A Quick Note on Bank Liabilities

I want to pick up on a theme Simon discussed in his last two posts: the recent panic over bank debt, particularly subordinated bank debt. I’ll probably repeat some of what he said, but with a little more background.

Remember back to last September. What was the lesson of Lehman Brothers? The most important asset a bank has is confidence. If people are confident in a bank, it can continue to do business; if not, it can’t.

For the last six months, where has that confidence been coming from? Not from the banks’ balance sheets, certainly. And not, I would argue, from the dribs and drabs of capital and targeted asset guarantees provided by Treasury and the Fed. It has been coming from a widespread assumption that the U.S. government will not let the creditors of large banks lose money, out of fear of repeating the Lehman debacle.

The story goes something like this. Let’s say that Citigroup were restructured – via bankruptcy, or via government conservatorship – in such a way that creditors did not get all their money back. (None of this applies to FDIC-insured deposits or to recently-issued senior debt that is explicitly guaranteed by the government.) They might be forced to convert debt for equity, or they might be stiffed altogether. The first-order concern is that this would have ripple effects that could take down other financial institutions. According to Martin Wolf, bank bonds comprise one quarter of all U.S. investment-grade corporate bonds; losses would be spread far and wide, hitting other banks, pension funds, insurance companies, hedge funds, and so on. If Citigroup did not support its derivatives positions, then institutions that bought credit default swap protection from Citi would face further losses. (I believe that most U.S. banks were net buyers of CDS protection, however.) The fear is that it will be impossible to predict how these losses will be distributed and who else might go down.

The second-order concern is bigger. After all, Lehman did not seem to force any major financial institution into bankruptcy, although it may have twisted the knife that AIG had already stuck in itself. Once investors figure out that bank debt is not safe, they will refuse to lend to any banks, and we are back in September all over again. Or almost: it is possible that the Federal Reserve’s massive efforts to provide liquidity to the banking system will be enough to keep banks functioning. But who wants to take that risk?

This is why, for the last five months, the government has been doing everything it can to imply that bank creditors (at least for “systemically important” banks) will be protected, without saying so explicitly, because that would suddenly increase the potential liabilities of the government by trillions of dollars.

So what changed this week?


Simon’s theory is that the semi-forced conversion of Citigroup preferred into common shares was taken as a sign that the government may try to force creditors to exchange their bonds for common stock in future bailouts. Preferred shares are not, technically speaking, debt. But they are a lot like debt, and once you finish converting preferred into common, the next layer of the capital structure is subordinated debt. Now, Tim Geithner could come out and say, “Yes, we forced a conversion of preferred into common, but we’re going to stop there and not do the same to creditors.” But no, actually, he can’t say that, because that would constitute an explicit guarantee of all bank liabilities. So the market is left wondering, and we know by now that markets don’t like uncertainty.

Another possibility is simply that more and more people are thinking that the government may end up restructuring debt. Martin Wolf and Willem Buiter, both very serious people, both have raised the question of whether the government should be protecting creditors. Wolf, I believe, doesn’t answer the question (although he discusses the issue very well); Buiter says no.

Each time the lines on that chart above have spiked upward, the government has taken some action to imply that creditors will be protected, without making any promises. Chances are we’ll see another action along those lines. At some point, though, the government may lose credibility.

As an aside, one of the steps in Sweden’s sometimes-heralded bank rescue program was an explicit government guarantee on all bank liabilities. If any country could guarantee its banks, you would think it would be the U.S. But the real barrier to taking such a step is probably political more than anything else.

Originally published at the Baseline Scenario and reproduced here with the author’s permission.

2 Responses to "A Quick Note on Bank Liabilities"

  1. Guest   March 7, 2009 at 11:33 am

    Nationalize the lot of the dodgy buggers, clean out the share holders and the non secured creditors, and break them up. Afterwords bollock and shackle the system.It’s rubbish, and the pain being inflicted on regular citizens is unacceptable.Let’s end this now and get back pre Reagan basics. (Peace and Prosperity)

  2. John Thayer   March 7, 2009 at 7:00 pm

    The critical error underlying the thinking of the Treasury and the Federal Reserve lies in their steadfast belief that assets have some sort of intrinsic value. In other words, they believe that all of those illiquid mortgage-backed securities held by the banks are not being given a fair shake by the market. Given enough time, they feel quite certain that the values of these assets will recover to at least close to their prior prices. To their way of thinking, restarting the markets for lending through massive infusions of capital will spawn this recovery.However, rule number one of markets is that prices change. Sometimes they go up, sometimes they go down. Real estate is certainly no exception. And, when asset prices were exaggerated by the availability of excessive credit, and borrowing took place with the belief that asset values would always provide collateral, a bubble formed. In other words, the asset values that the Treasury and the Fed are hoping to resurrect were artificially high and probably cannot be re-created other than through massive inflation achieved only through a degree of quantitative easing that would be injurious to the status of our sovereign debt rating.As long as the government continues to pursue this erroneous and ruinous course, we shall see the destruction of greater amounts of wealth and the further burdening of our progeny. The government is pursuing this course of massive bailouts in lieu of realistic resolution through its role as the “lender of last resort.” In fact, the government is the “BORROWER OF LAST RESORT!” When its ability to borrow begins to falter, reality will have to be addressed forthrightly.