naked capitalism

The US is considering more drastic measures to shore up the banking system, namely guaranteeing bank debt and removing the ceiling on deposit guarantees.

The idea of insuring bank debt may seem odd, given that writers like John Hussman have urged that bank bondholders, who knew the risks of investing and enjoyed the higher yields, should take their lumps before taxpayers do.

The proposal apparently being floated merely extends out to debt of 36 months and thus appears to be directed at freeing up the money markets and alleviating worries about rolling over maturing debt.

When I read the headline, I has assumed it was a broader guarantee, designed to address the sword of Damocles of credit default swaps. Credit default swaps are a significant multiple of the value of underlying cash bonds , and more contracts get written when a credit starts looking rocky.. Say you have, as Lehman did, $128 billion of bonds, the value of the CDS could easily be $500 billion, perhaps even a trillion dollars

Believe it or not, it is cheaper to insure the debt than pick up the pieces (in this environment) of losses on the credit default swaps. Perhaps the short term debt backstop also intends to achieve that end, too, but it appears to have more immediate aims.

It is horrific that we ever got in this position. But the authorities are in MASH mode, doing operations in the field trying to stabilize as many patients as possible. My big concern is whether anyone is doing triage, or merely running to work on the next bloody body they see.

Update 1:20 AM: The New York Times has a somewhat different take on these plans, which may suggest the degree to which things are in flux. Scroll down below the Wall Street Journal section to find excerpts from their story.

From the Wall Street Journal:

The U.S. is weighing two dramatic steps to repair ailing financial markets: guaranteeing billions of dollars in bank debt and temporarily insuring all U.S. bank deposits…

The top economic officials of the Group of Seven leading industrial nations will meet starting Friday in Washington where they intend to discuss a proposal from the U.K. government to bolster bank lending…

Under the U.K.’s recently announced plan, which it is now pitching to the G-7 members, the British government would guarantee up to £250 billion ($432 billion) in bank debt maturing up to 36 months. The British concept to expand its proposal to other countries has a lot of support from Wall Street and is being pored over by U.S. officials…

The move to back all U.S. bank deposits, which is only in the discussion stage, would be aimed at preventing a further exodus of cash from financial institutions, including small and regional banks, some of which are buckling under the strain of nervous customers. In recent weeks, customers have pulled money out of some healthy community banks under the assumption that the government will only insure all the depositors of larger banks in the event of a failure.

To remove the ceiling on deposit insurance, multiple government agencies would first need to agree that there was a “systemic risk” to the economy, thereby invoking a rarely used legal power. Amid repeated efforts by the federal government to prop up ailing institutions, some bank regulators say the move is justified.

It’s not clear that either idea will become reality,…

The plan in the U.K. was hammered out by Treasury Chief Alistair Darling as well as the chief executives of major British banks earlier this week after a sharp drop in U.K. bank stocks.

In the U.S., some $99 billion in just one type of bank debt is coming due between now and the end of the year. Hundreds of billions of dollars will need to be paid in the U.S. and Europe. Government backing would make it easier to issue new debt to help pay for that….

The U.K.’s decision to guarantee bank debt sparked talk that the U.S. would need to make the same move. On Thursday, the three-month dollar London interbank offered rate, or Libor, hit 4.75%. On the Friday before Lehman filed for bankruptcy protection, the three-month rate was 2.81875%. A surging Libor could exacerbate larger economic problems because many mortgages are tied to rates that fall or rise depending on Libor.

Offering unlimited or steeply higher deposit-insurance limits in the U.S. would closely resemble what several European countries, including Germany, Denmark and Ireland, have done recently. Regulators would have discretion about whether to raise limits for just retail accounts or for corporate accounts as well. If they use the authority, it is expected to extend to all deposits, as the loss of large corporate accounts for banks can be devastating.

“Our European friends have done it, so there will be great pressure to follow,” former Federal Deposit Insurance Corp. Chairman William Seidman said.

The FDIC has roughly $45 billion in its deposit-insurance fund to cover $5.2 trillion of insured U.S. deposits. Lifting the cap entirely would mean the FDIC would be guaranteeing the remaining $1.8 trillion of U.S. bank deposits. An element of the recently enacted bailout law gives the FDIC much broader authority to borrow money from the Treasury Department to backstop its fund if it became necessary.

