Bailouts and the risk premium

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Interest on some kinds of bonds is higher than on others.  That is because of the “risk premium.”  The higher the risk that the borrower will default, the higher the interest rate the lender will charge.  That is why high-yield bonds are called “junk bonds.”  High interest rates on certain corporate bonds offset the risk that the company that issued the bonds goes bankrupt.  High interest rates on certain government bonds offset the risk that the government defaults.

But the policy of the Federal Reserve Bank and the U.S. Treasury Department is that bondholders should be protected from risk, no matter what the cost to the public.  This goes against the principle of a free enterprise system, which is to reward success and punish failure.

These thoughts came to mind when I read a New York Times interview with Sheila Bair, outgoing chair of the Federal Deposit Insurance Corp., an Eisenhower-type Republican who found herself in the minority when she opposed the “too big to fail” mentality so prevalent in the government.  Here are some key paragraphs from the article.

Sheila Bair

… … Bair views her disagreements with her fellow regulators as a kind of high-stakes philosophical debate about the role of bondholders.  Her perspective is that bondholders should take losses when an institution fails.  When the F.D.I.C. shuts down a failing bank, the unsecured bondholders always absorb some of the losses. That is the essence of market discipline: if shareholders and bondholders know they are on the hook, they are far more likely to keep a close watch on management’s risk-taking.

During the crisis, however, Treasury and the Fed were adamant about protecting debt holders, fearing that if they had to absorb losses, the markets would be destabilized and a bad situation would get even worse. “What was it James Carville used to say?” Bair said.  “ ‘When I die I want to come back as the bond market.’ ”

“Why did we do the bailouts?” she went on. “It was all about the bondholders,” she said.  “They did not want to impose losses on bondholders, and we did.  We kept saying: ‘There is no insurance premium on bondholders,’ you know?  For the little guy on Main Street who has bank deposits, we charge the banks a premium for that, and it gets passed on to the customer.  We don’t have the same thing for bondholders.  They’re supposed to take losses.” … …

She had a second problem with the way the government went about saving the system.  It acted as if no one were at fault — that it was all just an unfortunate matter of “a system come undone,” as she put it.

“I hate that,” she said. “Because it doesn’t impose accountability where it should be.  A.I.G. was badly managed.  Lehman Brothers and Bear Stearns were badly managed.  And not everyone was as badly managed as they were.”

The whole article is well worth reading.  Click on Sheila Bair’s Exit Interview for the entire article.

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