Via Brad Delong, Buce of Underbelly is upset about the proposed terms of a BAC bailout.

Translated: okay, so equity gets hosed, which is just as it should be in insolvency. But it sounds like we will be paying $100 bill for something. And that would be? Why, the bondholders, I suppose–who else could it be, with numbers like this and on terms like this. It’s been the one abiding principle throughout the Geithner–no matter how parlous the state of whatever, no bondholder gets left behind.  Apparently we need to say it again, guys: capitalism means the risk of failure, and real failure when things go bad.  Bank bailouts that protect bondholders are ring-fencing for which the rest of us pay.  Sheesh, is that so hard to understand?

No, I think this is wrong. I do not know why there is an enormous externality associated with letting bondholders get hosed. It is one of the great questions of our age.

However, I can recognize an empirical regularity when I see it. The bondholders should be saved when possible. To misquote Mark Twain: its no wonder truth is stranger than economic models. Economic models have to make sense.

Yet, we live in the real world. Not in the model. When someone finds actual empirical evidence of moral hazard on the part of credit holders causing crises we can talk. For now we have definitive evidence of massive credit losses causes crises and that’s what policy should be based on.