Shaking Hands with the Government, or At Least With PIMCO

Good comments from a bond ghoul writing in the new Atlantic business channel on the nervousness among his compatriots given that it seems increasingly possible that bondholders will eventually be forced to share the bailout pain. As I have said here repeatedly, PIMCO has made it clear it is taking the other side of that trade, cozying up to the government and even suggesting how it should orient its umbrella of protection. Who is right?

The deepest, darkest concern of bond professionals is whether bond holders of banks will ever be asked to share the bailout pain.  Ever since Lehman the Fed’s reluctance to impair bank bonds has been palpable.  For starters, finance issues represent more than 60% of 1-5 year maturity bonds.  They are ubiquitous in pension funds, insurance company portfolios and, until last fall, money market funds (most money market funds have moved up the capital structure to CDs at this point, spooked by the post-Lehman panic).  So there are "systemic" reasons to protect them.  The same logic protects General Electric.  Furthermore, the capital structure of large banks is horribly convoluted.  If you wanted to get bondholders to contribute to recapitalization you’d have to create a scheme of cascading discounts to cover preferred stock and capital notes issued by the holding company and the senior and subordinated debt of the banks.  Near the top of this stack is the preferred stock investment of TARP, so a bondholder discount necessitates a TARP revaluation.  Also, the Guarantied "TLGP" obligations are holding company debt and would have to be discounted.  So the government would participate in any loss.

Still, one understand public sentiment on this issue. Apart from Lehman, bondholders, like CDS counterparties, have benefited at the expense of taxpayers.   This potential uncertainty is one of the things supporting wide bond spreads.  Despite the obvious government support, Citibank’s holding company bonds offer a plus-sized 5% premium over their government-guarantied paper.  Pimco, the gorillas of bond investing have publicly positioned themselves as if this pain-sharing will never happen.  "Shake hands with the Government", they claim. Others among us have hedged our bets.     On Monday Tuesday, Geithner will choose where to locate losses, or delay the reckoning again. 

More here.