When bank defaults are a good thing

One of the problems with the banking bailout in both the UK and the US is that it’s set up a massive moral hazard trade. Bank debt is trading at a massive discount to face value, and investors have been buying it in the hope and expectation that the governments of the two countries won’t let any major financial institution default on its debt after seeing the repercussions of the Lehman and WaMu defaults.

Given that many banks need a lot of recapitalization, the fact that their bonds are trading at a discount presents a great opportunity: they can swap those bonds for equity, or otherwise retire the debt below par, thereby reducing the bank’s liabilities and increasing its capital base. But bondholders will be averse to selling or swapping at the current levels unless they believe there’s a credible threat of default, even in the face of reassurance from the authorities that defaults won’t be allowed to happen.

So it’s great news that Bradford & Bingley has defaulted on its subordinated debt and that, as Neil Collins notes, “there’s nothing the holders can do”. Subordinated debt is meant to have equity-like characteristics, after all, including the risk that interest payments will be missed without the bank being considered to be in default. The fact that B&B’s customers are unaffected by this move is very welcome: in the US, I suspect the FDIC would intervene to take over any bank which defaulted on its subordinated debt*. In this case, by contrast, there’s still a chance that B&B might be able to continue indefinitely as a going concern. Sheila Bair, take note.

*Update: B&B has actually been taken over by the government once, so this is not a very good example. Although, as JH notes, it’s heartening all the same that the government doesn’t feel obliged to pay out on all of B&B’s remaining obligations, Anstaltslast -style.