During the financial crisis, the result of the "too-big-to-fail" strategy was to bail out the bondholders at the expense of the taxpayer. For example, during the crisis, the bonds of Bear Stearns, Merrill Lynch, Wachovia and Citibank all traded at less than 50 cents on the dollar. In the event of bankruptcy they would have received less than 30 cents on the dollar. After each of their bailouts the bonds appreciated back to near par (100 cents on the dollar). The bondholders were the biggest beneficiaries of the bailouts. The reason this occurred was that the Federal Reserve did not have the power to cram down the value of financial sector bond. They could wipe out equity holders – not bondholders. These bailouts and subsequent re-confirmation of too-big-to-fail have made financial institution bondholders a protected class. This is not good policy.
The reason Lehman is seen as the tipping point for the financial crisis was that it was one of the few times that the government did not protect the bond holders. Lehman’s bonds were owned by bond funds, money market funds and pension funds. Lehman’s failure caused the bondholders of financial institutions to panic and mark down the value of all bonds from all financial institutions. The real problem of Wall Street was exposed – they were dependent on borrowed money and held rotten collateral. The ripple effect was huge and resulted in a policy reversal. From that point forward the Fed stepped in to support financial institutions.
The Federal Reserve’s legal predicament was understandable. Current regulation allows the government to write down bank bond debt value by shipping them to the FIDC for markdown. This was implemented in the case of Washington Mutual. However, there is no current authority for the Federal Reserve to mark bondholders of non-bank organizations. We respect the opinion that these organizations have become too big to wait out the slow process of our current bankruptcy courts. The Fed should be able to act more quickly.
Many of these problems would have been mitigated if the Federal Reserve had a solution, short of bankruptcy, that could have been implemented. A bondholder cram-down provision, would let the Federal Reserve, assign the loses to those that deserved them and keep the institution alive afterwards. During the first drafts of the Financial Reform legislation, this bondholder cram-down provision was central to the administration’s request. Alternatively, the banks want to institutionalize ‘too-big-to-fail."
The announcement of the $90 billion tax on banks is unofficially balanced with a quid-pro-quo to back a too-big-too fail strategy. The government would indirectly guaranty the bondholders of the top 50 banks. From the point of view of banks and securities firms, a $90 billion tax over ten years is cheap insurance to for an implied guaranty for their bondholders. In the event of another crisis, the guarantee could cost at least a trillion dollars. The public gets nailed again!
A better solution is to eliminate the too-big to fail policy and enable the regulators to mark down bondholders.
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