US Considering Backing Bank Debt

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.

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  1. Anonymous

    At this point, isn’t the only option to nationalize all banks, wiping out equityholders? A 100% loss of bank equity value would seem a fair price to pay to save the real economy.

  2. pd130

    Maybe this administration’s penchant for privatizing everything in sight could combine with Moody’s conversion to open outcry rating in a useful way, by hiring the raters (all of ’em) to work with FDIC/OCC/SEC or whatever, to come up with a triage list over the next week or two.

    Commandeering, really, quiet as it’s kept.

  3. LJR

    I think a stake has been driven through the heart of the Republican party’s penchant for deregulation. There’s a bright side to everything that happens.

    I wonder if we’ll learn enough from this to actually design an economic system based on sound principles?


  4. Richard Kline

    By no means all banks in the US are insolvent. It’s stone incompetence that fifteen months into this the public authorities don’t know which ones and are worried about banks ‘accepting’ public intitiatives.

    Given that time is of the essence, the Treasury needs to have a little list: Dead Banks. These are called and told that they are being taken over post haste, and that in the very few days to impact they are to maintain all normal lending operations as the government stands behind those actions. Suitable announcements are made that the govenrment will be running the List, and counterparties are to continue normal operations as the government is the counterparty. Taking over a bank but allowing the financial system to shun it means seizing a corpse: it is the transactions which need to be salvaged.

    Paulson and Bennie don’t get that, or perhaps they get that but figure the banks will take care of it on their own. NO, they won’t. The government has to be proactive on keeping trading going, not working at a large remove. Oh well, it’s OJT, nobody planned for this. But if they drop another Lehmans there may not be much left to pick up afterwards.

  5. ubetchaiam

    “The fact that this is coming up in discussions about how to keep the financial system from imploding is deeply troubling.” BUT completely understandable once one realizes who owns the FED:
    “Some people think that the Federal Reserve Banks are United States Government institutions. They are private monopolies which prey upon the people of these United States for the benefit of themselves and their foreign customers; foreign and domestic speculators and swindlers; and rich and predatory money lenders.” — The Honorable Louis McFadden, Chairman of the House Banking and Currency Committee in the 1930s”

  6. Anonymous

    Paulson should be locked up together with his Goldman cronies before they cause more damage. Banks should be taken over by the government as they did in Sweden in the 90s. In these deleveraging mess politicians cause much more harm than it is necessary.

  7. Anonymous

    There is no use blaming the government for this. They are going to re-float the economy because there is nothing stopping them, there is no gold standard to maintain. The poor “incompetent” government has to refloat the economy because all the “naked capitalists” are running scared.

    Competent governments will end up owning all the banks so they can sell them later to extract the excess capital back out of the system.

    Competent government are going to collect a large chunk of interest for doing the job ( the incompetent will do stupid like buy up all the mortgages and reissue them at reduced rates). With negative returns on federal paper it can be said the scared “naked capitalists” are paying the government to sort out the mess.

    Obviously the banks won’t let it happen until being owned is the only option. Lehman brothers probable had to be allowed to default for no better reason than Richard S. Fuld, Jr. was silly enough to argue. I’d suggest there won’t be many more arguments. The English Government made being owned optional; you the bank decide if you need the money.

  8. Anonymous

    What shareholder equity? Is there going to be any left after tomarrow?

    I completely agree, how can these discussions be hinging on saving shareholder equity? Shareholders, for the most part, are either complicit in this mess, or should have know better. Who on earth still owns common stock in banks?

    Executive compensation? Ok, fine, but when we get done going thru the books, we are coming right back at you and you are going to have to pay for all of the stuff that disappeared during the accounting.

    The majority of banks that people deal with on a day to day basis, outside of the (NYC LA etc)area, are fine. They are small, they issue local mortgages, and they know the people who they are lending the money to.

    I know of an argument that took place on at a smaller bank board meeting in the early 90’s. The bank had branches in very small towns and very little competition. They were the only bank in most of the towns. The new president, who has since been replaced, was in favor of moving more into the commercial loan business. The argument against this was that they were too small to compete with the “big guys” and they made much more money on mortgages and smaller commercial, local loans. The president lost.

    This seems like common sense to me. Move into a market where you are one of the smallest, and have to compete with everyone, or make your own market. At that point it was common for commercial loans to get bid down to 25bps over prime. How do you make money doing that? Volume seems to have been the industry anwser. Probably makes the balance sheet bigger, but in the end does nothing for shareholders. Make 25bps on a commercial loan, or 200 on a mortgage? The person who told me about this was also the first to get rid of all of his incentive stock as soon as he retired and could. He would always say, never put your money into bank stock, put it in the bank, much safer.

  9. RJMConsulting

    To paraphrase the Clinton machinists: “Its the CDS, stupid!”

    We have Ford and GM spiraling down, Morgan Stanley (and Goldman) trading at distressed debt levels, and we have every counterparty that wrote protection on these (and similar) reference names all racing towards the cliff edge. With Libor going in the wrong direction, upcoming resets on the mortgages are likely to blow up a whole new batch of “formerly homeowners”.

    This thing may be moving on its own accord, and I fear that “coordinated govt action” might be the equivalent of putting a stop sign in front of an avalanche.

