2011 September 11 Sunday
Defense Of Bondholders Holding Back Economic Recovery

John Hussman argues governments are making a mistake by defending bondholders rather than allowing losses would cut the debt overhang that is weighing down economies. Agreed.

The global economy is at a crossroad that demands a decision - whom will our leaders defend? One choice is to defend bondholders - existing owners of mismanaged banks, unserviceable peripheral European debt, and lenders who misallocated capital by reaching for yield and fees by making mortgage loans to anyone with a pulse. Defending bondholders will require forced austerity in government spending of already depressed economies, continued monetary distortions, and the use of public funds to recapitalize poor stewards of capital. It will do nothing for job creation, foreclosure reduction, or economic recovery.

So far the banks that hold large amounts of sovereign debt are being defended against losses by their governments. The European lending to Greece, Ireland, and other heavily indebted countries has as one of its major aims the prevention of the bankruptcy of northern European banks that hold large amounts of PIIGS debt. Too much debt. What do to? Create more debt to fund the interest payments on the existing debt. It is a pyramid scheme that will collapse eventually with far more pain.

Hussman thinks the bondholders can afford the losses. I'm more skeptical. I think bondholders need to take major losses. But we need an agreed structure that allows the losses without causing a financial panic.

The alternative is to defend the public by focusing on the reduction of unserviceable debt burdens by restructuring mortgages and peripheral sovereign debt, recognizing that most financial institutions have more than enough shareholder capital and debt to their own bondholders to absorb losses without hurting customers or counterparties - but also recognizing that properly restructuring debt will wipe out many existing holders of mismanaged financials and will require a transfer of ownership and recapitalization by better stewards. That alternative also requires fiscal policy that couples the willingness to accept larger deficits in the near term with significant changes in the trajectory of long-term spending.

The problem is even bigger than the current mainstream projections show because of Peak Oil. Therefore even if bank and sovereign bondholders take big haircuts we aren't going to return to the old economic growth trend. At beset economic growth will be low or negative. More debt will go bad as a result. Future tax revenues will be lower as demands on governments rise from the unemployed and retired. Debt haircuts will just make conditions less bad than they otherwise would be.

As an example of the excessive bias toward protecting bondholders at the expense of everyone else look at the disagreement between the European Central Bank and the Irish government over whether bondholders of senior unsecured unguaranteed debt should get repaid after 2 major Irish banks failed. When companies fail bond holders take losses. So why should bond holders get bailed out by the Irish taxpayers for the failure of these banks? Answer: Other European banks would benefit from the taxpayer bail-out.

EUROPEAN CENTRAL Bank chief Jean-Claude Trichet has ruled out supporting Minister for Finance Michael Noonan in his push to avoid repaying some of the debt owed by Anglo Irish Bank and Irish Nationwide Building Society.

JP Morgan analysts think making Anglo Irish Bank debt holders whole is unnecessary and unwise.

In addition, the nature of Anglo Irish Bank as a run-off institution and clearly not having the same importance as a Pillar banks, would most likely have facilitated some type of burden sharing outcome with nominal contagion impact. We also note a willingness of domestic policymakers to implement burden-sharing on the institution. However, despite all these perfectly valid reasons we note that opposition of the ECB to the burden sharing outcome will most likely imply that the senior debt will mature at par, with the ECB most likely having concerns with the impact that broader contagion might have on its outstanding exposures to the European banking sector. In the event that Anglo Irish debt is not burden shared then we would take this as a very strong indicator of the lack of willingness to inflict losses on the senior unsecured debt of European banks under the current regime.

I find this push by the ECB outrageous. Western governments have been captured by the banking industry and its bond holders. Bond holders should take losses when companies fail. The total amount of debt should go down due to losses on the debt. Otherwise private debt gets converted into public debt and the needed shrinkage of the total debt burden does not happen. The political machinations to try to prevent Greek default have make the crisis there far worse. To lesser degrees the same is happening in most other Western countries including the United States.

Share |      By Randall Parker at 2011 September 11 10:11 AM  Economics Credit

Daniel said at September 11, 2011 11:53 AM:

Just think of the billions in bonuses that were paid out to bankers for issuing and trading that debt. It makes one sick.

SHTF said at September 11, 2011 12:14 PM:

"To lesser degrees the same is happening in most other Western countries including the United States."

A lesser degree? Just you wait! Better grab more gold, grub and ammo.

Black Death said at September 11, 2011 3:28 PM:

I suppose the words "moral hazard" no longer have meaning.

ziel said at September 12, 2011 1:06 AM:

Yes, there's no doubt that we will never have true recovery unless this massive debt overhang is vanquished. Problem is no one is quite sure how widespread the impact will be. The Big Banks will detonate for sure, and if no one gives a crap about them, it might also take down most insurers and mutual funds, basically putting the retirement of everyone over 50 in serious doubt.

But is anyone actually trying to examine all this to get a real gauge of the potential effect? I doubt it very seriously. I'm sure the analysis has been "Oh, it's gonna be real bad. So let's just prop up these bondholders until the economy recovers." Of course the economy will never recover - but for those making the decisions, tomorrow never comes, so they can just keep on pretending.

solaris said at September 12, 2011 12:27 PM:

>"Western governments have been captured by the banking industry and its bond holders"

Why don't we outsource the "banking industry" the way we have so many other industries, from steel to electronics? Because it is not, strictly speaking, an "industry" at all. The dictionary defines industry as "Commercial production and sale of goods" or "The sector of an economy made up of manufacturing enterprises".

So we should call it something like "the financial services sector". This sector is comprised of a comparatively small number (perhaps several hundred thousand) very wealthy people who call the shots in all Western states. And they're not going to outsource themselves because they prefer living in New York and London to Calcutta and Kuala Lumpur. The entire reason for existence of this "financial services sector" is to increase the net worth of those several hundred thousand people. Sometimes this has the side effect of creating wealth for other people as well. Other times, as in this long-running banking trainwreck, it means that entire countries have to suffer because the "Masters of the Universe" don't want to take their haircut. And when you control the governments of most states, you don't *have* to take the haircut.

Check it Out said at September 13, 2011 2:42 PM:

"Western governments have been captured by the banking industry and its bond holders"

Well, isn't that what Fascism is all about?

I think that big corporation owners have become the improved version of Mussolini. America has become like a modern gang of Mussolinies

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