Bail-Outs, Bail-Ins and Financial Stability

rcwhalen's picture

Below is a final draft of a research note that will be posted on later today.  See final for chart & notes.

It seems pretty clear that the initial reaction of the Federal Open Market Committee under Chairman Ben Bernanke helped to reduce credit spreads and
restore function to the bond markets.
The massive asset purchase operations that followed, however, have
distorted credit spreads and asset prices across most asset classes.

Witness the falling kitchen knife if the form of the market for mortgage servicing
rights or MSRs, which peaked around 5x cash flow during the height of
quantitative easing.
  Today that market
has fallen through 2x and seems headed back to the historical level close to
one time cash flow.
  Liquidity has
disappeared in the MSR market, but the consultants still mark these payment
intangibles looking at accelerating prepayment rates.

How is this helpful?  Isn’t QE supposed to
help housing finance?

And of course oil is now back in a contango market as distributors drown in excess
gasoline stocks.

All this courtesy of the FOMC.  



Bail-Ins and Financial Stability



In our last macro research note, Italy Slowly Moves Toward Comprehensive Bank
Rescue, we argue that the European Union must eventually support Italy’s banks
or risk the specter of financial contagion. Several readers questioned why
Kroll Bond Rating Agency (KBRA) is sufficiently optimistic to predict this
positive outcome, especially given that since the 2008 crisis Italy and other
EU nations have done little to address the festering situation in Europe’s
banking system. The mounting political and economic pressures in Europe are
another concern frequently cited in our discussions with investors.

The simple answer is when all of the alternatives are considered, KBRA believes
that the leaders of the EU will make
same judgment as the U.S. leaders did in 2008,namely that bailouts of existing
investors in the debt of large, systemically significant financial institutions
are far less costly and destructive to society as a whole than engaging in a
forcible debt liquidation. By responding to sudden financial crises with
benevolence rather than retribution, we can collectively avoid the worst
aspects of future financial disruptions. This very choice now faces the leaders
of the EU, but only time will tell if they will make the right decision.

It is self-evident that, throughout history, financial fraud often has been the
underlying cause of serious market disruptions.
   When deception is used to conceal risk the
eventual revelation of that risk causes investors to react with surprise and
fear, and rush for the exit. Systemic risk is when markets are caught unawares,
as in the case of the BREXIT vote in the United Kingdom and the failure of
Lehman Brothers in 2008. When a systemic event occurs, the cost of credit
intermediation (CCI) increases dramatically, decreasing market liquidity and
the effective leverage in the global economy. One measure of CCI is the
difference between investment grade and non-investment grade credit spreads.
Chart 1 below depicts the high yield and “BBB” option adjusted spreads from 1997
through today.


KBRA believes that one of the reasons the U.S. economy rebounded following 2008 was
the fact that the Federal Open Market Committee, under Chairman Ben Bernanke,
understood the crucial importance of CCI and restoring normal credit spreads.
The contraction of wealth creation capacity that occurs following a systemic
“surprise” to the markets reduces overall economic growth and feeds a spiral of
debt deflation described by Irving Fisher in 1933. 

Chart 1 also illustrates the near-catastrophic increase in CCI following the collapse
of Lehman Brothers and Washington Mutual in beginning of Q4 2008. These were
events that led to the failure of a number of other private and
government-supported financial institutions. When it comes to CCI and credit
spreads, up is bad and down is good for the markets and the economy. Following
the 2008 crisis, credit spreads spiked, causing CCI to increase and reducing
the capacity of the global economy to generate wealth and growth. But in the
years that followed, credit spreads fell back to normal levels, allowing the
U.S. markets for corporate debt and asset-backed securities to bounce back

The U.S. approached the post-crisis clean-up quickly, using a combination of
traditional resolution measures and public bail-outs for several large
financial institutions, including American International Group (NYSE:AIG),
Citigroup (NYSE:C), Fannie Mae and Freddie Mac (together the GSEs).  These moves to “bail-out” the debt investors
of large financial institutions provoked widespread political condemnation in
the U.S. and elsewhere, but in fact helped to compress credit spreads, reduce
CCI and slow the debt deflation that threatened the global financial markets.