    If the capital needed to stop the chain reaction is simply too large, it leaves only “extra-legal” powers. Novation, by mutual necessity.

    Meanwhile, at 2.07a EST, the Nikkei 225 futures are off more than 10%… is a 3 day bank holiday a “good” thing in this case?

  10. Anonymous

    “Who on earth still owns common stock in banks?”

    That would be index tracking “Actively managed” Mutual Funds. The manager obsolve themselves by saying they didn’t lose any more money than the index did.

    And finance media people are shocked why mutual fund redemptions are so high. Duh.

  11. baychev

    The FDIC has coverage for only 0.8% of all deposits, now the gov’t will back debt that probably exceeds GDP. How is this going to soothe any sane investor?
    And what happens to the CDSs written on this debt? Cancelled, default is triggered, or the protection sellers get a free ride from the gov’t?

  12. doc holiday

    Great info Yves!

    What hits me though is the concept of this being a multi-front war, which divides limited and finite resources. The FDIC and this battle are all about immediate money stability for depositors — but yet the derivative battle rages on without regulation or a clear plan of attack, as how to manage the Trillions of dollars in uncertainties that threaten to engulf the entire system (which FDIC vows to protect with its systemic risk powers).

    Meanwhile, all this chaos is overshadowing the subprime foreclosure bombardment and the shocks from those battles, which contribute to on-going cumulative chaos which is fueling stock market crashes globally. These crashes are destabilizing as they move like a pathogen from market to market, or a cancer mutating out of control. These steps for guaranteeing billions of dollars in bank debt, are good steps, but the real focus is to follow the money cancer and see if there is any type of containment of the derivative mess.

    The derivatives that consume cash seem to be like metaphorical financial hurricanes that draw fuel from hot money flows that spin massive amounts of cash as in a giant money laundry operation. The chaos of the derivatives at this point are as unpredictable as betting on how long it will take for the casino to burn down and then spread to the rest of town — while the authorities look on with dropped jaws. This is madness!

  13. Anonymous

    All these plans are US$ negative and burden the taxpayer with debt I really don’t think they deserve by any stretch of the imagination and a positive outcome that can’t be guaranteed.

    Greed for the most part, lost your house, life savings and retirement with no prospect for a job plus ruining the neighbors in the process who have acted responsibly.

    Be awhile before trust returns.

  14. Anonymous

    “It’s stone incompetence”

    Exactly. What should have been handled by private sector merger, asset sales, default, BK has been snowballed by govt into global disaster. Why on earth would anyone wish to put politicians and bureaucrats in charge of anything by fiat and diktat?

  15. ciccocicco

    Looking at investments ideas here.
    Dollar/Euro, we know some exogenous elements are impactting it. How clear is the understanding of these elements, why hedge funds are not jumping in?

    Are we sure that after all this mess is over (or after the world as we knoe is over) the dollar will be kaputt?

    Is Europe in better shape (I think yes?

    This can be a major trading opportunity, have you seen any detailed analysis?

  16. tompain

    The calls for wiping out bank equity holders are astonishing and foolish. Government seizure of private property without compensation is illegal, and for good reason: capital flight makes economic success impossible. If bank shareholders lose money on their investments in the normal course of business, so be it, that’s the risk/reward of capitalism. Wiping them out pre-emptively “for the greater good” is wrong and will prove to be counterproductive. To date, every confiscation or signal of increasing likelihood of confiscation has been followed by a sharp move downward not only in bank stocks but in the entire stock market. Why? Two reasons come immediately to mind. One, if the government decides to confiscate banks for the greater good, why assume it will stop there? Airlines, auto manufacturers, drug companies, HMOs, oil companies – let’s seize them all, it’s for the greater good. Two, contrary to the posts here, LOTS of people own banks stocks. Everyone who owns any passive index fund owns a lot of bank stocks. Pension funds hold bank stocks. Insurance companies hold bank stocks. Other companies hold bank stocks. Foreigners and foreign banks own banks stocks. Look at who lost money when GSE equity was wiped out. Look at who lost money when LEH collapsed. Lots and lots and lots of people. Some of the posters on this board who want to wipe out bank equity probably lost money and don’t even realize it.

    You think you’ve seen a market crash already? You think the economy is headed for a severe recession. Wait and see what happens if common equity continues to be arbitrarily wiped out. Smoot Hawley will look like an act of brilliance.

  17. Anonymous

    Call me naive, but at some point doesn’t the average person, using common sense, start to doubt the trustworthiness of the Federal promise to insure trillions of deposits? At some point, won’t this alone start to cause bank runs? If the feds are the ultimate bank, why can’t there also be a run on this ultimate bank?

  18. Anonymous

    By the way, as banks stocks collapse, every share that is being sold is being bought. Who do you suppose those buyers are? Stupid retail investors who are unaware there happens to be trouble in the banking sector?

  19. Anonymous

    9:11, the answer to that is that the government can print as much money as is necessary to make good on its insurance. The government cannot guarantee the purchasing power of your deposits, but it can certainly guarantee the nominal value.

  20. "Kingfish" Slaney Black

    Every day, a new strategy gets floated by the treasury. Maybe we’ll do this. Maybe we’ll do that. Maybe we’ll just sit on our hands and suck lemons.

    This is not the way to reassure markets.

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