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