Home > finance > What if the bond markets priced in actual risk?

What if the bond markets priced in actual risk?

June 7, 2012

A friend sent me this article written by Daniel Gross, which talks about how taxpayers in Europe and in the U.S. are paying for the mistakes of bondholders. First he starts with Ireland:

When Ireland’s large private banks collapsed spectacularly a few years ago, the Irish government formally assumed the debts of the private banks. To ensure that bondholders of Irish banks would remain whole, the government undertook a massive bailout. To pay for it, it has inflicted vicious austerity on its populace.

He moves on to Greece:

As Liz Alderman and Jack Ewing reported in the New York Times this week, about two-thirds of the $177 billion in European aid to Greece given since May 2010 has been used to make payments to bondholders and other lenders. The upshot: Greece is imposing significant austerity on its citizens for the sake of preserving the value of bondholders.

And the U.S.:

Yes, it’s true that the U.S. in 2008 and 2009 acted to keep bondholders from taking big losses. The taxpayers formally assumed the debt of Fannie Mae and Freddie Mac without insisting bondholders take any haircut, just as the Irish taxpayers formally assumed the debts of their large banks. That was a big and expensive mistake. In a time of austerity, the U.S. government is channeling tax payer funds to make interest payments on bonds that were first issued by for-profit entities.

He points out that Spain appears to be taking the same approach, and that the actual people of Ireland and Greece are having second thoughts about paying all these bills, expressed through who they are voting for. I believe it’s left to the reader to wonder what’s going to happen to Spain.

Gross suggests a different tact for governments to use, namely to ignore old debt and to provide insurance for new debt issued by the banks and other private companies. The U.S. did this during the crisis, it was called the Temporary Liquidity Guarantee Program. His point is that we’ve made money off this program and we’ve let lots of really insolvent banks fail as well.

On the other hand, I’d argue, we haven’t let the big banks fail, so there’s a limit to its effectiveness (but I won’t blame this program for that, because that’s a problem of political will). And it’s of course not altogether clear that the insurance it sold was sold at market value, since if it had been, I’m guessing it wouldn’t have been such a boon to a given company to issue debt and pay for insurance versus just issuing debt at a higher risk premium. In other words, I think the “Liquidity” in “Temporary Liquidity Guarantee Program” is key.

But he’s got it basically right- taxpayers are definitely on the hook for risky bets other people took. And backups and guarantees by governments definitely skews the bond market. Specifically, big companies end up paying less than they should given their risk, and the taxpayers foot the bill in situations of default (which aren’t allowed to actually be defaults with respect to the bondholders).

So sufficiently big companies are paying too little for debt. That’s about half the story though. The other half is how normal people are paying too much for debt.

For example, with student debt, Bloomberg recently reported that private issuers of student debt are charging as much as credit card companies:

Tovar, who lives with her parents in the Chicago suburb of Blue Island, owes $55,600 to Chase Student Loans, a unit of JPMorgan, according to a May 17 statement provided by her. A loan for $24,794 carries an interest rate of 10.25 percent, as does a second loan for more than $2,619. A third for $28,187 has a rate of 8.97 percent. She has a balance of $42,326 in loans from a different lender.

Given that these loans are effectively undischargable through bankruptcy, what is the real risk for private issuers in getting their money back? What would a fair market price be for these loans? And why don’t we have a fair market?

Categories: finance
  1. James Howard
    June 7, 2012 at 10:47 am

    With respect to the high interest rates charged on student loans, of even more concern (IMO)is a statistic quoted on Bloomberg several days ago: of the 2009, 2010, and 2011 college graduate population, only 16% have managed to find a full time job. Sounds awfully low, but Bloomberg is pretty careful about its sources for this type of informantion.


  2. Gordon
    June 7, 2012 at 11:22 am

    There are huge differences between consumer loans – such as debt accrued on credit cards – and student debt, and those differences are what drive the pricing that you reference.

    A credit card company typically offers very low limits to new borrowers, and can change both the limits and the associated rates as they become familiar with their borrower. Critically, information about their borrowers’ credit worthiness becomes available over a very short time horizon (the first payment will be due less than two months after the card is issued, and monthly payments thereafter) and in real time.

    The opposite is true for student loan providers: they provide a very large amount of credit up front, and have no information about their borrowers ability to repay until 4 years after the first loan has been extended. It’s a completely different order of risk to a credit card loan, and the rates should reflect that.

    There are estimates that 25% of the trillion dollars or so in outstanding student debt is delinquent: limiting the price of those loans isn’t going to make them more affordable, it’s going to make them less available. Perhaps if colleges stopped charging tuition for fluffy degree courses that afford enrolled students no hope of finding a job, those students wouldn’t need to take out loans and wouldn’t become delinquent; credit card companies wouldn’t need to charge to cover the costs of those delinquencies, and costs for the students borrowing to fund education that DOES add value would come down.

    Or you could give the lenders recourse to the college which granted the degree that the loan funded in the first place…. perhaps then they’d focus on making sure that they were charging a tuition rate which corresponded to the actual value of the degree that the were offering?


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