U.S. mouth writing checks its body won’t cash

By J Saft
April 8, 2009

James Saft Great Debate — James Saft is a Reuters columnist. The opinions expressed are his own —

A look at credit insurance prices for U.S. banks shows that market thinks the government’s mouth is writing checks its body can’t or won’t cash.

Despite a blistering rally in bank shares and Herculean efforts by the U.S. to build confidence in its financial sector, the price of insuring some leading banks’ debt against default has increased markedly in recent weeks.

That tells us that bond investors have serious doubts about the popular perception that the United States won’t allow systemically important institutions to fail, or in saving them in some form won’t make bond holders take substantial losses.

Since the KBW index of bank shares began a 65 percent rally on March 6 the cost of insuring Citigroup for five years via a credit default swap has risen to an annual payment of 627 basis points from 470, meaning it costs 6.27 cents to insure every dollar. Wells Fargo 5-year CDS stand at 292.5 basis points, as against 240 on March 3 and 120 at the end of December, while Bank of America’s ended last week at 355, exactly where it was on March 6 but 50 above its March 3 level.

The people buying this insurance fear if a big bank fails over the coming five years, or needs further buttressing with public money, the bill will be too large for the U.S. to bear, either politically or otherwise. That implies that there could be burden sharing by creditors, either through some sort of divvying up of the remaining assets or through forced or government orchestrated conversions of debt into equity.


The options for the U.S. aren’t particularly attractive. As pointed out by Tyler Cowen in the New York Times here for the U.S. to simply fess up and say it stands behind all bank debt is to take on a gargantuan liability and to effectively neuter bond holders as a force for market and company discipline.

If the U.S. were to allow someone big to go down and make bond holders suffer too, there is a legitimate fear that creditors to the banking system would stage a disorderly wildcat strike which could bring down many healthy institutions.

It is very similar to the situation last year when the U.S. took Fannie Mae and Freddie Mac into government conservatorship and did everything short of explicitly guaranteeing the two mortgage lenders’ debt. But that wasn’t enough for the markets, specifically the Chinese, who lightened up on Fannie and Freddie bonds, making mortgage rates higher than they otherwise would have been and hampering monetary policy. Ultimately the U.S. was forced to use the Federal Reserve to buy up Fannie and Freddie debt directly as a means of keeping mortgage finance flowing.


Remember too that these are 5-year credit default insurance contracts, so the same cast of characters might not even be in charge when the bills come due. The range of outcomes is pretty wide and so it’s no surprise people want insurance.

It is possible too that the CDS market is distorted or deluded; after all these might be the same people who are paying good money to insure against U.S. sovereign default, an event that might happen but would surely leave very few counterparties with the ability to make good claims.

To be sure, this doesn’t create funding problems for banks at this stage. They are able to sell bonds backed by the Federal Deposit Insurance Corp’s rather hopefully named Temporary Liquidity Guarantee Program. If those CDS spreads don’t come down it isn’t going away any time soon. It has already been extended into 2012 and I’d expect more in due course.

So, the U.S. is likely to continue to make soothing noises to bank creditors while saying nothing too specific or legally enforceable, all the while hoping that something, anything, turns up. That might work.


However, the current fudge imposes its own costs. Banking is a long-term business built on trust. The very existence of concerns among creditors will breed them among clients and will tend to undercut a bank’s ability to get new business and hold on to the old. Lack of trust is a vicious cycle.

So should the U.S. force creditors to pay their share if a major bank needs rescuing? My heart says people should bear responsibility for their decisions and pay the costs. But even the most puritanical capitalist should be extremely worried about what holding this particular group of vested interests responsible for their mistakes might mean for the rest of us.

Remember too that the rather successful Swedish bank bailout made creditors whole, but hit equity holders and management. I’d settle for that.

— At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. —


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What a murkey mess.
The banks themselves seem to demand collateral and liens on assets for extending finance, forcing bondholders to be unsecured creditors, with a diminished asset base.
I wonder who can issue credible CDS insurance at present – MBIA? AIG? Perhaps CDS prices are now less reliable as an indicator of the risk in the insured bonds.

Posted by Survivor? | Report as abusive

It might be worthwile to have a look at who-owns-whom. The liabilities banks(1) have towards others banks doesn’t seem to be the issue. The idea is that if you have Bank A owing Bank B say 100 and Bank B to Bank A 90 those would cancel out during nationalization of both banks. How many banks would have to be nationalized to capture 50, 70, 80, 90, 95 % of all liabilities the banks have?

(1) Banks in this context are Finanical Institutions (FI).

