When Bank Defaults Are a Good Thing

One of the problems with the banking bailout in both the UK and the US is that it’s set up a massive moral hazard trade. Bank debt is trading at a massive discount to face value, and investors have been buying it in the hope and expectation that the governments of the two countries won’t let any major financial institution default on its debt after seeing the repercussions of the Lehman and WaMu defaults.

Given that many banks need a lot of recapitalization, the fact that their bonds are trading at a discount presents a great opportunity: they can swap those bonds for equity, or otherwise retire the debt below par, thereby reducing the bank’s liabilities and increasing its capital base. But bondholders will be averse to selling or swapping at the current levels unless they believe there’s a credible threat of default, even in the face of reassurance from the authorities that defaults won’t be allowed to happen.

So it’s great news that Bradford & Bingley has defaulted on its subordinated debt and that, as Neil Collins notes, “there’s nothing the holders can do”. Subordinated debt is meant to have equity-like characteristics, after all, including the risk that interest payments will be missed without the bank being considered to be in default. The fact that B&B’s customers are unaffected by this move is very welcome: in the US, I suspect the FDIC would intervene to take over any bank which defaulted on its subordinated debt. In this case, by contrast, there’s still a chance that B&B might be able to continue indefinitely as a going concern. Sheila Bair, take note.

Comments

[battman:]

Am I wrong or could they be being buying debt with the hopes of bankruptcy wihich would trigger the CDS's. Why settle for a discount when you can get potentially multiples of that debt back through CDS's. The same debt can be insured multiple times.
The fate of GM was predetermined because why would a bondholder want 10% of his money back in stock, when bankruptcy ensured him 100% of his money back. And again, the debt could have been insured at multiples of it's face value.
The current motivation is to profit from failure, not to reward success, but ensure failure. It's a shame really, many good people will suffer because a few people feel the need to make huge amounts of money. They say greed is good right?

May 28 09:21 AM

[LKofScotland:]

Absolutely right when it comes to CDS's. While creating personal wealth however they're not creating any "real" wealth as in jobs and industries. Even these more rarified short sellers (don't call them that because they're merely "buying" a form of "insurance") are even buying into the banking system out of fear of regulators and policy types who know their bread is buttered by industry and not clowns creating paper wealth purely for their own benefit and not for the benefit of uncle sam (let alone a single job.) Hence the government's attempt to distinguish between "good" and "bad" capitalists. Great article on banks and more importantly "bankruptcy." This is a needed process that will happen no matter what the government does now because government policy is actually exacerbating the problem and not helping by printing too much money. In other words, no need to cry over the "lack" of bankruptcies" because in fact government policy is accelerating not decelerating the process. P.S.--don't you just love those people who tell you higher real rates are great news.

May 28 11:52 AM

[jimmy46:]

Bank debt is trading at a massive discount to face value,"""""

You like giving datapoints,
how about some numbers for specific banks?

Jun 03 03:32 PM