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When the government’s guarrantee of the banks runs out…

Not being a high faluting economist but instead more like Poo a bear of little brain, I have been wondering why the Irish government has guaranteed not only the depositors who are ordinary families and businesses but also the creditors of the Irish banks, especially the bond holders who are experienced, sophisticated investors.  What makes them so different, so worthy of protection in contrast to the hapless shareholders?  The investors still holding BoI and AIB shares tend to be loyal ex-employees and simple retired people who had a simple faith in their financial betters; – all the sophisticated pension and investment fund managers have apparently got out months ago.  It hardly seems fair or even efficient from a moral hazard viewpoint particularly when the ordinary resident tax payer will have to foot the bill.

Well, that situation might well change.  Our Minister for Finance, having lost his taste for financial innovation, is watching what other smarter heads decide before he take any further action.  He must be following Gethner’s moves in the US Obama admistration with great interest.  So are Peter Boone and Simon  of the baseline Scenario and occasional contributors to the Wall Street Journal.  They call the high stakes game that is being played before our eyes and that of the market ;- the Real Geithner Plan, a ‘Nuclear Option’. The Obama administration last week proposed draft legislation for a “resolution authority” that would effectively permit the government to liquidate or restructure large systemic financial institutions.

Imagine what happens when these powers are passed. The U.S. Treasury and FDIC would immediately have the tools need to walk into America’s largest financial institutions, such as Citibank or Bank of America, and liquidate them, or rewrite their contracts and capital structures. Such powers are clearly useful: if the banks are undercapitalized, and private money is not available, then the government could force creditors to swap claims into equity, thus instantly recapitalizing the banks while avoiding use of taxpayer funds. With such steps, the problem of moral hazard, where creditors to banks are bailed out by taxpayers, would at once be forgotten. Shareholders in banks would lose through dilution, some (unsecured?) creditors would lose with debt-equity swaps, while the nation would be better off having a well-capitalized banking system. The banks would remain private but now be controlled by (ex)creditors.

Is this the ultimate fate for our delinquent banks too?

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