James Kwak is a smart guy and likely posting a bit quickly, but I think he accidentally stumbled upon a common misconception:
If the administration is right and the banks are healthy (and to the extent they aren’t healthy, their capital will be topped up with convertible preferred shares), then bank bonds are safe. Even subordinated bonds (the ones that get paid off after senior bonds and insured deposits) are protected by the bank’s capital – both common and preferred shares. So if the administration is correct that the banking system is adequately capitalized, and will be even more adequately capitalized after the stress tests and capital infusions, then banks will be able to pay off all of their bonds.
Junior capital does not “protect” senior capital. That’s the essence of what is so bizarre about the rush to convert from preferred to common to beef up Tangible Common Equity.
Imagine the entire right side of the balance sheet existing not in parallel but in series, top to bottom. All of the assets are liquidated, and it comes time to pass them out, one claimant at a time, from taxes and wages payable all the way down. Wherever you are in line, it should be apparent that it does not matter at all who is behind you. If you are in line for a popular concert ticket to a 5,000 seat area, it matters crucially that you are number 4,998 as opposed to 5,002 in line, and it is completely irrelevant whether you are 5,002 out of 5,003 or 5,002 out of 150,000.
The subordinated debt is supported only by the assets that underly it and the free cash flows that service it. If there are $120bn of assets in the current environment and the subordinated debt sits behind $130bn of claims, it is in a dangerous place regardless of whether there is $1 equity below or $130bn. The problems with the financial sector are on the left side, not the right, and it is essential our policymakers appreciate this.
