The following piece was written about two weeks ago for Finacorp clients.? If you are an institutional investor, and would like to be a Finacorp client, please e-mail me.

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Before I get to my main topic, bank bonds, I need to explain my overall theory for this economic crisis. We are presently in a period of debt deflation. This follows a long period where government policy encouraged the buildup of private debt as a ratio of GDP to levels not seen since the Great Depression. Since 1984, the Federal Reserve ran a predominantly easy monetary policy that was quick to bring back the punchbowl the moment the economy showed modest strains.

Under such ?favorable? management of monetary policy, businessmen and consumers bid up the prices of assets, and borrowed money to do it. The additional buying power from leverage set in motion a self-reinforcing cycle that raised asset values, and raised the willingness of lenders to lend progressively more on those assets on favorable terms.

In addition to easy monetary policy, there were other factors that contributed to the increase in leverage. Securitization gave new classes of loans liquidity during the bull phase of the cycle, as leverage built up. Also, bank examiners were increasingly ?hands off? in reviewing the solvency of banks. Derivatives also made the balance sheets of financial institutions more opaque, making regulation more difficult.

Equilibrium is a weak concept in economics. Weak, because most of neoclassical economics relies on the concept that markets tend toward equilibrium. If there is a tendency toward equilibrium, in all my years as a practical economist, that tendency is weak at best. Capitalist economies are dynamic, and equilibria are fleeting. Also, when the government intervenes, it changes the terms of what an equilibrium would be.

But eventually, the unsustainability of the increase in debt would eventually be revealed, and the inability of the assets to service the debt would appear. The value of the assets had been inflated far above equilibrium levels, and a self-reinforcing cycle in falling asset prices began, with a collapse in leverage as defaults grew.

I call this a depression, and it is little different than what happened prior to and during the Great Depression. Monetary policy is tight. Ben Bernanke may not think of it as tight, but his actions are not inflating the nominal value of collateral in order to lessen the debt load. We are facing nationalistic sentiment across the globe, and the international division of labor is breaking down. The only thing different at present is that fiscal policy is as loose as loose can be. Average Americans are blinking at what the government is doing with a sense of moral horror, because those who were imprudent are rewarded by those who were prudent.

How this Affects the Banks

In this environment, bank balance sheets get compromised. The value of loans decline as creditworthiness falls and defaults rise. Also, there are unique securities that were previously thought ?money good.? They trade at low prices because there is a scarcity of buyers who can genuinely buy and hold for the duration of the security. Balance sheets are never big enough or long enough during the bust phase of a cycle, and few risk managers run stress tests severe enough for a bust phase like we are in now.

So, the Government Intervenes

The US Government acts in a wide number of ways in order to fight the crisis. The FDIC takes over failed institutions and sells them off with some degree of subsidy in those banks in deeper trouble. In some situations, where there is a large derivatives counterparty, like AIG, the government acts to protect the stability of the financial system as a whole. Granted, the government should ignore holding companies, and focus on the regulated subsidiaries that are a legitimate interest of the government, but at least in the initial phases of this crisis, the government has allocated funds to holding companies. This is a boon to those that hold holding company unsecured bonds, but expensive to the taxpayers. How long will the largesse continue?

Away from that, we have the distraction of Congress as they try to:

• Make the banks lend more
• Control remuneration to employees
• And control spending on conferences and other normal aspects of business where rewarding talented employees and loyal customers is the norm.

Away from all of this, the Fed tries to heal lending markets at the risk of replacing them. So it goes.

Government Action is not Big Enough, or Effective Enough

The government is a big player in the economy, but not so big that it can dictate terms independently. The economy is larger than the resources of the government; if the government tries to keep the price of a large asset class like residential housing above its equilibrium level, it will fail as borrowers line up for a lot of loans.

But there are other factors that make the response of the government weaker:

• They don?t really understand the crisis that they are in. They will try any Keynesian remedy, even though it won?t work.
• There is enough disagreement in Congress over what to do, that any approved project is a hash, and not capable of fixing the problems.
• The Fed will create a bunch of obscure lending programs, but won?t let inflation take hold which might help those with assets that are underwater.
• There is a limit on what the government can borrow, ill-defined as that is. International lenders will balk, and domestic lenders will look for higher rates.

Taxation capacity of the government is limited as well. Who wants to raise taxes during a severe recession?

So what can we expect today?