Hundreds of smaller U.S. banks and non-bank financial institutions failed as a result of
the 2008 financial crisis, ending up in receivership or bankruptcy. Debt and
equity investors frequently took significant or total losses as a result of
these failures. On the other hand, in the case of AIG, Citigroup , and the
housing GSEs, debt and equity investors were bailed-out at public expense. The
equity holders were subject to severe dilution but were ultimately spared the
total loss borne by equity investors in smaller financial institutions. The
creditors of these institutions were rescued entirely and at public

Nationalization cum Monetization

In Europe, the EU member states have moved slowly to address bank solvency issues.
As KBRA noted in a previous report Will Negative Interest Rates Save Europe’s
Banking System?, the total of bad assets still unresolved in the EU banking
system is probably a multiple of the official total of €1 trillion. This
suggests very strongly that many financial institutions in Europe will need to
be recapitalized, a view that has been recognized for years by institutional
investors. The uncertainty with respect to the actual condition of EU banks is
the single biggest obstacle to raising new capital funds. But given that many
EU banks are trading at a fraction of book value in the global equity markets,
raising new equity in the private capital markets seems to be problematic.
Unresolved bad assets also constrain economic growth.

As in the case of the U.S. rescue of AIG and Citi, the only way to stabilize the
situation facing a number of EU banking institutions is for the respective
nations to first extend direct sovereign support in order to restore some
degree of confidence among investors and the public. Together with the
substantial liquidity being provided by the European Central Bank (ECB), direct
state support for troubled banks in Italy and other EU nations can eliminate
the immediate risk of systemic contagion. These banks would then need to write
down bad assets, a painful but necessary process that would then open the door
for new private capital inflows as equity valuations rise and credit spreads
fall. KBRA believes the act of public support will allow a smooth transition
from public support back to private ownership once institutional investors
regain confidence in the asset quality of EU banks.

It is important to note that simply converting debt to equity, a process that is
commonly referred to as a “bail in,” is not sufficient to address the trouble’s
in Europe’s banking sector and could lead to a systemic catastrophe unless
preceded by other measures. The leadership of the EU has been demanding that
Italy, for example, convert existing debt in that nation’s banks held by retail
investors to equity before any state support can occur. Converting debt to
equity is merely an adjustment to the balance sheet that does not provide new
funds to the troubled bank.

KBRA believes that the first step to addressing Europe’s banking crisis must involve
a credible extension of state support to troubled banks to alleviate public
fears and allow for an orderly restructuring process to move forward.
“Nationalization cum monetization” is the only way to bridge the gap between
insolvency and systemic risk - and financial stability. Direct governmental
support, combined with the liquidity support already available from the ECB,
should enable the governments of the EU member nations to avoid a financial
calamity and recapitalize troubled banks.

Many European financial institutions will ultimately need fresh capital to address
their financial problems and eventually regain the trust of investors. Again,
the U.S. experience with the public rescue of C, AIG and the GSEs is instructive
here and provides a practical roadmap for the political leaders of the EU to
follow. KBRA believes, the leadership of the EU can gain the time needed to
address the asset quality issues facing Europe’s banks only by first addressing
the immediate threat of systemic risk.


One of the unfortunate political side-effects of providing state support to large
banks and other financial institutions is that it generates anger and
resentment on the part of the public. Sensing this angst, political leaders
hesitate to take the steps necessary to avoid a repeat of past debt-deflations
of 2008 and, more appropriately, the 1930s. In Italy, for example, an explicit
bailout of the country’s banks would likely give greater impetus to populist
political forces seeking broader debt cancelation for private individuals and
companies. Yet the price of political inaction is an increased likelihood of
financial contagion, a result that will only make the present global trend
towards political radicalization accelerate.

