Cramdowns for All

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That Congress is talking about cramming down investors who bought bonds made from bad mortgages begs a question: Why not do the same to investors in bonds from bad banks?

Bad banks have essentially the same problem as the home owners: they owe more than their assets are worth. But Washington politicians and regulators aren’t moving to reduce the bad banks’ debts. Instead, they’ve added capital and now they aim to improve bank portfolios by buying out some toxic assets and guaranteeing others. None of this does anything about the debt. In fact, the actions add to the nation’s debt because Treasury will have to issue bonds to pay for these tonics.

Hashing out schemes to improve the banks assets is a lot like a financially-strapped couple discussing how to spend money to make a house worth more than its mortgage. Should they try to get a personal loan to replace the ragged roof and rebuild the broken driveway? Each step would help attract a buyer, but, in the end, the couple would still owe more than the sale would repay. The problem is they have too much debt.

Bond investors are inclined to a different diagnosis: debtors’ assets aren’t worth what they should be. Bill Gross, the legendary bond trader, wrote in his latest investment outlook: “To PIMCO, the remedy…is simple and almost axiomatic: stop the decline in asset prices.” Gross says Washington policymakers should focus on firming up asset prices, particularly house prices. That, of course, would make it more likely that bond investors would be repaid.

In an ideal situation, beleaguered homeowners would cut their spending and come up with the cash to make timely repairs and loan repayments. Ideally, banks whose assets don’t cover their liabilities would rebuild their capital and meet their obligations. But too many homeowners and too many banks don’t have the means to do that.

That’s one reason why legislation is pending to empower bankruptcy judges to ease mortgage terms. To Wall Street, these would be “cramdowns,” situations where lenders will have to accept less than what they contracted for, be it less timely principal or interest. They’re cramdowns in the sense that the loan changes would be virtually crammed down the throats of the mortgage lenders. Lenders to banks have been big winners in the governments’ actions so far. The exceptions that prove the rule are last year’s seizures of bank assets of Washington Mutual and IndyMac that cost those bonds nearly all of their par value. Stockholders, in contrast, have been hit at bank after bank as Treasury stepped ahead of them and bought preferred shares. Yet, bond investors handed the banks leverage with too little discipline.

How much leverage did the bond investors deliver? Long-term liabilities, outside of advances by Federal Home Loan Bank, amount to about $850 billion of the financing for $13.5 trillion in banking system assets, according to estimates credit strategists at Bank of America. That’s about 6% of assets. For some banks, it is a lot more. Nearly 12% of Bank of America’s assets were funded by long-term liabilities, according to its 10-Q from September. For Citigroup, it was nearly 15%—some $300 billion of long-term liabilities. Try to imagine those Citi creditors having to reduce their claims by even 15%, some $45 billion. Yes, the lenders would hurt and scream, but Citi stockholders have had it much worse, losing about 90% of their market value the past year. Taxpayers already have put $45 billion on the line through TARP investments. They’ve also guaranteed about $250 billion of asset values.

Why aren’t we hearing more about cramming down bank bondholders? Maybe there’s worry that some of the bondholders are too big to fail and couldn’t withstand the hits. Maybe some are foreign lenders who the U.S. can’t afford to anger. Or, maybe it is just easier now to have the U.S. Treasury write checks.

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