Let?s start with the recent past. What have the Federal Government?s actions been with respect to the financial sector so far, and how have bondholders been affected? Here is a non-comprehensive list:

Company	Government Action	Effect on Bonds
Bear Stearns	Forced sale to JP Morgan, with some government asset purchases. Equity gets a seemingly low price.	Bonds are still money good.
Fannie Mae, Freddie Mac	Pseudo-nationalization. Equity gets diluted down to near zero, preferred also. Government backstopping the large losses for now, leaving debt capitalization unaffected.	Senior bonds are money good, and may become pari passu with Treasuries eventually.
AIG	Pseudo-nationalization. Equity gets diluted down to near zero, preferred also. Government backstopping the large losses for now, leaving debt capitalization unaffected.	Senior bonds seem to be money good for now, but increasing losses make that less than certain.
Lehman Brothers	No action. Lehman goes into Chapter 11. Common and preferred are wipeouts.	Senior bonds not money good. Recovery values very low and speculative.
Countrywide	Encouraged a merger with Bank of America	As good as Bank of America, with some small amount of extra legal risk
Merrill Lynch	Encouraged a merger with Bank of America	As good as Bank of America, with some small amount of extra legal risk
Washington Mutual	Encouraged a merger with JP Morgan	JPM did not take on all of the bonds. The bonds taken on is JPM quality, and that not taken on is risky.
IndyMac	FDIC took it into conservation, and is selling off the pieces	No bonds
Citigroup	Large investment from the TARP. Guarantee of a large amount of assets. May need even more?	Government actions have helped the position of the bondholders so far. The question is how much more is the government willing to do?
Bank of America	Large investment from the TARP. Guarantee of a large amount of assets. May need even more?	Government actions have helped the position of the bondholders so far. The question is how much more is the government willing to do?
Downey Federal	Filed for liquidation; US Bancorp buys the operating companies.	Bonds trade near zero
Group of large banks receiving unasked-for aid	TARP money was offered to, even forced on some banks. Since the TARP investment is senior preferred. Warrants go along with the TARP money for shares equal to 15% of the preferred investment. Slight chance of dilution.	Government actions have helped the position of the bondholders so far. The question is how much more is the government willing to do?

There are a few common threads here. In general, where the government intervenes, they do so through preferred and common stock investments, and occasionally buying liabilities in situations of severe stress. Also, aside from the takeovers that went through the FDIC, in general, the government has been bailing out holding companies directly, rather than regulated operating entities, which is an odd way of assuring solvency of the financial sector.

So far, all of these actions support the position of bondholders. When the bailouts began to happen, there was some talk of protecting senior unsecured bonds among policymakers, but nothing formal was set as a policy.

Increasingly, there is talk in the media of why bondholders get off the hook so easily, so this operational hypothesis may come under political pressure, particularly since many bonds are issued at the holding company. The holding company can go under with a low level of impact on the regulated operating entities, which if the regulators have been doing their jobs (cough, cough) they should be able to stand on their own, or sold off to better management teams.

Also, this does not apply to smaller institutions. There is some size level where the regulators say, ?Liquidate and sell off the pieces.? Even for the small banks that got small amounts of TARP money, the regulators will let them go under. TARP 1 was a unique exercise where the money flowed freely with very little in the way of restrictions. That won?t happen again.

If this crisis gets larger, and I think it will, with many entities asking for money, and many coming for second, third, fourth, fifth, etc. allotments of aid, the political will to protect the banks and other financials will erode. Along with that will erode support for holding company bondholders.

Opinion:

In bonds, better safe than sorry. So far government actions have supported bondholders, but that may not persist for a number of reasons:

• As the crisis gets larger, the resources of the government will get stretched. Already, the government is feeling pinched.
• Political pressure is building to make the bondholders of bailed out institutions feel some pain.
• The rationale behind bailing out holding companies is dubious. Eventually policymakers will not bailout holding companies because it does not protect the financial system.
• So far returns on government actions have been poor, to say the least. The concept that the government would make money on this was laughable at the time, but now it is proven ridiculous.
• Eventually the government will take larger insolvencies through the FDIC, and bondholders will accept some amount of equity and warrants for their bonds.

Buying financial holding company bonds is a bet on stability of policy, and that the crisis does not grow. There may be some opportunities in buying unsecured bonds of financial companies here, but institutions relying on government support may prove to be poor investments, because the odds of policy shifting against bondholders is moderate. Don?t assume that ?too big to fail? means that holding company bondholders get a free pass.