For example, it is no accident that both of the major political parties in the U.S.
have adopted platforms that call for radical new regulation of large banks,
including the return of the Depression era Glass-Steagall laws separating
depositories from securities dealing and other commercial activities. KBRA
believes that advocates of such policies should recall that when Glass-Steagall
was adopted in 1933, the U.S. economy was on its knees and the law was
essentially adopted by Congress without debate. We believe that, at the end of
the day, the leaders of the EU will avoid financial contagion and eventually
make the difficult choices needed to avoid a repeat of the 2008 market crisis.
By embracing benevolence rather than retribution, the leaders of the EU can
avoid contagion and thereby increase the probability of a successful resolution
of the dangerous predicament now facing the European banking sector and also
improve prospects for economic growth. 


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steelrules's picture

Canadian Bank CIBC 

CIBC sells negative-yield bonds for 1st time Bank sells 1.25 billion euros worth of debt guaranteed to lose money in long run

lynnybee's picture

we are all living in a giant bank.   i trust no one, nothing except gold & silver coinage in my pockets.  bi-metalism.   gold & silver have to circulate as money (once again) like in the old days.   i really do remember coins in my pocket as a child with dates on them from the late 1800's & early 1900's, pennies, nickels & dimes & quarters.     those s.o.b. bankers!   i know what they've done to us all & we allowed it.   

JailBanksters's picture

The Economy is Fine, Fine it's Fine how come nobody ever listens

As long as Banks can loan something that doesn't exist and charge interest for it, and there are Bail-ins, Bail-Outs, Helicopter Drops and as long as Paper IOU's (Bonds) are exchanged for money that doesn't exist that are exchanged for assets of real value then everything is Just Fine. It's only when that stops is everything NOT Fine.

DaNuts's picture

"Systemic catastrophe followed by orderly restructuring process thereby regaining the trust of investors."

More of the same then.

You nearly fooled me for a second but I guess you don't know anything else apart from the system that you were indoctrinated into, KBRA is a bond ratings agency after all.

and this is the biggest load of shite I have read in weeks!

Dark Daze's picture
Dark Daze (not verified) Jul 28, 2016 1:37 PM

Look. Here is what I think of 'bail-ins' of depositors in light of the current world wide depression. First, people are not spending what little discretionary income they have because rates are negative. Second, if you steal money from depositors then you are only going to make the current depression worse, and quite likely spark violent revolutions everywhere, to say the least. Third, for most of the banks that would require capital assistance, such as Pasche Monte or DB, there is simply not enough exisiting liquidity in debt and depositors accounts to clear the bank's debts, which would make things doubly bad as depositors would be wiped out, bond holders would be wiped our and those banks, plus the 17 other 'Fed Reserve banks' would still fail, spectacularly, or, the government would still be required to bail them out to keep them alive.

What is needed is nationalization, but nationalization under a law that will forbid and prevent ANY future devolution of these banks back to the private sector. Dividends will always be paid out, tax free, to every citizen twice a year. The banks will always be required to carry a minimum of 20% Tier 1 capital which can not be exclusively government bonds (must be at least 10% gold and silver) and banks in the private sector will never be allowed to have more than 50% of the total capital market in any one nation.

The private sector in banking, especially banks in the US, have shown repeatedly that they can not be trusted at all, and put an entire nations well being at risk when they fail or nearly fail. That situation is no different than a governments failure to maintain public order or national defense. Quite frankly, when private bankers are allowed to endanger a nation, it is and should be correctly identified as treasonous, and the entire board and top level of management should be dealt with under the laws of treasonous conduct.

Honest Sam's picture

I would add one other condition to be implemented immediately

Diversity in the Chairmen and members of the FED, Chicago Board of Trade, SEC, and global financial organizations like the IMF and Worldbank (the  word looks like something out of Orwell).

