Debts, Bonds and Lies

I would like to get a few things straight. First there is absolutely no legal, moral, ethical or even practical reason why bond holders in a bank or any other financial institution should not suffer losses. If a bond buyer has lent his/her money to a bank which becomes insolvent, it is there in black and white, in the bond holder’s contract with the bank, that said bond holder can suffer losses.

All bond holders, from the most humble junior and subordinated up to the super, uber senior can be expected to suffer losses. This is not a matter of opinion. It is not me wanting it to be true. It simply is true.  Talk to a bond holder. Read the contract or what it says on the bond itself.  The bond holder lends money and in so doing gets payments of interest and then his/her capital back upon maturity of the bond.  Depending on the seniority of the bond, the holder is further and further up the pecking order when it comes to getting his money back in event of insolvency.

That is point one.

Point two.  No matter how fantastically big, powerful and important, even systemically important, a bank is, the contract between the bank and its bond holders, is a PRIVATE contract between two private parties.  It is legally binding upon them and NO ONE ELSE.

This new notion of systemically important is NOT a legal, ethical, or moral imperative.  The bond holders can take the bank and its administrators to court if they feel they have been illegally dealt with. But it has nothing to do with you or me or our taxes or our nation.  

If the government has a stake in a bank which goes bankrupt, the state’s holdings stand before the law with the same rights as those of other bond/debt holders.  If the nation who bailed out a bank owns the most senior debt, then it gets first call on assets. If some moron politician settled for subordinated debt then the state and its citizens will get shafted.  

The settlement of debts between, depositors, shareholders and bond holders is already enshrined in law and precedent.

This is why governments need to be very careful when they start getting involved with bailing out financial institutions. Basically make sure the tax payer is top of the food chain or don’t help the bank at all.

But somewhere in the financial mess created by the banks, this notion of ‘systemically important’ was created.  It has been smuggled in and used to give the impression that if a bank is ‘systemically important’ then the government has a ‘duty’ to the financial system, to bail it out. And that the bond holders of such a bank are in some way ‘not supposed’ to suffer any loss. You hear this said as if it was some point of financial law. IT IS NOT.

What it is, is a real-politik claim that once a government is involved with the fate of a systemically important bank, THEN this changes the game, And in the new game, the government must not, can not, allow the bond holders to take a loss, because if the government does allow this, then the ‘bond market’ will get seriously offended and never talk to them again.

But remember, this outrage is NOT because the government would have broken some legal and financial agreement, not broken any contract with the bond holders. The outrage would be simply that the bond holders don’t like to lose money.  

There is NO onus on a government to make any of the bond holders, even the most senior, inviolate from losses.  All the government has to do is ensure that the proper order of seniority is observed when it comes to settling the bankrupt bank’s debts.

But, people will say, that is all so naive. In the real world there are consequences.  Indeed there are. So let’s look at them.  Let’s look at Ireland as an example.

Standard argument is that if Ireland had allowed its insolvent banks to go down this would have ruined the country.

Let’s say Ireland had allowed financial events at Anglo Irish to take their natural and mathematical course. The bank has debt far, far greater than all its assets.  Most of its assets are worth a tiny fraction of what they  were purchased for.  SO the bank closes its doors.

The government under its deposit insurance scheme makes sure 99% of depositors get all their money back.  A small percentage of those who are wealthier will not get all their money back.  Known as collateral damage. And as Charlie Munger said recently, suck it up and cope!

The administrators job is now to use the bank’s assets to pay off its debts and its creditors.  First find out what assets it actually has.  Then find a price for them.  This can be done by putting them on a market today. Or by a more complex agreement to put the assets into a closed financial vehicle, which will over time try to recover what can be recovered from loans and assets.  As long as those owed money are happy to get their money slowly.  

Either way, because ALL modern banks operate huge leverage there would be very few assets underpinning all the banks liabilities and debts.  Meaning that even in the best case there will be very little to be spread around all those wanting their money back. Most of them will get bugger all.

Bear in mind ALL the investors, share holders AND bond holders would be perfectly aware of the leverage being run by the bank they gave their money to.  SO NO ONE can complain or claim to be hard done by on that score.  Please refer back to Mr Munger for further clarification.

What happens then, is what the Americans often refer to as a cram down. There is a huge hole of debts. There is a pile of assets.  You start with the most junior on the pecking order and you take their money and you use it to fill up the hole – paying off debts. You keep taking people’s money and keep chucking it in the crater the bank had dug.  You slowly work your way from the most junior up to the most senior. You stop when all the debts have been paid off. Whatever is left is returned to those who have not yet had their money taken.  Basically the most senior bond holders will be the last to have their money used to pay off debts and the first to get paid.

THAT is how the law is written. It is what everyone involved signed up for when they lent their money to the bank or bought its shares.

Now if that had happened all Ireland’s banks would have imploded.  True.  Also true is that, that is exactly what HAS HAPPENED.  They imploded anyway.  The economy would have massively. contracted if the banks had been allowed to die. Also true. And also what has happened anyway.  Unemployment? Would have gone up and has. So far no difference between the two scenarios: banks allowed to die and banks bailed out by the tax payer.

But here is a massive difference.  If the banks had been allowed to die the Irish state would NOT have had to borrow €50 billion which is a quarter of an entire year’s GDP.  Ireland would NOT have a debt of 32% of its GDP. 10 times higher than it should be.

Ireland’s borrowing need today would be €50 billion LESS.

Now critics will counter – yes but Ireland would be locked out of the bond market by those who felt shafted by the government.  What, like Ireland IS LOCKED OUT, you mean?  Of course this isn’t enough of an answer. But this is.  Ireland would need so much less that they would be able to get all they needed from the ECB. Ireland IS borrowing from the ECB.  If they had not given €50 billion to bond holders and other assorted wealthy blood suckers, Ireland would have such modest borrowing needs they would be fine to call upon the ECB for the next several years until the bond market came round.  AS IT DOES. Argentina defaulted, and is now able to borrow. So did Russia.  

The facts are that Ireland has unsupportable borrowing costs and a huge debt to service because it chose to save bond holders who had NO CALL at all to be saved. that it’s craven, possibly corrupt and certainly witless politicians did so at the expense of their own people, is a betrayal and a crime.

If Ireland had not done the insane thing that all nations have decided to do, then Ireland would NOT have to face the kind of austerity it is facing.  There would have been some austerity. But it would at least have been in order to pay Ireland’s debts NOT the debts of bond holders who have no allegiance to Ireland.

If Ireland had not bailed out the bond holders Ireland would have money for its schools and hospitals.  It would also have been able to capitalize two new banks.  5 billion in government capital into each  bank, with a modest leverage of 10:1 would provide 100 billion euros of lending.  These banks would have been clean and without any hidden debts.  The bond market would actually have considered investing in such a bank.  Where would you invest your money? In a bank with undisclosed debts or in a clean bank?

Of course the bond market was never faced with this decision.  Instead it engineered for itself a far more lucrative decision.  Invest in, buy the debt of, insolvent banks which have a 100% government guarantee of zero possibility of every making a loss or refuse to lend until the idiot government gets desperate and raises the rate it will pay, and then invest.  Now THAT is a great choice isn’t it?  Do you wonder that the bond market is rather happy with the current state of affairs and does not want to see any new ideas coming in to spoil things?

I could go on but I won’t. This is part of what makes me so angry at the way our financial situation has been engineered and distorted by the wealthy, for the benefit of the wealthy and with the total connivance of our political class and our media.

Let’s get one thing straight. Bonds are supposed ot be safe but NOT sacrosanct. That is the self serving LIE we are paying for.