Monday, February 09, 2009
dealing pain to bank bondholders
Here's the problem: All of the large banks have substantial loans on their balance sheets that resemble the assets underlying home equity asset-backed securities and commercial mortgage-backed securities. In the asset-backed security markets, these loan assets are valued anywhere from $0.50 to $0.90 on the dollar, depending on type, location, avg. credit score, etc. Home equity lines of credit ("HELOCs" in bond parlance) are particularly severely discounted. Apart from State Street and Bank of NY/Mellon, there isn't a bank among the TARP recipients that does not own these assets in multiples of their capital, nor is there a bank that has charged off more than 5% of their value. ... The upshot is that taking true marks-to-market on assets leaves all of these banks without any tangible equity. Restoring confidence is a large chore when there is no capital supporting the bank. ...
The deepest, darkest concern of bond professionals is whether bond holders of banks will ever be asked to share the bailout pain. Ever since Lehman the Fed's reluctance to impair bank bonds has been palpable. For starters, finance issues represent more than 60% of 1-5 year maturity bonds. They are ubiquitous in pension funds, insurance company portfolios and, until last fall, money market funds (most money market funds have moved up the capital structure to CDs at this point, spooked by the post-Lehman panic). So there are "systemic" reasons to protect them. The same logic protects General Electric. Furthermore, the capital structure of large banks is horribly convoluted. If you wanted to get bondholders to contribute to recapitalization you'd have to create a scheme of cascading discounts to cover preferred stock and capital notes issued by the holding company and the senior and subordinated debt of the banks. Near the top of this stack is the preferred stock investment of TARP, so a bondholder discount necessitates a TARP revaluation. Also, the Guarantied "TLGP" obligations are holding company debt and would have to be discounted. So the government would participate in any loss.
Still, one understands public sentiment on this issue. Apart from Lehman, bondholders, like trading counterparties, have benefited at the expense of taxpayers. This potential uncertainty is one of the things supporting wide bond spreads. Despite the obvious government support, Citibank's holding company bonds offer a plus-sized 5% premium over their government-guarantied paper. Pimco, the gorillas of bond investing have publicly positioned themselves as if this pain-sharing will never happen. "Shake hands with the Government", they claim. Others among us have hedged our bets. On
MondayTuesday, Geithner will choose where to locate losses, or delay the reckoning again.
i'm counting on delaying the reckoning again, but it cannot last forever. the losses are so titanic in relation to the government balance sheet that treasury yields will rise enough to force monetization from the fed and the full measure of quantitative easing will begin. how that dynamic plays out in the press, public and political system will be interesting.