No more Semites appointed and the current one at the FED, Yellen, needs replaced.  40 years of Sicilians in that job and the Media would be shouting Mafia Control.

Withdrawn Sanction's picture

Bail ins and nationalization are essentially equivalent from a depositor's point of view.  The money necessary to recapitalize banks and nationalize them would come from whom?  Yes, taxpayers, who will stroke a check out of where?  Yes, out of their checking account.  

A bail in simply avoids the middle man (i.e., the government nationalizers).  Unfortunately, a bail-in leaves the same incompetent banksters in charge of the firm they'd already run into the ground thereby requiring the bail-in in the first place.

The banks in the US do indeed have a particularly sorry track record of roughly every 10 years or so getting their collective tits in a wringer.  Latin American debt in the 1970s, the oil bust and subsequent S&L mess in the 80s and early 90s, the Russian/LTCM crisis in the late 90s, the housing bubble in the 2000s, and soon the eurozone mess will metastasize and infect exposed US banks.

Given these regular failings, it's easy to see why some might reach for the expedient of nationalization.  Putting government in charge (via nationalization) only takes the depositor out of the pan and places him squarely in the fire.  Banksters may be incompetent, but government bureaucrats...what are they?  What's worse than incompetent?  The mind reels for a suitably descriptive adjective. 

Im not advocating a bail-in; just pointing out it's essentially equivalent monetarily to a nationalization. 

So what's the solution?  Im not sure at the moment, but bringing back double liability for officers of failed institutions might be a healthy start.  Yes, yes, I know, using civil and criminal procedures is a quaint notion as far as banks are concerned, but one has to start somewhere.  

LawsofPhysics's picture

The laws of treason have been articulated already in the constitution my friend.  They have been ignored and subjugated already, if we were truly being responsible citizens, we would have revolted already!!!

Once the few have obtained such power and control, they will not willingly give it up, so it is very apparent to myself, and many of my military brothers and sisters that global Weimar is now in fact inevitable.  This essentially means WWIII.  Once enough "elite" have been killed, then and only then, will any meaningful discussions and a return to a just rule of law occur.

same as it ever was...

morethan1's picture

I'm wondering if MDB wrote this......

RaceToTheBottom's picture

MDB is a prankster.  This scuum is real, working in the belly of the beast, trying to lay the groundwork for more tax payer bailouts.

Death is too good for them all.

geno-econ's picture

Dissapointed in RCW essay.  Pointing to US bailout as an example of a solution is not valid as our economic and financial situation is still in peril. Saving private financial institutions that went astray to the point of criminal activity with public debt or bailins only kicks the can until the debt load sinks all ships. Simply put, the bank perpetrators have not been punished or forced to change their ways which makes expansion of our economis/financial policy by EU, Japan and China a global catastrophe. In fact the bankers have been rewarded. Current stimulus and monetary policy over the past decade including more than  doubling of the national debt does not represent an effort to lessen the effects of a business cycle but rather an addiction by bankers to enrich themselves with taxpayer money. This is why Trump is seen as the only hope, misplaced as it may be.  Could it be RCW trolling for overseas bank clientele ???

Withdrawn Sanction's picture

Agreed.  This sounds like it was written by a summer intern.

"We believe that, at the end of the day, the leaders of the EU will avoid financial contagion and eventually make the difficult choices needed to avoid a repeat of the 2008 market crisis."

Sure.  Good luck w/that belief.  The phrase, "whistling past the graveyard"  comes to mind.

RaceToTheBottom's picture

What a pathetic cut and paste excuse for an article.


Why should I wade through that POS?  Trial Balloon written by a WS apologist.


Is this April Fools day?  


LawsofPhysics's picture

LOL!!!!  Unless there is accountability the same corrupt motherfuckers and BAD behavior will get worse!!!!

A few guillotines NOW or WWIII later.

Choose wisely motherfuckers.