Governments, Bonds, And Unintended Consequences

by: Jim Delaney

Throughout the turmoil that has beset the markets and the economy since the housing market became a house of cards there have been certain words or phrases have dominated the lexicon. “Credit Crisis” and “Bailout” come to mind as does “irrational exuberance” for that period when the bubble was still inflating. It was de rigueur for a while to measure how important a word was by stating how many times it had appeared in the media in the recent past. I do not have access to any such word counters but I can tell you that the phrase I am constantly bumping into these days is: “unintended consequences”.

Konrad J. Friedman defines this phenomenon as “the proposition that every undertaking, however well-intentioned, is generally accompanied by unforeseen repercussions that can overshadow the principal endeavor.”

It would take at least a month’s worth of these overviews to discuss every instance where the government’s interventions in the financial markets have produced said “consequences” but I will limit it to one example on one day. There will be too much to discuss as the week unfolds to spend time tilting at every congressionally constructed windmill.

Kathleen Shanley, Senior Bond Analyst/Finance with Gimme Credit, is interviewed in Barron’s this week. She begins by explaining the difference between a bond and a stock from the investor’s point of view saying; “The bondholder doesn’t have the potential to share in the upside of a company’s growth, so the most a bondholder gets back is their principal and interest.” Kathleen goes on to explain that in the case of a bankruptcy what the bondholder does have is a “senior claim in the capital structure.” “As a bondholder you don’t have the opportunity for a large upside [equity holders], but you are more protected on the downside.”

Ms. Shanley says that things now are different than a few years ago, when debt financed LBOs and share buybacks favored equity holders as the leveraged transactions bought shareholders out at a high price while the debt got downgraded, sometimes to Junk.

Understanding that reward is in proportion to risk, it makes sense that there would be a group of investors that would eschew the upside of stocks for safety of bonds.

Based on there place in the capital structure along with the billions in dollars of aid they have received from the government one would expect that the bond’s of the nation’s largest financial institutions would be trading at levels indicative of a low risk of default.

Such, however, is not the case. Yield spreads on bank bonds are averaging 8.23% relative to Treasuries and 3.65% more than industrial companies according to Merrill Lynch index data. To put this in perspective this relationship was the opposite way before August of 2007.

The clue as to why this might be the case comes from U.S. Representative Brad Sherman, CA, Dem who was recently quoted as saying; “These banks can go into receivership, shed their shareholders, shed or reduce the amount they owe to their bond holders and come back out much stronger institutions.”

John Bartko, a credit analyst with S&P thinks the fears exhibited by the high spreads are well placed. “It’s only intuitive that the government would contemplate the thought, ‘why are we only putting this on the taxpayer?’” Additional government assistance could carry with it “the possibility that debt holders could then be required to participate”.

Mehernosh Engineer, a strategist at BNP Paribas SA, London thinks; “We’re seeing the start of next leg of the crisis and that’s going to be financial bondholders taking a haircut as lenders default. There’s been a perception that banks’ senior bondholders are untouchable, but that’s going to change.”

Where are the “unintended consequences” in all of this? According David Darst, an analyst at FTN Equity Capital Markets, “Most U.S. bank debt is held by insurers and foreign investors, with a small portion owned by mutual funds.” Foreign investors (China, the largest holder of U.S. Treasuries) are already voicing concerns regarding the quality of Uncle Sam’s debt and many have already been burned by investments in the preferred shares of FNM and FRE.

Raising the specter of senior debt losing its inherent protection for its holders will only add to the spreads required by investors to buy the debt. This can only increase the amount of interest these institutions are required to pay to service the debt and therefore delay if not prevent the return of these companies to profitability.

Equity holders are always aware of the risks they take when purchasing a stock and that risk is always 100% of the money invested. Bondholders, be they the insurance companies which many depend on for retirement income as well as the traditional “term” products or foreign investors who fund the massive deficit this country now has and which is expected to grow to previously unheard of levels in the years to come, did not sign on for the questionable return of their principal and interest.

So before Washington starts bringing bondholders to the barber shop, one can only hope that they realize the repercussions of the “unintended consequences”.