Why are taxpayers bailing out unsecured bank creditors?

Edward Harrison wrote an interesting post on his blog, Credit Writedowns, that lays out why bank "bailouts are bad, defaults are good" is not as black and white an issue as it is made out to be.

Regular readers know that your humble blogger doesn't look at the issue as bank 'bailouts are bad, defaults are good', but rather that bank bailouts are completely unnecessary.

They are unnecessary because banks can continue with no interruption in their day to day business with negative book capital.  Between government guarantees of their deposits and unlimited access to the central bank for liquidity, banks can address any concerns over a run on the bank.

Mr. Harrison starts by asking the question of "why are taxpayers bailing out unsecured bank creditors".

Back in early 2010, I recounted how Matt Taibbi, Barry Ritholtz and I each felt that the Swedish model was the right one, instead of the all bailout all the time approach that is standard fare right now. 

Clearly, the Obama people didn’t want this solution because they are captured by the financial services industry. That’s why the U.S. is going the Japanese route of bailouts and accounting dodges. 

Nice to see the he favors a Swedish model over the Japanese model for how to handle a bank solvency led financial crisis.

So, what is the right thing to do. Politically, it seems nigh impossible to allow bondholders to take the haircuts they deserve. Nowhere is this happening now. 

Bond investors made calculated capital allocation decisions. They misjudged the risk and must face the consequences. To bail them out is a moral hazard which encourages the misallocation of capital. 

And in Ireland’s case, and in Europe more generally, there is the question of economic nationalism to boot because the periphery’s creditors are foreign institutions. It’s not like the Irish government bailing out Irish creditors or the Greek government bailing out Greek creditors but more Irish and Greek governments imposing depression and huge debt burdens on Irish people to bail out foreign creditors. That’s some seriously combustible stuff. 

But there is the systemic risk dilemma: 

My problem here is that the holders of bank liabilities – depositors and creditors – have other options. They can always withdraw their support from an institution that they feel will fail – creating a self-fulfilling prophecy. This means that taking too much of a haircut on bondholders, especially senior bondholders, will undermine confidence in the system. 

In the Swedish example from the 1990s, this was recognized and a blanket guarantee was given to all depositors and creditors of institutions deemed to be solvent… 

This is a solution that was geared to address the ‘Bear Stearns problem’, where lines of credit are pulled and a firm goes under before it is clear that said firm is actually insolvent… 

However unpalatable a senior debt guarantee might be, it seems a wise option to consider...

Under this blog's blueprint for saving the financial system, existing bondholders receive a blanket guarantee.

My reasoning is slightly different from Mr. Harrison's.  He makes the case that bondholders should take a loss because they misjudged the risk of the banks.  I don't think they misjudged the risk because they never had the data they needed to correctly analyze the risk in the first place!

Furthermore and more importantly, the bondholders did not have any information that would cause them to question the financial regulators' representation over the years leading up to the financial crisis that the banks were solvent and low risk.

Bottom-line:  in the absence of disclosure of the information needed to assess each bank's risk, governments had and have a moral obligation to guarantee all depositors and debt holders.

Please note, that under this blog's blueprint, there is a natural end to this blanket guarantee.  Under the blueprint, banks are required to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  Hence, risk can be assessed and market participants can adjust the pricing of unsecured debt accordingly.

Six months after each bank starts providing ultra transparency the blanket guarantee ends and any unsecured debt issued after this is subject to haircuts based on the bank's future performance.

Six months provides market participants with enough time to independently analyze the data and determine the price they need to receive to take on this unsecured debt.

The issue is separating liquidity and solvency. In a systemic crisis, the illiquid can be rendered insolvent. So, a credible senior bondholder guarantee can underpin the capital structure of a solvent organization and induce investors to roll over debt. 

That’s why the Swedes guaranteed senior bondholders in the 1990s. As I put it then: "To my mind, this all speaks to the overriding need for policy makers to ascertain who is illiquid and who is insolvent and to as demonstrably as possible subject the insolvent and the solvent to the most differential treatment one can muster." 

Bank solvency is a measure at a point in time.  By definition, a bank is solvent if the market value of its assets exceeds the book value of its liabilities.

Under the blueprint for saving the financial system, whether a bank is solvent or not, it receives liquidity.

With ultra transparency, it is the market that determines which financial institutions have a franchise that is capable of restoring a bank to solvency through rebuilding its book capital accounts through future retained earnings after absorbing all the losses the bank faces and which financial institutions do not.

Those banks that the market does not believe have a strong enough franchise should be resolved by the financial regulators.  Any losses after the resolution process can be subsequently recouped from the banking industry as part of the cost of the deposit guarantee.