Economic Reality Confounds Laws to End Bailouts

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When Ireland faced a creditor revolt and required European Union and International Monetary Fund (IMF) loans to avoid a sovereign bankruptcy, banking system collapse, or both, there was much talk about the need to impose haircuts on bondholders. On the eve of the eventual bailout package, negotiators were seeking ways to force creditors to Irish banks to accept losses, have their bonds converted into equity, or otherwise share in the costs of the rescue. When the package was announced, however, talk of haircuts vanished and creditors’ positions were ultimately protected at 100 cents on the dollar. The omission of haircuts was initially blamed on legal restrictions. The EU and IMF wished to “avert the threat of an immediate court challenge from any senior bondholder.” The larger issue, however, is not legal, but economic: how do governments, or multinational financial institutions, that are supposed to serve as custodians of the economic order impose losses on a financial system that is not equipped to absorb them?

Losses for bondholders are obviously attractive from a political perspective, as they show taxpayers in countries financing bailouts that investors are forced to pay their fair share. The problem is that the imposition of such losses can create more problems than it solves. The creditors to European governments are largely European banks who’ve been able, under European financing rules, to leverage positions in European government debt in excess of 50-to-1. This was the result of two factors: the collateral policy at the European Central Bank (ECB) that allows any eurozone government’s debt to be regarded as functionally equivalent to German government debt for the purposes of loans; and EU rules that assign a 0% risk weight to eurozone sovereign debt in spite of the rather dramatic differences in actual risk profiles. The result is that dodgy sovereign debt that would be worth very little if not for the bailouts pays very low coupon rates and sits on balance sheets where these holdings are almost entirely funded by debt. In many cases, losses of 2% or more would leave the bank underwater on its position and create a substantial capital hole. Losses in the range of 30% to 40%, as is common in sovereign defaults, would topple many banks. Their insolvency would then quickly feed through to the rest of the financial system as swaps counterparties, overnight lenders, and other financial firms take desperate actions in response to the insolvencies, as was seen in the aftermath of Lehman.

The ad hoc bailouts of Greece and Ireland have thus far proven to be highly unsatisfying. First, no one knows if the basic terms of the agreement will hold. The rating agencies responded to the bailout by cutting Ireland’s credit rating, highlighting the uncertainty about the sustainability of the package. The taxpayers in creditor states like Germany are not terribly fond of the idea of having to pay for the profligacy of others. As a result, Germany proposes a “crisis mechanism” that would require creditors to suffer losses on sovereign debt after 2013. But since many outstanding obligations mature after 2013, what is the point of holding on to these bonds today if they are likely to be worth far less than face value at maturity? At the same time, citizens in debtor nations are being asked to endure extreme budget cuts and tax increases to pay off the unsustainable debt load. The government in Ireland seems likely to be replaced by another that may decide that the conditions of the bailout are too onerous, especially since it is easy to characterize the pain as being inflicted to prop up failed bankers. With political support for bailouts tenuous at best in both creditor and debtor nations, there is simply no reason the credit facilities should make creditors breathe easy about their positions.

Secondly, the ad hoc nature of the bailouts worries investors because it is eerily reminiscent of the U.S. policy in the run-up to the Lehman collapse. Even if the existing bailout packages were written in stone, that does not mean precisely the same accommodation would be offered to Portugal or Spain in the event that either country faced a banking crisis or sovereign default. (Click here to read the Calomiris-Lachman plan for Spain – posted exclusively at e21.) Bear Stearns failed and its creditors received 100 cents on the dollar; Lehman failed and its creditors got less than 9 cents. Will the same thing happen to creditors exposed to the next European country that comes to the IMF-EU for a rescue? As the ECB itself explained, failure of all eurozone governments to reduce budget outlays substantially would substantially increase the risk of a financial meltdown by keeping alive lingering concerns about the next domino to fall.

