Bank preferred debt, I argued on March 1, 2009, would not be allowed to go under after the fashion of Fannie and Freddie preferred, because shutting off payment on bank preferreds would ruin the insurance industry. Credit protection on the insurers was trading at over 1,000 basis points above LIBOR that week, which marked the nadir for the banks. As I wrote then,

…the global insurance industry took down 40% or more of the commercial bank “hybrid” Tier I capital securities issued in the past six years, or over $320 billion of the $800 billion float. That’s not counting preferred stock and other yield-hog favorites. Haircut these bonds, and the insurers will do the dead man’s float. AIG isn’t the only insurance company that wrote protection for the banks (although it was the most aggressive).

That’s why the federal government has no choice but to bail out AIG, and no choice but to bail out the banks — unless it wants to let the insurers go down, or separately bail them out. Banks and insurers are tied together in a daisy-chain in which all survive or all fail.

Of course, were insurers to let it be known that whole life insurance policies aren’t paying quite what they expected to, or that they might have to stagger life insurance payouts over time, the result would be a level of panic that the Obama administration doesn’t want to think about. Pension plans already are cutting payments because of the commercial mortgage disaster. Word is getting around: nothing is safe. Your bank deposits might be safe, but not your pension, or your insurance policy, or your annuity.

The same applies with a vengeance to the banks and municipal debt. As Bloomberg reported yesterday, the banking system owns well over $200 billion in municipal bonds:

Citigroup Inc., State Street Corp. and U.S. Bancorp are among U.S. banks whose municipal bond holdings have reached a 25-year high just as state budget deficits swell to $140 billion, the most since the start of the recession.

Commercial lenders added more than $84 billion to theirholdings since 2003, according to the Federal Reserve, pushing total investments to $216.2 billion at the end of the first quarter. Bank regulators and ratings companies are ramping up scrutiny of banks most at risk of being forced to raise more capital should debt prices slide.

“There is a huge untold problem here,” said Walter J. Mix III, a former commissioner of the California Department of Financial Institutions who closed 30 banks during the last banking crisis in the 1990s. “The economics lead to the conclusion that there will be downward pressure on these bonds.”

At Cullen/Frost Bankers Inc., the biggest Texas lender, holdings of municipal debt exceeded Tier 1 capital, a key measure of a bank’s ability to absorb losses, by $491 million at the end of the first quarter, data compiled by Bloomberg show. For State Street, based in Boston, the holdings make up 50 percent of Tier 1 capital. U.S. Bancorp, the Minneapolis lender, has a ratio of 28 percent. It’s 11 percent at Citigroup, the data show.

If municipal debt actually defaulted, the capital position of the banking system would be impacted, bank preferred debt might stop paying, and the holders of bank preferred debt–starting with the insurers–would be in serious trouble. The $800 billion bailout package for Europe’s PIIGS (Portugal, Ireland, Italy, Greece, Spain) in May was in fact a bailout for the banking system, which holds hundreds of billions of dollars worth of such debt. We don’t know quite how much, because European banks don’t have the same reporting requirements as American banks (and American banks’ overseas branches don’t have the same reporting requirements as their domestic branches).

It’s a pretty safe surmise that the global banking system’s holdings of non-US government debt is not much different than the profile of American banks’ purchases of US government debt.

Banks are shedding non-government, i.e., corporate risk in their securities portfolios at the same time:

Why buy munis? For all of Warren Buffett’s dire warnings about municipal finances, the fact is that the federal government can’t let major municipal debtors (at the level of states, for example) go under without also bringing down the banking system and everything else.

If it goes, it all will go together. That’s why munis ultimately will be bailed out. A Democratic administration whose core constituency is public employee unions will do everything in its power to keep them happy (and a Republican Congress, which we likely will have in 2011, may frustrate this). But ultimately it’s a matter of survival.

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