result in a complete undermining of confidence and a run on the bank?

Greycap said...

Yes. Debt and its cost is only one aspect of the operations of a company in the real economy. But it is the substance - the body and blood - of a financial institution. It is not possible to speak of "debt restructuring" and "continued operations" in the same breath. A defaulted bank is a pariah.