In reality there is a better third choice available: bank equity holders.
Bank equity holders are able to provide almost unlimited funds to absorb the losses in the banking system. They can do this because they can provide the capital that is currently on the balance sheets of the banks and the future earnings of the banks.
In a modern banking system with deposit guarantees and access to central bank funds, banks can support the real economy and operate for years with negative book capital levels. Examples of this include the large US banks who had made loans to Less Developed Countries in the mid 1980s and the US Savings and Loans with their underwater mortgage loan books in the 1980s and early 1990s.
Spain's plan to rid banks of toxic real estate assets is reviving the politically heated debate over how creditors and taxpayers should share the vast losses still being incurred by the euro zone debt crisis.Your humble blogger's preference is neither existing creditors or taxpayers, but rather bank equity holders.
Nowhere is the issue in sharper relief than in Ireland.
The government took an 85 billion euro IMF/EU rescue package to bail out the country's banks, felled by a reckless decade-long building boom, and extended a blanket guarantee to 440 billion euros of the banks' liabilities, including senior bonds....
The overriding reason why Dublin cannot bow to public calls to "burn the bond holders", even if it wanted to, is simple: the European Central Bank would not permit it....
This experience colors the advice that Irish academics proffer to Spain, which is hoping to cleanse banks of their sour property loans without adding to a public debt burden that is already so high that some investors believe Madrid too will need aid from the IMF and European Union.
"Resolve the banks if you have to and don't get forced by the ECB into paying 100 cents on the dollar to bond holders in banks that are bust, which is what we were forced to do," said University College Dublin economics professor Colm McCarthy.
The ECB's fear that forcing losses on bond holders would rattle markets was borne out to a large extent during last year's negotiations over a second IMF/EU rescue for Greece.
After months of saying no, the ECB relented in July and accepted the need for holders of Greek sovereign bonds to take a 21 percent writedown. Soon after, the government bonds of Italy and Spain came under heavy pressure.
"The ECB would say the same would happen to the senior bond market. You'd kill it for a long, long time and they're anxious to avoid that," said Alan Ahearne, a professor of economics at the National University of Ireland in Galway.
Shareholders and owners of subordinated debt have shared in losses during the crisis and in some cases have been wiped out.
"But it's still the case that no senior bank bond holder has taken a loss in the euro area, and I see no signs of flexibility from the ECB on that," Ahearne said.There is no reason that existing senior bank bond holders have to take a loss. They can be protected while the bank equity holders absorb the losses.
Ahearne learned the hard way what happens when a banking system is drowning in bad debt.
He was special adviser to late finance minister Brian Lenihan when Ireland set up a "bad bank", the National Asset Management Agency (NAMA), in December 2009 to buy tens of billions of euros of property loans that were under water and sinking fast.
Without a change of heart by the ECB, Ahearne said any losses in excess of Spanish banks' equity and subordinated debt would ultimately be borne by the state.
"If property prices keep falling - and they're likely to keep falling in an environment in which the economy is continuing to contract - those losses will be mounting. And unless something changes in the European approach, those losses will fall on the Spanish taxpayer," he said.
Officials in Madrid insist that Spanish banks' 184 billion euros of troubled real estate assets are manageable, not least because new provisioning rules will force the lenders to write down some 60 percent of that total.
Nevertheless, the government wants banks to start transferring dud real estate assets soon, on a voluntary basis, to liquidation companies.
Spain has restructured its banking sector three times and is confident that a carve-up will obviate the need for another rescue of the banks, whose non-performing loan ratio has risen to 8.2 percent, an 18-year high.
Investors are less confident. Suspecting that the state will have to write a cheque at the end of the day, they have driven up yields on Spanish bonds that are unsustainably high in the long run. Ten-year yields eased on Friday to around 5.70 percent.
"Spain is trying to find a way to have its cake and eat it too. They want to get these assets of the balance sheets of the banks. On the other hand they don't want the central government to take on liabilities that would balloon out Spain's debt to GDP. So they have to find a compromise," said Marchel Alexandrovich, European financial economist at Jefferies, an investment bank, in London.The simple way for Spain to have its cake and eat it too is to have the banks recognize the losses hidden on and off their balance sheets.
