The Great Repudiation Revisited

Posted by: Michael Mandel on February 18

Back in October, I wrote a story where I argued that the U.S. was heading for a Great Repudiation of foreign debt: “Will Washington act in a way that imposes large losses on foreign investors—in effect, repudiating some of the debt?”

The looming problem of the foreign debt is a big reason why Obama’s bank rescue plan seems so weird. Christopher Whalen of Institutional Risk Analytics gets the point. He recently wrote that:

What is required in Washington is an adult conversation, between the US government on the one hand and the holders of the bonds of the largest banks on the other. Many of the bond holders of the large banks are foreign governments, central banks and investment funds and not a few of these sovereign names are in really serious financial difficulties. Since the receiverships for Lehman Brothers and Washington Mutual, where bond holders took a near total loss, these foreign investors have been vocal in demanding that US taxpayers protect them from further harm.


But to deflect these cowardly, expedient arguments, the US government must be willing to lead by example to show that there really is only one way to restore confidence in zombie banks: use receivership to wipe out the common and preferred shareholders, conserve the deposits and sell the good assets to new investors, and then restructure the remaining operations of the bank to maximize recovery to the bond holders and other creditors.

In other words, at some point the bondholders are going to have to take a big haircut.

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Reader Comments

Viking

February 18, 2009 01:55 PM

This is the problem when government start meddling in the workings of the financial system.If you allow the system to work under the rules that everyone understands ,you would allow banks and companies to go thru the bankrupcy process.This will always vipe out stockholders first.Then bondholders will receive proceeds as the company is liquidated or negotiate a haircut as part of a chapter 11 process to keep the company operating.In other words no one can argue with the market making these adjustments,but everyone will argue when the government starts picking winners and losers.This is why I have argued from the start that the only thing the government should have done is provide unlimited FDIC insurance on deposits in banks,but otherwise stay out of the way.This would have provided a sharper but shorter adjustment back to health,but more importantly,it would have protected the prudent saver and punished the people who took excessive risk.

LAO

February 18, 2009 02:17 PM

I am getting really tired of seeing friend's and family's futures diminished just to facilitate other nations' destruction of the climate, the environment, precious resources, their own citizens' health, and continuation of our inability to ever successfully compete with them. It seems to me that this situation could be turned into an opportunity for some win-win negotiation.

CompEng

February 18, 2009 03:08 PM

Absolutely right. And this is what's going to tank the dollar and finally deal the death blow to the current global economic organization where the world makes stuff, America buys it, and Europe and Asia lend us the money to do it. This is what will send oil soaring back up for America (although not globally) even as American demand drops. It's what will wipe out the US government's ability to borrow so far beyond its means, send up inflation, and by the way, send America (and much of the world) into an actual depression.
All the cheerleading and the big stimulus giveaways around the world are in an effort to avoid this scenario, but greed and a belief in anti-gravity finance and globalization at any price have already done it.

Or hopefully I'm completely wrong. I'd be more than happy to be found the idiot pessimist on this.

Lord

February 18, 2009 05:18 PM

How many more institutions would this leave insolvent which when liquidated would leave still more insolvent? People have this fanciful notion that this next round would solve all our problems leaving only healthy ones left, but it isn't that easy. Yet printing money wouldn't be inflationary since it would only be counteracting these deflationary losses. I say print it and let them take their losses in exchange rate or make other investments here with it. They can take their choice.

Joe Cushing

February 18, 2009 06:55 PM

I like the haircut idea. It transfers wealth to those who were prudent from those who were not prudent. It also frees up those assets to be put to use. This is a libertarian idea. Receivership of this kind is really just accelerated bankruptcy.

Viking makes some good points though.

Mike Mandel

February 18, 2009 09:49 PM

CompEng,

There's no way out of the box without innovation...but that's always been true, going all the way back to Malthus. I'm less worried about economics than I am about war.

CompEng

February 18, 2009 10:48 PM

Now there's a scary thought. I'm going to give humanity the benefit of the doubt on that one.

Of course, you're right about economics... life will go on, and on a big enough scale this is just a bump in the road. But it seems so terribly sad, especially since there's an existence proof of a better way. We have the capability to take care of ourselves: we mostly did it yesterday, if only we knew how to organize ourselves properly.