Posted by Robynne | Report as abusive

What you gain on the swings you are inevitably going to loose on the roundabouts. Yet for some reason the US Government thinks that its total wealth is more than the sum of its many parts; the people. It is simply not possible to continue to borrow, insure and guarantee in the real world from monopoly money; it does not add because the basis for paper money lies in its correlation with actual value in the real economy. That is where the problem starts, because it no longer does. Even though it says in God we Trust on the back of the US Dollar; God is not paying for this, people are. Other major banks will doubtless be forced into liquidation, because the houses, hotels and cars bought on the monopoly board during the 1990s and since the unhappy millennium unfolded were not actually afordable in the real world. If mortgaging the future to pay for the present was teh beginning of the problem, and the old swings and roundabouts addage has merit, then pay back is going to a hitch!

Posted by Peter J. Middlebrook | Report as abusive

Does it occur to anyone that these CDS instruments are not a safe way to insure against default? CDS do not seem to have the same capital reserve requirements of other financial instruments in banking and insurance. Why hasn’t this type of derivative which is partly responsible for this catastrophic economic meltdown been outlawed or highly regulated. Or maybe we should all just get into the CDS business. It’s kind of like a license to steal. Hey buddy, want to buy some insurance?

Posted by Jonathan Cole | Report as abusive

Read Mr. Cole above. Then let the banks fail. Send the depositors down the street to a regional bank that isn’t as stupid as a giant. Nothing is too big to crash. It will be cheaper. Insist in adding economics and finance as mandatory courses in school. The current course of action is expensive and dumb.

Posted by Andrew Franks | Report as abusive

hi do the people really think that we lend the banks money for it to be rested over a period of time for it to stay there forever and we cant get hold of it and mis trust in us the lenders for them not even to give a little loan of our money back too us an keep on saying that word administration beating around the bush legacy keep trying to fool us the public for how long i must say every country can not be in the euro

Posted by Mr neil Maysiur | Report as abusive

On the topic of “burden sharing” and “costs”, I’d like to suggest putting the political leaders into the spot light as well. For example, why has Tony Blair been allowed to slip out of the driving seat just as he steered not just the British economy, but large parts of the global economy, over the edge of a cliff, and then swans off to be a Middle East Peace Envoy, where he achieved more than he did anywhere else (and that added up to nothing) after which he now seems be trying to wrangle his way into his newly founded Catholic faith’s politics. The banks bad behaviour was a direct result of poor legislation, and even poorer administration of legislation, which the politicians are responsible for. The greedy little two-homers, property investors etc., should be burned if they put themselves in the fire.

Posted by Peter H | Report as abusive

The U.S. government has been writing checks it’s ( expletive deleted) can’t cash and not paying back debt since Ronald Reagan. Those who sew a foul crop must reap that harvest.

Posted by Anubis | Report as abusive

I agree with other folks: who on earth is a credible writer of credit default swaps at this time? And as far as the ones who are doing it with no rational credibility, are we going to bail them out next???

Why is it being done? Some clown satisfying a paper policy in a way he knows amounts to zip?

Posted by Pete Cann | Report as abusive

Our women will be wearing Burkas, and our daughters will be handed off as Saudi domestics if we stay on our present course. Our continued reliance on fossil fuels, and cheap tainted products from China will cause us to deplete our savings, and inevitably fall into servitude to the producers of the world. I suggest emphasis in 21st century job skills, solar panels, motor scooters, and domestic production! Why allow China to corner the commodities market with deals in Africa, South America, and Australia, while we sit on our hands? We should be fighting them for this stuff, and making our own products. We should make these domestic products of top quality, the way we used to. Disposable products are contributing the most to global warming and toxic byproduct emissions through their production, and these products are inherently designed to require replacement, making them a never ending source of energy consumption and toxicity. Using foreign oil is like smoking crack, and buying Chinese goods instead of making them ourselves is cracked. Production is needed to back up our currency, or currency devaluation, and an undermining lack of confidence in our monetary systems will prevail. Already the Chinese are backing off of American debt, and suggesting an official world reserve currency. We have dug ourselves into a hole by doing less and less real work, and expecting our standard of living to somehow miraculously be maintained through manipulation of other people’s money. Now it has been revealed that all of this was the proverbial house of cards, and the creditors are calling.

Posted by David E. Connolly, Jr. | Report as abusive

On the subject of CDS, do you know that people are buying insurance on US issued T-Bills? Now who would be the counter-party to that? What company can claim they will have the funds to cover you if the US government fails? I guess it would be the Saudis and Chinese.

Posted by perk | Report as abusive

The US came off the gold standard and now has gone over to the debt standard. The actual price of something means nothing anymore. The buyer only looks at the payment amount and wants immediate gratification regardless of the price. This is the basis for the inflation that has crushed the USD.

Posted by Paul | Report as abusive