The tide may be turning in Europe. I'm not talking about the economy, which continues to get worse. Rather, I'm talking about the trend of bondholders coming out ahead of citizens in a long-running zero-sum financial game.
When Ireland's large private banks collapsed spectacularly a few years ago, the Irish government formally assumed the debts of the private banks. To ensure that bondholders of Irish banks would remain whole, the government undertook a massive bailout. To pay for it, it has inflicted vicious austerity on its populace.
The move won plaudits for Ireland in international financial circles. But the Irish people aren't so pleased at having to transfer wealth to European investors who knowingly took risks on private-sector investments. And that's making them rethink their commitment to European policies. On Thursday, as part of the continuing reaction against the government's solicitude for bondholders, Irish voters headed to the polls to vote on the latest European fiscal stability pact.
Bondholders vs. Citizens
In Greece, where voters recently cast lots of votes for a political party that advocates defaulting on its sovereign debt, the bondholder-vs.-citizen plot line is a little more complicated. From the outset, Europe's efforts to bail out Greece haven't been aimed at Greek banks, or inefficient Greek companies, or Greek bureaucrats. They've been aimed at the public and private entities throughout Europe that (foolishly, it turns out) bought Greek public-sector bonds and then held on to them -- even after it was clear the country lacked the capacity and will to collect sufficient revenues to stay current.
As Liz Alderman and Jack Ewing reported in the New York Times this week, about two-thirds of the $177 billion in European aid to Greece given since May 2010 has been used to make payments to bondholders and other lenders. The upshot: Greece is imposing significant austerity on its citizens for the sake of preserving the value of bondholders. The electorate doesn't seem particularly interested in continuing to suffer for the sake of making coupon payments.
Now, Spain seems to be turning into something of a hybrid of Ireland and Greece. It's got a private-sector banking crisis spurred by excessive real estate lending (a la Ireland) that has morphed into a public-sector debt crisis in part because the country has imposed deep, ineffective austerity measures at a time when the economy is shrinking and unemployment is high (a la Greece).
But rather than learning a lesson from Ireland, Spain seems to be doubling down. The stockholders and bondholders of Spanish private-sector banks must be protected! As Spanish Prime Minister Mariano Rajoy said earlier this week: "We are not going to let any regional government fall, or any bank fall, because they can't . . . if that happens, the country will fall."
Once again, a European government is standing up and declaring that public sector and private-sector bondholders mustn't suffer. But why not? Bondholders suffer all the time when the companies whose debt they purchase fail. Stockholders get wiped out first, and then the bondholders take a hit, with those holding unsecured bonds getting hit first. That's how capitalism and markets work.
Yes, it's true that the U.S. in 2008 and 2009 acted to keep bondholders from taking big losses. The taxpayers formally assumed the debt of Fannie Mae and Freddie Mac without insisting bondholders take any haircut, just as the Irish taxpayers formally assumed the debts of their large banks. That was a big and expensive mistake. In a time of austerity, the U.S. government is channeling tax payer funds to make interest payments on bonds that were first issued by for-profit entities.
A Better Way
There's a better way. During the crisis, the Federal Reserve and the Treasury Department guaranteed all sorts of financial instruments: money-market funds, asset-backed debt, the commercial paper market. The FDIC started an initiative to guarantee the debt issued by banks, the Temporary Liquidity Guarantee Program.
But these programs differed in some important respects from the Fannie/Freddie and Irish bailouts. The U.S. government didn't offer to guarantee old debt and bonds that had been amassed before the crisis. Rather, it agreed to guarantee new debt and bonds issued after the crisis. And it charged significant fees; it sold insurance rather than quickly assuming responsibility for making debt payments.
So in the TLGP, for example, the FDIC has collected $10.36 billion in fees from banks who issued more than $300 billion in guaranteed debt in 2009 and 2010. There have been no defaults, and the amount of debt insured has fallen to $116 billion. Meanwhile, hundreds of banks did fail, as the FDIC's failed bank list shows. And while their depositors were protected to a degree thanks to deposit insurance, these banks' other financial stakeholders suffered significant losses.
Look, bonds are legal contracts. It's not that easy to shirk them, and it shouldn't be. But when investments fail, bond investors routinely receive less than they expect, either because the market knocks down the price of their bonds or because they negotiate settlements in or out of bankruptcy court. It's an established practice for industrial companies, consumer products companies and media companies. There's no reason that it should be any different for financial services companies.
When politicians say they'll put the prerogatives of bondholders — of private entities like banks, or public entities like regional governments, of or public-private hybrids like Fannie Mae — ahead of the needs and desires of their citizens, they may win friends in the councils of the European Central Bank and Davos. But it's no way to nurse a wounded economy back to health. And it seems a very poor way indeed to win an election.
Daniel Gross is economics editor at Yahoo! Finance.
Follow him on Twitter @grossdm; email him at email@example.com.
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