also because the government has just demonstrated that it will indeed nationalize a large bank. Bond prices on weaker banks would plummet and interest rates and credit default spreads would soar. These reactions, plus the likely reactions of the stock market, could spark a flight by trading counterparties and customers, weakening these banks further. Other types of financial institutions, such as life insurers, could be similarly hit, although likely to a lesser extent as they generally are not perceived as having as much potential government support.
Damage to the overall bond markets and to the health of other financial institutions. Direct losses on bonds of nationalized banks, plus the potentially larger aggregate loss of market value of bonds of other weaker banks, could hit bond investors hard. Bonds of financial institutions make up a large part of the bond market which means this would have a major impact on debt investors. Many of these investors are life insurers, banks, or other financial institutions that the federal government might feel the need to rescue.
Reduction of the ability of banks to raise debt capital as they recover from this crisis. There will come a time when the crisis eases enough for private capital to begin flowing more freely back into the banks. (Goldman Sachs, for example, just raised $5 billion by selling common stock.) Much of this capital would come in the form of bond purchases. Raising that capital would be significantly harder and more expensive if debt investors have just seen large losses due to a nationalization.
Structural complications somewhat hinder the process of implementing the haircuts. There are several complications. First, much of the debt at the large banking groups is actually at the level of the bank holding company. Under current law, haircutting those bonds would either require a bankruptcy filing or persuading the bondholders to accept an out of court settlement, probably using the threat of a filing. Bankruptcies are exceedingly messy and reaching an out of court settlement can be very difficult. Worse, the process of pushing for a bankruptcy or pursuing an agreement with the bondholders would almost certainly create a crisis of confidence for the bank if pursued prior to a nationalization or would add great complications if pursued afterwards. Second, it is very difficult legally to force bondholders to take losses without also forcing losses on other creditors who are in the same broad group of “general creditors” for bankruptcy purposes. This would include suppliers, employees who are owed money, etc. If nothing else, this adds political difficulties to the process by substantially expanding the range of parties who are damaged. It should be noted that the Administration has requested expanded “resolution” authority that would extend to bank holding companies, which might eliminate or reduce these complications.
Gives current debtholders more say in the bank’s future. It is difficult to force losses on debtholders without also giving them a claim on future recoveries from the bank or bank holding company. In practice, this means that debtholders would likely receive stock in exchange for taking their haircuts. This would mean that the government would need to take into account these minority shareholdings in the bank as it made decisions going forward. At the extreme, if little new taxpayer money is infused, the government might be trying to control an institution in which it owned a minority of the shares. It also