LAO

February 19, 2009 01:12 AM

Come to think of it, my earlier comment betrayed obvious personal bias. The citizens of some U.S. trading partner nations are probably equally as tired of our self-serving and abusive ways.

Still, I have encountered earlier attempts to pursuade China, in particular, of the golden opportunity they have had to leap-frog past the weaknesses of the developed world, much like H. Clinton is undertaking to pursuade them now, and they just don't seem to get it or want to consider it. If they are unwilling to attempt a better approach to capitalism, then I am inclined to have less sympathy for their suffering at the hands of our brazen bankers. I can hardly blame Obama/Geithner for not facing the problem head-on, but China wanted to play ugly American-style hardball, so why should they not now accept the consequences along with the rest of us?

Mike Reardon

February 19, 2009 01:43 AM

Imagine the State of California defaults behind its Budget deficit, and with further obstruction into the next Budget coming in June is then unable to reestablish any credit lines going forward.

The centers of national education and innovation in California will not be able for any national efforts going forward over the whole next decade.

I’m not that concerned with external war this week, I’m afraid of political dramas centered in orthodoxy that will end crippling our whole history going forward.

Mike Mandel

February 19, 2009 09:12 AM

CompEng,

What's the 'better way' that you see?

CompEng

February 19, 2009 11:04 AM

Mike,
if I could define it, I could get a Nobel prize, don't you think? But in math you don't necessarily have to have the solution to prove one exists. Plus, there's a lot of potential problem statements here. Which one to start with?

How do you avoid the consequences of popping asset bubbles? Drain the bubble when you see one inflating. How do you avoid a credit crash? Don't put you cash in an asset bubble.

How do you avoid traveling waves of trade debts? If your trade partners are small enough, keep sending them cash. If your trade partners are large enough, poor enough, and committed to a trade surplus, you're going to lose a lot of your productive capacity, so you'd better put in policies that encourage a high savings rate early. Devaluing your currency by making huge loans to your trading partners is probably also a shrewd move. And put your investments in research and production, not assets. And on a national level, keep subsidizing a small core of strategic capabilities so when the monetary see-saw comes back, you have some seeds of production for your economy.

You can have the insight that governments don't "interfere in markets", they participate in markets: how else can you address what are economic externalities at a personal level? You just have to make sure governments are accountable to their people for their actions. Big personal debts, low savings rates, high saving rates, trade surpluses, trade deficits: these were mostly individuals responding rationally to a hodgepodge of national policies that became an international system. If we were up front about that, we could have seen where this was going, figure out where we anted to be, and made a plan. But the people with the capacity to do that were too busy getting rich by taking advantage of current conditions.

No "system" can irradicate human stupidity, or our unwillingness to take responsibility for our own fate. But faith in our system has certainly kept us from being smart.

So, instead of redirecting our economy incrementally at what makes sense, now we're forced to do it wholesale in a low credit environment. But there are market agents with both cash and productive capacity: Asian governments. They have the capability to restart and reorder the global economy, if they have the will.

Bottom line: the way out is to invest in something that somebody with money needs. The way to avoid the mess is to look for bubbles and drain or pop them early.

Tim Jones

February 28, 2009 10:49 PM

War will not be a problem.

many of us internally have wondered for years why we have been quietly building up shockingly massive attack assets in Europe for over a decade now. The average person in Europe would be shocked if you knew the shear amount of US military tonnage secured in bunkers under their feet.

The current events also help explain why we the insistence of bringing a 12th aircraft carrier active in 2011. People forget that the US naval fleet quietly has been building a fleet that is larger than the next 13 nations behind us combined. A truly awesome force if you think about it, and helps many of us now understanding what the overall DOD plan us. Meaning, these guys clearly understand history... :)

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

 

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Michael Mandel, BW's award-winning chief economist, provides his unique perspective on the hot economic issues of the day. From globalization to the future of work to the ups and downs of the financial markets, Mandel-named 2006 economic journalist of the year by the World Leadership Forum-offers cutting edge analysis and commentary.

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