Much depends on how far real estate prices still have to fall. So far, house prices in Spain are down 22 percent from their 2007 peak, compared with slumps of 34 percent in the United States and 49 percent in Ireland.
"Unfortunately, the Spanish government has not clearly explained how much more adjustment they expect for the Spanish housing market, what this implies for the banking sector, and how the government intends to deal with the consequences," Deutsche Bank economists Thomas Mayer and Jochen Moebert wrote.
Although Spanish property experts point to an array of factors that make it unlikely that prices will fall by more than another 15 percent, the IMF has said "greater reliance on public funding may be needed", while Moody's Investors Service sees a risk that the banks could still become a burden for the state.
In a note published on Friday, economists at Barclays Capital estimated future expected losses for the Spanish banking system of 198 billion euros.
Banks had made 110 billion euros of provisions as of the end of 2011, leaving 88 billion euros of losses to be cover, BarCap calculated.
Profits over the next two years and buying back discounted junior debt might yield 40 billion euros, but the investment bank saw a need for extra public sector support of 46 billion euros to meet the shortfall in bank capital. The state has already injected 16 billion euros of capital, it said.And why only use profits over the next two years to cover the losses and not profits for the next decade?
In the absence of external investors, creating an asset management company, or bad bank, to buy the toxic loans would not reduce the fiscal cost for Spain of recapitalizing the banks. But it could improve investor confidence if the tainted assets were sold for credible prices.
"This could pave the way for a return of private foreign capital into the country. However, the process may reinforce investor concerns if the valuation process shows large provisioning shortfalls," BarCap concluded.Alternatively, the banks could provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details. This would let investors determine how much damage was done to each bank's balance sheet and how long it is likely to take to repair such damage.
Trinity College Dublin economics professor Philip Lane said the trick was to purge the banks of sufficient risk so their books are "clean" once more in the eyes of the markets, without saddling the government with too big a bill.
"To guard against being overly generous from the taxpayer's point of view, some of the downside risk would stay at the bank. If the transfer values are too good, down the line it would be recouped from the banks," Lane said.I recommend leaving all of the risk and ultimate losses with the banks. With ultra transparency, the risk could be monitored.
Ireland's experience shows just how difficult it can be to set the right price in fast-falling markets.
Even after NAMA took a huge chunk of bad loans off Irish banks starting in February 2010, house prices continued to fall and mortgage arrears kept rising, exposing an additional capital shortfall last year of 24 billion euros.
The total cost of recapitalizing Ireland's banks so far is estimated at 86 billion euros, or 52 percent of GDP.
For McCarthy, the University College Dublin economist, making governments pay for disastrous private-sector lending decisions is not just iniquitous. By refusing to countenance losses for senior bond holders, the ECB is destroying market discipline, he argued.Actually, by not requiring banks to provide ultra transparency, regulators are preventing banks from being subjected to market discipline.
The ECB is quite rightly pointing out that since before the beginning of the financial crisis the regulators have misrepresented the solvency of the banks. Just look at the results from the latest round of stress tests.
This is important since only the regulators currently have access to all the useful, relevant information in an appropriate, timely manner for assessing the risk of each bank.
In effect, the ECB is saying that the senior debt holders relied on the regulators representations on bank solvency and as a result they should be protected.
I agree with this position.
I also think that banks should be required to provide ultra transparency so in the future senior bond holders do not have to rely on solvency representations made by regulators, but instead can be held responsible for their own independent assessment of solvency. Being held responsible would mean that buyers of newly issued senior bonds in the future would no longer be protected from losses.
"We have built a moral hazard machine and it needs to be stopped," McCarthy said. "There is no market discipline if you continue to give 100 cents on the dollar to people who bought bonds in banks that are closed in the Irish case."My view of the moral hazard machine is the implied guarantee to investors that results from governments' representations on bank solvency.
Having governments assume banks' obligations to their creditors also risks doing permanent damage to the sovereign bond market because buyers will stay on strike if they cannot quantify states' contingent liabilities, he said.What cannot be quantified on the bank books, cannot be quantified if it become a liability of the sovereign.
"Clearly, the ECB thinks that bank debt is more important that sovereign debt. But there comes a point where these things just have to be faced. A sovereign insolvency in Spain, or in Italy for that matter, runs the risk of a very big financial catastrophe in Europe," McCarthy said.