The cronies get 100% or more; the non-cronies get a kick in the guts
By Nathan Lewis
A new strategy has been unveiled around the world,
with the first test run in Cyprus. Despite early denials, the “bail-in”
strategy for insolvent banks has already become official policy throughout
Europe and internationally as well.
At first glance, the “bail-in” resembles the normal
capitalist process of liabilities restructuring that should occur when a bank
becomes insolvent. Equity investors and most-junior creditors lose everything;
less-junior creditors get a debt/equity conversion, and senior creditors get
100%. The bank can remain in operation, and does not have to liquidate any
assets. No public money is
required.
I have been an advocate of restructuring insolvent banks according to
these basic
capitalistic principles,
which requires no public funds.
The difference with the “bail-in” is that the order of
creditor seniority is changed. In the end, it amounts to the cronies (other
banks and government) and non-cronies. The cronies get 100% or more; the
non-cronies, including non-interest-bearing depositors who should be
super-senior, get a kick in the guts instead.
All insured deposits (individuals and legal entities) up to €100.000 have, as of 26 March 2013, been transferred from Laiki Bank to the Bank of Cyprus. In addition, the entire amount of deposits belonging to financial institutions, the government, municipalities, municipal councils and other public entities, insurance companies, charities, schools, educational institutions, and deposits belonging to JCC Payment Systems Ltd have been transferred to the Bank of Cyprus.
Did you get that? Financial institutions (e.g. German
banks, and central banks including the Bundesbank) get full repayment, along
with government entities, while everyone else gets to eat sand.
If you were robbing a bank, would you take only a
little of the money in the vault? No, you would take all of it. The bankers see
it the same way when they rob you.
Once you have performed the initial crime of sticking
the losses with the non-crony creditors (who are generally senior), while the
cronies (who are generally junior) get out scot-free, you might as well keep
going.
This can take a number of forms. One is the
possibility that the assets of the bank will be sold at firesale prices to
other cronies. A “bad” loan might not be worth the full 100 cents on the
dollar, but it might have a reasonable economic value of 50 cents. Sell the
loan to a crony for 5 cents, and the crony effectively gets forty-five cents of
instant profit — a nice 10x gain. The losses are taken by the non-crony
creditors. This is one reason why I generally do not recommend liquidation, but
rather continuation as a going concern for insolvent banks.
Another strategy is loan write-downs. Crony borrowers
effectively get loan forgiveness — you no longer owe any money! Indeed, the
crony borrowers might get the loans (due to advance information) just before
the bank’s restructuring. The loan forgiveness ends up as losses for non-crony
creditors. This has already happened in Cyprus, where investigations have
already begun regarding loan write-offs for local lawmakers.
Then we have the “use-the-bank-as-a-dumpster”
strategy. Another crony bank, which also has impaired assets, sells the assets
to the failed bank at full price. The failed bank might use a loan, perhaps
from the central bank, to pay for this purchase. After the restructuring, the
central bank claims front-of-the-line status and gets all its money back.
Again, the non-crony creditors eat the losses — losses which originated at
another bank!
As it is, many banks in southern Europe have what
amounts to large borrowings from the Bundesbank, in the form of “Target2″
balances. These total more than €750 billion presently, indirectly owed by
banks in Spain, Italy and elsewhere. The Bundesbank would claim
front-of-the-line status on these borrowings as well, and again non-crony
creditors, who would otherwise often be super-senior, eat the losses.
But we would never do that in the United States,
right? Try this headline:“Citigroup Says Debt Beats Peers in Advance of
‘Bail-In’ Rule.”
In principle, depositors are the most senior creditors
in a bank. However, that was changed in the 2005 bankruptcy law, which made
derivatives liabilities most senior. In other words, derivatives liabilities
get paid before all other creditors — certainly before non-crony creditors like
depositors. Considering the extreme levels of derivatives liabilities that many
large banks have, and the opportunity to stuff any bank with derivatives liabilities
in the last moment, other creditors could easily find there is nothing left for
them at all.
A bank is a levered structure. It might have $10 of
assets, $1 of capital and $9 of liabilities. If the value of the assets falls
to $8, then the bank is insolvent. That would mean the creditors (liabilities)
would have $8 to distribute among themselves. They would get $8/$9 or
eighty-nine cents on the dollar of debt and equity book value. Even then, most
of the losses would be borne by junior creditors, and senior creditors should
get a full recovery.
Let’s give a real-life example: In December 1931, the
Bank of the United States, a large commercial bank, failed in a wave of bank
insolvency that claimed six hundred and eight U.S. banks in just two months.
It was the Great Depression. Over six hundred U.S.
banks failed in two months alone. The assets of the Bank of the United States
were liquidated into one of the worst markets of the twentieth century. It was,
in other words, the worst imaginable situation to be a creditor to an insolvent
bank.
Nevertheless, creditors eventually recovered $0.835 on
the dollar. Senior creditors probably got a full recovery. That’s the way it is
supposed to work.
When super-senior depositors have huge losses of 50%
or more, after a “bail-in” restructuring, you know that a crime was committed.
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