A blanket guarantee on deposits could present risks apart from exposing the FDIC to enormous costs…

Yet not making such a move opens up the possibility that customers with large deposits in U.S. banks might withdraw their funds and move them overseas to jurisdictions that offer more insurance….

“I think that lifting the cap entirely is something that may have to be done, really, just in the next few weeks,” said Camden Fine, chief executive officer of the Independent Community Bankers of America, a trade group.

Bank regulators believe the “systemic risk” clause in federal law gives them the authority to lift insurance limit…Last week, the FDIC invoked the risk clause for the first time when it agreed to take on some potential losses to assist in the sale of Wachovia Corp. to Citigroup Inc….

Customers’ fears have spurred bank runs across the country, especially at wounded financial institutions. IndyMac and Washington Mutual Inc. collapsed, in part, because of late runs on their deposits. Wachovia, which came close to failing twice in recent weeks, has seen large outflows of deposits since last week, according to someone familiar with the matter. Wachovia declined to comment on its deposits.

From the New York Times:

The United States and Britain appear to be converging on a similar blueprint for stemming the financial chaos sweeping the world, one day before a crucial meeting of leaders begins in Washington that the White House hopes will result in a more coordinated response.

The British and American plans, though far from identical, have two common elements according to officials: injection of government money into banks in return for ownership stakes and guarantees of repayment for various types of loans….

The Treasury’s openness to direct infusions of cash is a remarkable change in tone from a few weeks ago…Treasury officials, however, said the emphasis changed in the last week, largely because stock markets kept spiraling down.

Prime Minister Gordon Brown of Britain made the case, in a letter to President Nicolas Sarkozy of France, for another option gaining favor among economists — guaranteeing short- and medium-term loans between banks. By persuading banks to resume lending to each other, the plan aims to shake loose the paralyzed credit market. “This is an area where a concerted international approach could have a very powerful effect,” Mr. Brown said Thursday in the two-page letter.

Administration officials are discussing aspects of the British proposal but said different economies have different rules that complicate a single joint action.

One senior administration official argued that expecting an agreement on proposals like Mr. Brown’s would be “irrationally raising expectations.”

Still, recapitalizing the banks and jump-starting their lending are at the top of the list of remedies that many economists are now suggesting. By acting in concert, countries can maximize the punch of their actions, these experts said, while avoiding distortions that occur when countries go different ways.

“At a minimum, you want to curtail damage,” said Carmen M. Reinhart, a professor of economics at the University of Maryland. “You don’t want the beggar-thy-neighbor policies that characterized the Great Depression.”

“At a maximum,” she continued, “you can get general principles — the need for a swift recapitalization of the banks, the need for liquidity — so we don’t get an even bigger credit crunch.”…

The White House confirmed that the Treasury Department was considering taking ownership positions in banks as part of its $700 billion rescue package. But officials said the idea was less developed than the plan to buy distressed assets from banks through “reverse auctions.”

The goal, Treasury officials said, is a plan that would be broadly available to all banks, rather than through specific rescue packages negotiated on a case-by-case basis. That makes it likely that the government could afford to take only a small stake in any single institution.

The direct injections of cash would be for comparatively healthy banks. If a bank is failing and needs to be rescued or shut down, the Federal Deposit Insurance Corporation would handle it through its own procedures….

For their part, American officials questioned how the British government and the banks would value the capital injected into the banks, for purposes of taking equity stakes. They also said the proposal was vague about how the government would treat executive compensation….

Britain’s plan also hinged on the willingness of several of the largest banks — Royal Bank of Scotland, Barclays and HSBC Holdings, among them — to sell preferred shares to the government. It is not clear, administration officials said, that the largest American banks would agree to this, particularly given the restrictions on executive pay.

Another concern banks are likely to have is that any government ownership stake would dilute the holdings of existing shareholders.

Dear God, Rome is burning, and the Treasury Department is hung up on niceties like executive comp and the standing of existing shareholders. If the bank needs capital, current sharedholder WILL be diluted. The fact that this is coming up in discussions about how to keep the financial system from imploding is deeply troubling.