Lucien Bebchuk gets it Right

For your "socialism for the rich" scrapbook:

Governments must not bail out bondholders, by Lucian Bebchuk, Commentary, Project Syndicate: A year after the United States government allowed ... Lehman Brothers to fail but then bailed out AIG,... a key question remains: when and how should authorities rescue financial institutions?

It is now widely expected that, when a financial institution is deemed “too big to fail”, governments will intervene if it gets into trouble. But how far should such interventions go? In contrast to the recent rash of bailouts,... the government’s safety net should never be extended to include the bondholders of such institutions.

In the past, government bailouts have typically protected all contributors of capital of a rescued bank other than shareholders. Shareholders were often required to suffer losses or were even wiped out, but bondholders were generally saved by the government’s infusion of cash. ... Bondholders were saved because governments generally chose to infuse cash in exchange for common or preferred shares – which are subordinate to bondholders’ claims – or to improve balance sheets by buying or guaranteeing the value of assets.

A government may wish to bail out a financial institution and provide protection to its creditors for two reasons. First,... a protective government umbrella might be necessary to prevent inefficient “runs” on the institution’s assets that could trigger similar runs at other institutions.

Second, most small creditors are ... unable to monitor and study the financial institution’s situation when agreeing to do business with it. To enable small creditors to use the financial system, it might be efficient for the government to guarantee (explicitly or implicitly) their claims.

But, while these considerations provide a basis for providing full protection to depositors and other depositor-like creditors..., they do not justify extending such protection to bondholders.

Unlike depositors, bondholders generally are not free to withdraw their capital on short notice. They are paid at a contractually specified time, which may be years away. Thus, if a financial firm appears to have difficulties, its bondholders cannot stage a run on its assets and how these bondholders fare cannot be expected to trigger runs by bondholders in other companies.

Moreover, when providing their capital to a financial firm, bondholders can generally be expected to obtain contractual terms that reflect the risks they face. Indeed, the need to compensate bondholders for risks could provide market discipline: when financial firms operate in ways that can be expected to produce increased risks down the road, they should expect to “pay” with, say, higher interest rates or tighter conditions.

But this source of market discipline would cease to work if the government’s protective umbrella were perceived to extend to bondholders... Thus, when a large financial firm runs into problems that require a government bailout, the government should be prepared to provide a safety net to depositors and depositor-like creditors, but ... the government should not provide funds (directly or indirectly) to increase the cushion available to bondholders.

Rather, bonds should be at least partly converted into equity capital, and any infusion of new capital by the government should be in exchange for securities that are senior to those of existing bondholders.

Governments should ... make their commitment to this approach clear in advance. ... This would not only eliminate some of the unnecessary costs of government bailouts, but would also reduce their incidence.

H/T Mark Thoma.