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The Bond Bailout Conundrum

I’ve been assuming that eventually the taxpayer will wind up paying off Citi’s debts to its bondholders. But there’s a twist! At the moment, there’s uncertainty as to whether or not the bonds will ever be made good on. Consequently, Felix Salmon observes that right now you can snap up a Citi bond for seventy cents on the dollar. This raises the prospect that many of the bonds may get bought by hedge funds, and then a substantial swathe of a Citi bondholder bailout would go not to the original creditors, but to vultures who were making a pure moral hazard play:

Right. If hedge funds start buying up Citi’s bonds at 70 cents on the dollar, hoping that eventually the bank will be nationalized and its obligations guaranteed by the U.S. government, they’ve probably got another thing coming. It’s one thing to pay off bondholders who invested years ago in good faith, but quite another to pay off speculators hoping to cash in on a taxpayer bailout.

Still, it’s tricky. After all, how do you tell the speculators apart from the other creditors? You can’t. So either everyone gets a haircut or no one does. And if everyone does, nobody quite knows what will happen. Bottom line: buying Citi bonds at current prices might be a good deal, but only if you have nerves of steel. Their future is murky indeed.

This is a tough problem. It has some similarities to one of our republic’s founding debates — what to do about the debt from the Revolutionary War. Alexander Hamilton thought it had to be paid off. His populist opponents took the view that this was nuts. It would be one thing to pay off debts to the soldiers who’d fought the war and the creditors who financed it. But by the time of the argument, most of the debt was in the hands of vulture speculators who’d bought it up at depressed values. Hamilton argued that it was important to establish the credit of the United States and that assuming the debt would lay the groundwork for an authoritative central government and a prosperous future.

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And I would say that I’m basically with Hamilton on this. If done appropriately — in the context of a nationalization plan — I think basically paying off the creditors with a fairly minor haircut will be the right thing to do. Yes, that’s more public debt. But right now people are basically too willing to loan money to the U.S. government and too unwilling to loan it to anyone else. Serious avoidable defaults will intensify that trend, whereas government intervention to build confidence in the safety of other investments will help. But I don’t see how this would be remotely feasible absent public ownership of the upside to Citi and the installation of a substantially new board of directors that sends the message that a new sheriff is in town.