I bolded the cases where government actions were taken. What common factors can be found in the actions of the government?

• Unwillingness to harm bondholders. Common and preferred stock can be diluted/destroyed, but not unsecured debtholders, not even junior ones.
• The US Government is willing to give up protections for taxpayers if it would save institutions that they deem “too big to fail.”
• They are willing to give the money to the holding companies, rather than protecting operating banks and other regulated financials.
• The US Government is willing to do it in pieces, with grumbling, but they will keep doing it until the US economy either normalizes, or falls apart.
• The economic incentives of the banks become muddled with the goals of the government. More money is available to those that support the goals of the government, rather than only profits.

I think that the government’s actions encourage the laziness of bankers – why sell assets when you can finance them? Why try to eke out profits when the government feeds additional liquidity to those that do their bidding?

As I said in my last article, there is some political pressure to make the bondholders of some of the holding companies share in the pain. I don’t think that will be effective in the short run for two reasons:

• Inertia – DC is slow to change even strategies that seem not to be working.
• Large bond managers (e.g., PIMCO, BlackRock) that are providing many services to the US Treasury regarding the TARP have large holdings of senior debt, and they will do all they can to tell policymakers that it is a bad idea to have senior debt be compromised. It would have large systemic risk implications! Possibly, there is regulatory capture going on in the boldest way ever. Bond managers, representing the bond market, tell the US Treasury what they should do. Shades of the Clinton Administration.

Personally, I don’t think that the balance sheet of the US Government is big enough to handle all of the liabilities that they will be asked to absorb, equitize, or guarantee. Bondholders need to watch for stresses and strains that will appear in the currency and Treasury security markets, and be prepared for the day when the US Government says, “No more. We can no longer afford this largesse. No one is too big to fail. Chapter 11 and RTC 2 for all failed financial companies.”

That is the main risk here, but it should not appear for a while. Gauge your own willingness to play in the bonds of firms like Citigroup and Bank of America. Without continued help from the US Government, they are insolvent; current prices factor in support for some time, but if that help should evaporate, prices will drop considerably. Dancing near the edge of a cliff is rarely advisable, even if you get paid to do it. Play this carefully.