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Cramdowns for All

Posted by: David Henry on February 03

That Congress is talking about cramming down investors who bought bonds made from bad mortgages begs a question: Why not do the same to investors in bonds from bad banks?

Bad banks have essentially the same problem as the home owners: they owe more than their assets are worth. But Washington politicians and regulators aren’t moving to reduce the bad banks’ debts. Instead, they’ve added capital and now they aim to improve bank portfolios by buying out some toxic assets and guaranteeing others. None of this does anything about the debt. In fact, the actions add to the nation’s debt because Treasury will have to issue bonds to pay for these tonics.

Hashing out schemes to improve the banks assets is a lot like a financially-strapped couple discussing how to spend money to make a house worth more than its mortgage. Should they try to get a personal loan to replace the ragged roof and rebuild the broken driveway? Each step would help attract a buyer, but, in the end, the couple would still owe more than the sale would repay. The problem is they have too much debt.

Bond investors are inclined to a different diagnosis: debtors’ assets aren’t worth what they should be. Bill Gross, the legendary bond trader, wrote in his latest investment outlook: “To PIMCO, the remedy…is simple and almost axiomatic: stop the decline in asset prices.” Gross says Washington policymakers should focus on firming up asset prices, particularly house prices. That, of course, would make it more likely that bond investors would be repaid.

In an ideal situation, beleaguered homeowners would cut their spending and come up with the cash to make timely repairs and loan repayments. Ideally, banks whose assets don’t cover their liabilities would rebuild their capital and meet their obligations. But too many homeowners and too many banks don’t have the means to do that.

That’s one reason why legislation is pending to empower bankruptcy judges to ease mortgage terms. To Wall Street, these would be “cramdowns,” situations where lenders will have to accept less than what they contracted for, be it less timely principal or interest. They’re cramdowns in the sense that the loan changes would be virtually crammed down the throats of the mortgage lenders.

Lenders to banks have been big winners in the governments’ actions so far. The exceptions that prove the rule are last year’s seizures of bank assets of Washington Mutual and IndyMac that cost those bonds nearly all of their par value. Stockholders, in contrast, have been hit at bank after bank as Treasury stepped ahead of them and bought preferred shares. Yet, bond investors handed the banks leverage with too little discipline.

How much leverage did the bond investors deliver? Long-term liabilities, outside of advances by Federal Home Loan Bank, amount to about $850 billion of the financing for $13.5 trillion in banking system assets, according to estimates credit strategists at Bank of America. That’s about 6% of assets. For some banks, it is a lot more. Nearly 12% of Bank of America’s assets were funded by long-term liabilities, according to its 10-Q from September. For Citigroup, it was nearly 15%—some $300 billion of long-term liabilities. Try to imagine those Citi creditors having to reduce their claims by even 15%, some $45 billion. Yes, the lenders would hurt and scream, but Citi stockholders have had it much worse, losing about 90% of their market value the past year. Taxpayers already have put $45 billion on the line through TARP investments. They’ve also guaranteed about $250 billion of asset values.

Why aren’t we hearing more about cramming down bank bondholders? Maybe there’s worry that some of the bondholders are too big to fail and couldn’t withstand the hits. Maybe some are foreign lenders who the U.S. can’t afford to anger. Or, maybe it is just easier now to have the U.S. Treasury write checks.

Reader Comments


February 3, 2009 11:43 PM

Great story. Are you talking about regulation pertaining to the “Bad Bank” scenario or maybe a involuntary Bankruptcy of the insolvent institution?

I think it would be just as easy to make “Cramdown” applicable in involuntary 11s. I think if these Institutions seriously want to remain independent and not be nationalized Bankruptcy may be the best option. Using Cramdown will allow a “Bottom floor”, cramming down the value or knowing you have a “Court Ordered” value might buy back a little investor confidence. The presence of a “Bad Bank” to hold those bonds, guaranteeing them, would be beneficial in Chapter 11 and in consumer Chapter 13s. A “Bad Bank” could also serve as a Chapter 13 Mortgage Servicer, centralizing and monitoring every aspect of a recovery. With bonds and homes both working together in a Bankruptcy scenario I think you can maximize the return for the American People or at the very least stopping the free fall. Should it be forever? I hope some day that if a “Bad Bank” is created that there has to be a provision to keep it dormant after a recovery and used only in situations such as we are currently experiencing. .


February 4, 2009 09:37 AM

Simple answer, you would change the nature of business in the US. When you start retroactively changing contract by force, then we really are becoming socialist. When the sanctity of contracts bend with the political wind, that is the end of America.
I have a fair compromise, since these people who took these subprime mortgage dont have the capacity to understand what they are signing, purchase the assest under terms they can no longer enter into credit contract. I could live with that, then there would be some accountability


February 4, 2009 10:54 AM

Can I take it back?

The idea of a "Bad Bank" acting as a Servicer of sorts for Chapter 13 Mortgage Mods. After watching CSPAN last night and listening to the COO for the FDIC testify, I would like to retract that idea. It seems as though Housing Administration would be better equipped for that task. I learned that the FDIC would be managing the "Bad Bank" and frankly his testimony was awful. The man just could not answer straight and seemed somewhat detached from knowing what is actually happening to "real" people. As I gleaned from the testimony, Housing Administration has access to TARP money to expand their ability to restructure loans. The problem NOT ONE, "HOPE" rework was been insured by Housing Administration so far. The lady (I forget her name) said that as of the date of the hearing, they were supposed to have helped 44,000 homeowners. She cited "qualifiers" had effectively stopped the majority of homeowners from even applying for "HOPE". ie. recent loss of employment, high debt to income, etc...

Common, Mr. J-Lo, socialism? Why are consumers, who can be experts at other things, ie. plumbers, electricians, etc.., are held to a higher standard when it comes to "financial matters" than certified financial managers? ie. Mortgage Brokers, Bankers etc.... There was a two way street and the one coming from the financial sector had way more room and was packed with semi trucks. There was a mechanism that actively sought out to flood the system with these "toxic" sub prime loans. More risk = more profit for all of the "leverage", the MBOs, and derivatives.

rc whalen

February 6, 2009 10:56 AM

If the market for private label securitization is not dead yet, this proposal will be the dirt on the coffin lind. Congratulations on yet another fine piece of public policy.

J. Michael Steele

February 8, 2009 07:58 PM

Did I read this too quickly, or is it just unconnected rambling. My money is on the second option. What exactly was the thesis?

David Henry, BusinessWeek

February 9, 2009 04:44 PM

It seems that some things here were not written clearly.

As for my original post, the main point was to ask why people who made loans to bad banks through the bond market should not consequences along with the government and taxpayers.

The notion that a bondholder should get back something less than promised doesn't come naturally in a normal times. A bond is a bond, after all. These are exceptional times. To show in the original post that the normal attitude is giving way, I made reference to Congress taking a step toward inflicting consequences on people who made bad lending decisions through mortgage-backed securities. Proponents of mortgage modifications apparently think that these lenders bear some responsibility for making bad loans. I wanted readers to ask whether that same logic would not also apply to lenders to bad banks. The reference to mortgage modifications was also a device for drawing a contrast and showing how bank bondholders have been doing comparatively well in Washington. The post did not set out to weigh the pros and cons of mortgage modifications.

Thank you for your interest. This blog is no longer active.



BusinessWeek's Adrienne Carter, Jessica Silver-Greenberg, and David Henry deconstruct the mysteries of high finance, Wall Street, and hedge funds for pros and ordinary investors. E-mail them directly if you've got tips about big deals, a hedge fund, or even securities industry gossip.

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