In January, the European Financial Stability Facility (EFSF) will issue the first pan-eurozone bonds in history to help finance the bailout. The EFSF was created on the condition that by January 1, 2013, all 27 EU countries must ratify a treaty amendment to create a permanent “stability mechanism to safeguard the stability of the euro area as a whole,” with financial aid for distressed governments “subject to strict conditionality.” Some believe the EFSF bonds are the way forward, as single European bonds would eliminate the diversity of euro-denominated sovereign offerings, take pressure off of peripheral states, and lead to more integration of fiscal policies across the currency zone. Supported by nations like Italy and Belgium that could be next in line for a crisis, the idea was predictably panned by officials from Germany and France whose borrowing costs would likely increase if they were to fund deficits through eurozone bonds rather than their own sovereign issues (given that the eurozone average credit quality is less than Germany’s on a standalone basis). The other alternative is for the ECB to increase its bond purchase program. The ECB has purchased €73 billion of bonds so far this year. The problem is that the ECB exposure to credit of technically insolvent nations would threaten the solvency of the ECB itself. As Citi Chief Economist William Buiter has written, the “ECB and the Eurosystem ’swim naked’: there is no Euro Area fiscal authority that, explicitly or implicitly, stands ready to act as the recapitalisor of last resort for the Eurosystem.” The ECB can print money to cover the cost of overpaying for government debt, but the inflationary impact of such operations is dangerous and most unwelcome, especially for inflation hawks in Germany. As a consequence, there is now talk of assessing member states to increase the capital base of the ECB so that it can buy Portuguese, Spanish, and perhaps Italian government debt in a manner that would not raise concerns about currency debasement. In essence, the ECB would provide a supportive bid in the market for government debt to keep bond prices high (and interest rates low) while countries engage in the austerity programs necessary to balance budgets in time for the permanent facility in 2013.

Whatever the negotiators decide, the problems will remain long after a suitable “stability mechanism” is established. If the IMF and EU negotiators had the ability to wave a magic wand and eliminate all of the legal obstacles to cramming down Irish creditors, it would have done nothing to eliminate the basic economic problems. In addition to creating a cascade of losses for holders of Irish and Greek debt and their lenders and counterparties, these haircuts would have likely triggered a run on Portuguese and Spanish debt and accelerated the crisis. Put another way, the EU and IMF would have possessed the legal authority to trigger the same disastrous outcome that would have occurred in the absence of a bailout.

This is a key point to contemplate as policymakers ponder how best to “end bailouts,” as the Federal Deposit Insurance Corporation (FDIC) is now trying to do with respect to the “orderly liquidation authority” granted to it by Dodd-Frank. If powers to inflict losses on creditors would lead to the same outcome as avoiding the bailout altogether, why would anyone expect a change in legal regime to produce a different outcome? In its rule, the FDIC attempts to differentiate between short-term and collateralized debt (protected) and long-term debt (subject to losses). Won’t this have an impact on funding decisions, as banks seek to shorten maturities to have more protected debt? Isn’t this what creditors will demand? What about revolving credit facilities that can remain “open” for years but tend to fund short-term draw downs used for cash management purposes? How does the collateral rule work in a situation where the market value of the collateral is below the face value of the loan? Does the creditor become unsecured and subject to loss? Even in cases where the market value is temporarily low and the security is not impaired? There is also a confusing clawback feature that creates legal unpredictability through a requirement that certain creditors repay bailout funds. The proposed rule raises a number of questions about both the advisability and feasibility of pre-committing to a resolution process for different claims.

Moreover, the rulemaking avoids two rather large issues: the FDIC does not have the power to wind-down large cross-border financial institutions with subsidiaries operating under the laws of other nations; and the FDIC arranged large “open bank” rescue packages for Wachovia, Citibank, and Bank of America in 2008 rather than taking over these institutions’, instead insured them into receivership. In the midst of a crisis where losses are likely to cripple the financial system, why would anyone believe the FDIC would follow-through with its elaborate “orderly liquidation” template instead of providing whatever support is necessary to help the failed bank through the crisis? If the government’s threats not to bailout banks’ creditors were credible, we wouldn’t need to give the FDIC authority in the first place. In a world without moral hazard, creditors to large financial institutions would access the risks presented by the activities and charge interest rates to compensate for those expected costs. All the legal authorities granted to the FDIC have done is change the nature of the pre-commitment from “no bailouts under any circumstances” to “bailouts only for certain creditors and only for a period of time until stability is restored and the funds can be clawed-back.” Neither is credible.

As with the euro zone, the new U.S. legal rules have done nothing to eliminate moral hazard that allows firms (or governments) to borrow at rates that are unsuitable for the risks they assume. If a creditor accepts 5% yields for a risk that it should demand 8% interest rates to assume, you cannot demand that creditor accept losses unless you are willing to accept that all similarly situated institutions will see their rates shoot upwards as a result. By focusing on new and creative legal regimes rather than economic fundamentals, the euro zone resolution facility and Dodd-Frank rulemakings will institutionalize bailouts rather than end them.