The basic thing about investing in big banks’ unsecured debt is that once upon a time it was a pseudo-risk-free proposition because, like, it’s a bank, what could possibly go wrong,1 and now it’s like,2 hi, you are buying the mezzanine (call it 10-to-30%-loss3) tranche in an actively traded and extremely opaque CDO full of goofy stuff and, hey, put a price on that.
I don’t know who’ll be good at putting a price on that but it stands to reason that Jes Staley, the former head of JPMorgan’s investment bank who left for BlueMountain shortly after several billion dollars of JPMorgan’s money made the same voyage, would. He thinks so anyway:
On a panel at the Bloomberg Hedge Funds Summit in New York, Mr. Staley discussed what is known as resolution authority, in which regulators help wind down failing banks. The process of adapting to these new rules, he said, would give banks a “more clearly defined capital structure,” and thereby create opportunities for investors.
“There’s going to be tremendous mis-pricing between the different levels of the capital structure in these banks,” Mr. Staley, who is known as Jes, said on the panel.
One imagines that, if all goes according to plan, then at some point between now and the end of time:
- There will be some bank debt (deposits!) that is bail-outable and more or less government guaranteed;
- There will be some other bank debt (repo!) that is collateralized and more or less money-good, ish;
- There will be some other other bank debt that is bail-inable and more or less clearly mezzaniney and going to be toasted in any bank failure; and
- People will believe that.
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In the war against bankers’ pay the EU has a secret weapon:
Banks should pay bonuses in debt, which would be wiped out if a bank failed, an EU banking report will suggest as Europe attempts to step up the fight against bankers’ pay.
I’ve been sort of fond of this for a while. It’s a way for bankers to eat their own cooking: if you’re a banker, what you produce, more or less, is debt, so you might as well stand behind the basic soundness of that debt by owning lots of it. You can fine-tune this theory – for instance, Credit Suisse circa 2008 produced asset-backed securities, and Credit Suisse circa 2011 produced derivatives-counterparty credit risk, so that’s what its bankers got – but the basics are sound. In particular, if you are a banker, one thing that you don’t produce – that is sort of an unwanted byproduct of your operations, imposed by regulators but not particularly liked by you – is equity, so getting paid in equity is a little perverse.1
There’s a little theoretical tension here, though, which is that there’s also good reason to think that bankers should be the lowest on the totem pole in terms of getting their money back if they blow up their banks. You could just about imagine a bank capitalized with 10% equity, 10% banker-pay junior debt, and 80% senior debt, say, failing and recovering 85 cents on the dollar. So the real debt gets paid off 100%, but where does the 5 cents go? Classically the “debt” that the bankers get is senior to the “equity” that public shareholders get, but it seems a bit rough to pay the nasty bankers before you pay the widow-and-orphan shareholders. Read more »
Today the EU issued a discussion paper about how it plans to forcibly write down the debts of shaky banks if it ever comes to that, which for some reason is called a “bail-in,” I guess in the sense that the bailing is coming from creditors who are already in the bank’s credit rather than from taxpayers who aren’t. It’s pretty interesting, go read it, or read Bloomberg’s piece about various bits of squabbling over it and also somewhat counterintuitively a statement from EU guy Michel Barnier (left!) that “There’s a big international consensus on the principle.”
Actually there probably is; the principle is pretty sensible, which is that there comes a time in many companies’ lives where the best way to preserve value not only for the enterprise but also for the creditors is to write down some of the debt to allow the company to continue as a going concern that can pay off the rest of the debt. This is why we have bankruptcy, but bankruptcy seems to be too slow and scary for banks. The worry is, you have a bank and it’s got like $15 of equity and $100 of debt and its assets go from $115 to $90 and all of the debt holders start looking at their watches and being all “hey this has been fun but I’m actually late for this thing so would it be too much trouble for you to give me my money back?” and the bank has to sell a bunch of stuff to meet those demands then that looks like a fire sale and people figure it out and all of a sudden that $90 becomes, like, $60, and the debtholders get back 60 cents on the dollar instead of the 90 cents, and they’re like “crap, if I’d just said ‘I’ll take $90, and also whenever you have it is fine, no rush,’ I’d have much more money.”
Of course that’s all sort of obvious so one thing that the creditors could do is just not do that, and voluntarily and quickly write down their debt so that the bank wouldn’t have to have a fire sale to meet their claims, but, knowing creditors, that’s not what would happen, so you need some sort of resolution mechanism to protect them from themselves. Read more »