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Marketplace Scratch Pad

Short back and sides

Paddy Hirsch Apr 29, 2009

The debate over haircuts for debtholders has finally gone mainstream, thanks to David Leonhart over at the New York Times.

What on earth am I talking about? Simply, the idea that taxpayers shouldn’t be the only ones on the hook for bailing out the banks. Bondholders, the people who lent the banks the money, and thus arguably enabled their excesses, should also share in the pain. How? By swapping their bonds for shares in the banks. Because the bonds would likely be valued downwards before the swap took effect, this would mean they’d be taking a loss, or a haircut. And if stock prices didn’t recover, it could turn out to be a high-and-tight, boot recruit crew cut.

This isn’t pie-in-the-sky. Leonhart heard econ adviser Larry Summers raise the idea on TV recently.

On “Meet the Press” on April 19, Mr. Summers said one option for increasing the banks’ capital was “asset liability swaps,” by which he meant a voluntary exchange of loan forgiveness for equity.

We need this money. If the IMF is to be believed, banks worldwide could eventually have to dispose of as much as $4 trillion in bad assets. We heard last week we’ve only got $100 billion or so left in the TARP. Say U.S. banks are holding a quarter of that $4 trillion, well, we’re still $900 billion in the hole. That money has to come from somewhere. I’d rather it wasn’t from me.

Leonhart leaves it to Raghuram Rajan — then the director of research at the I.M.F. and now a University of Chicago professor — to make the case for Wall Street, saying haircuts really do have the potential to make some financial firms insolvent and cause worldwide problems.

Baloney, says Henry Blodget at Business Insider. He says the bond market has already priced some losses in. Bonds issued by banks are trading at extreme discounts, suggesting that bondholders already know they’re in for a trip to the tonsorial parlor. They’re just hoping the barber doesn’t turn out to be another Sweeney Todd.

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