Why Are Bank Creditors Being Protected?

Justin Fox questions why bank creditors, other than depositors, are getting a pass in the current crisis? Bank shareholders and taxpayers are taking a hit so why not the creditors, particularly those bank bondholders? Here is Fox:

These bank bonds are mostly in the hands of large, sophisticated institutional investors — pension funds, insurance companies, mutual funds. It may be too much to ask small depositors to monitor the risks at the banks where they put their money and pay for getting it wrong. But these bond buyers are pros. If there is to be any market discipline of risk-taking by banks, bond investors ought to be the ones who enforce it by withholding their cash from the bad apples — and paying the price for misjudgments. Plus, a few concessions from creditors could ease the burden on taxpayers dramatically. If Citi's $486 billion in wholesale debt were converted into common shares — admittedly a pretty extreme solution — the company's balance-sheet woes would evaporate. Which is why these arguments have been gaining in popularity.

Fox calls this protection of bank bondholders the "great bond bailout." So why have the bondholders not taken a hit along with shareholders and taxpayers? The answer is that it would bring about another global credit crisis on the scale of what happened late last year. Here is how James Kwak describes such a scenario:

Let’s say that Citigroup were restructured - via bankruptcy, or via government conservatorship - in such a way that creditors did not get all their money back. (None of this applies to FDIC-insured deposits or to recently-issued senior debt that is explicitly guaranteed by the government.) They might be forced to convert debt for equity, or they might be stiffed altogether. The first-order concern is that this would have ripple effects that could take down other financial institutions. According to Martin Wolf, bank bonds comprise one quarter of all U.S. investment-grade corporate bonds; losses would be spread far and wide, hitting other banks, pension funds, insurance companies, hedge funds, and so on. If Citigroup did not support its derivatives positions, then institutions that bought credit default swap protection from Citi would face further losses. (I believe that most U.S. banks were net buyers of CDS protection, however.) The fear is that it will be impossible to predict how these losses will be distributed and who else might go down.

The second-order concern is bigger. After all, Lehman did not seem to force any major financial institution into bankruptcy, although it may have twisted the knife that AIG had already stuck in itself. Once investors figure out that bank debt is not safe, they will refuse to lend to any banks, and we are back in September all over again.

Kwak notes that this fear of another systemic failure of the financial system is why the U.S. government is bending over backward to protect bank creditors without actually saying so. I suspect the U.S. government is also trying to placate the concerns of certain foreign governments whose holdings of U.S. debt securities could be impaired if bond markets collapsed. Note that without this government protection many of the big banks are effectively insolvent. Unless the economy suddenly recovers and asset prices rebound, this insolvency will have to be meaningfully addressed at some point. When this restructuring takes place it could get ugly.