“Too Big to Fail” and the pricing of sovereign debt

There is a notion amongst politicians and those with investable capital that, in the name of market stability, some corporations are “too big to fail”. The argument seems to be that the bankruptcy of very large corporations will have such large detrimental effects on the economy, that governments must bail them out when they get into financial trouble. We have seen this in Canada and the United States with the massive loans to GM and Chrysler, and in the US financial markets with the TARP bailout of AIG, Citigroup, and Bank of America. We have also witnessed the same situation in Iceland and Ireland with the bailout of the banks.

Whether or not governments should or should not bail out large corporations is a normative question and is not subject to economic debate. No government will ever possess the intestinal fortitude to try the experiment and let a company like General Motors fail.

What we are more interested in is the inefficient pricing of corporate and sovereign debt in the market. For example, Fitch Rating currently has a default rating of ‘BBB’ on AIG’s unsecured senior debt securities. This is the lowest possible rating in the investment grade category. If AIG is deemed TBTF, the appropriate credit rating should be that of the issuer that will bail them out. The US currently has a debt rating of AAA. In this scenario, AIG debt is underpriced and it’s yield too high to reflect the true probability of default. A Reuters article found on Huffington Post makes just this argument about pricing new bank debt. (Click here for article)

The problem extends to sovereign states as well. An article in the Globe and Mail makes a good case for letting the weaker European states default on their debt inflicting losses on the owners of their bonds. (Click here for article) The investors did, after all, receive higher yields to compensate them for their risk. Today, for example, the Irish 10-yr bond is trading at 633 basis points above the German 10-yr bond. If, as expected, the other euro-nations and the IMF offer Ireland the bailout that they need, the debt will be assumed by taxpayers in Germany and France. The yield on Irish and German debt should be the same as they are being paid from the same tax base. Either German bonds are overpriced (yield too low) or Irish bonds are underpriced (yield too high) or both. Ireland got into this problem by treating Irish banks as too big to fail. Now Ireland has become too big to fail. The UK, not a member of the eurozone, is in favour of the Irish bailout since a large number of investors in the Irish banks are residents of the UK. Germany and France will also commit to a bailout of Ireland, for if they don’t, panic will spread to Portugal and then Spain. An article on the Australian website The Age explains the logic of this. (Click here for article)

Markets are not efficiently pricing debt. If a company or a sovereign nation is too big to fail, and investors are not required to take a loss in the event of bankruptcy, then the debt should trade at the same price as the saviour, and the interest rate on the saviour’s debt should reflect the risk of financial bailouts.