Why banks find it so easy to borrow
John Lounsbury attended the most recent meeting between bloggers and Treasury officials, including Tim Geithner. He reports:
In one brief exchange an interesting thought emerged. The fact that bank stocks are trading at or below book value seems to be in conflict with the fact that banks are having little trouble in selling bonds. The thought was expressed that the bond market is looking at solvency and the stock market is looking at future profitability. Markets now are telling us that investors are not worried about insolvency but do have questions about profits in coming years.
I have thought about this after the meeting and wish I had asked the question if there is still some backstop mentality in the bond market – the government will not let these banks fail.
The first thing worth noting here is that from a policy perspective we want banks to have low spreads and low stock prices: both of them are an indication that they’re approaching low-risk, utility-like status. High spreads and high stock prices would imply a banking system full of gambling and risk.
It’s not really the case that a low stock price is “in conflict with” a low spread on a bank’s bonds. To the contrary, it’s an indication that the market believes that the government is, or will be, doing its job when it comes to bank regulation. High stock prices come from excess profitability, which in turn comes either from inappropriate risk taking, like the prop trading which is being outlawed by the Volcker Rule, or else from the kind of predatory fees which the Consumer Financial Protection Bureau exists to crack down on.
But yes, the market still believes that the government will bail out bank bondholders. As Tyler Cowen asked Geithner (or possibly one of the other Treasury officials):
“What I really want to know is how your incentives have been changed! What is to say that next time the decision will not be made to again bail out the bondholders?”
There’s an enormous amount of institutional pressure, within any government, to bail out bondholders who get themselves into trouble. It happened with AIG, it happened with Citigroup, and it will surely happen with California or any other large state approaching default as well. It didn’t happen with the automakers, and the squeals of pain from bondholders were very loud and astonishing to behold.
So the best way to avoid a future bailout of bondholders is to ensure that it never becomes necessary. Because if there’s another banking crisis, the pressure on the government to bail out bondholders will be just as strong as it was last time around.