From an institutional sales desk that must remain anonymous
Last Thursday I devoted my note to Gary Gorton’s talk (http://www.levyinstitute.org/news/?event=32) at the Hyman P. Minsky Conference and in all honesty it wasn’t my best effort. Since then, debate about the merit – or lack thereof – of the speech has picked up and I feel compelled to address it again because having listened to the speech again I feel as though it cuts to the very heart of the financial crisis. The problem is that Gorton’s arrogant tone and irreverent, possibly self-serving sidebars distract from his key observation.
His key observation is that what is gained by having the Fed and other policymakers guarantee bank liabilities – namely, financial stability – is lost through the ensuing complacency which tends to spawn longer, more damaging crises. It’s vintage Minsky as far as the theory aspect is concerned, but while Minsky was an optimist when it came to our ability to regulate our way out of this conundrum, Gorton is very much a pessimist…and I think that Gorton is totally on the mark in this regard. If I am an amateur devotee to the Austrian School of economics, it’s not because I don’t appreciate Minsky’s insights but rather that I do not share his optimism that greed will not pervade the regulatory sphere and render it useless.
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Sitting at the conference last week, while listening to another speech (not Gorton’s), I scribbled down the following rhetorical question in the margin of one of the handouts:
Isn’t it a simple question of whether or not the rules are going to be followed? Shouldn’t the primacy of “the rules” – of the law – be asserted unequivocally, unhesitatingly, and at all times, so that “the system” can adapt around this unyielding set of rules?
I was sick and tired of hearing people explain “too big to fail” (or “too complex to fail” or “too interconnected to fail” or whatever) as this naturally occurring problem that is with us no matter what and which can only be mitigated through “intelligent” or “dynamic” regulation (e.g. forcing larger banks to increase their equity capital funding relative to levels of equity capital funding required for smaller banks – and other, like schemes). The truth is that you don’t need regulation – dynamic or otherwise – if you enforce the rules which are already in place.
Yeah, I’m going there: you allow the FDIC to take “prompt corrective action” in the case of depository institutions and the so-called shadow banks have to fend for themselves. Financial debt gets slashed aggressively (bankruptcy for shareholders and haircuts for bondholders) and you endure a massive debt deflation in the financial sector.
What about “ticking time bomb” derivatives? Below I’ve pasted charts from the Office of the Comptroller of the Currency’s (OCC’s) quarterly report on bank trading and derivatives activities for the 4th quarter of 2010. They show that four commercial banks account for 95% of the total gross derivative exposure in the United States. If derivatives are the problem, you can easily do what Sweden did in 1992 to solve its banking crisis: issue a temporary “general guarantee” on all derivative claims (. That will buy you time as you nationalize those four major players in order to process those claims in an orderly fashion. Net credit exposure as of the third quarter of 2008 was $435 billion (source is once again the OCC), which means that the institutions on the wrong side of those derivative trades could be bailed out relatively cheaply by the government after subordinate and senior bondholders are wiped out.
Meanwhile, go ahead and temporarily guarantee principal for the money market mutual funds, as Treasury Secretary Paulson in fact did in September 2008. This isn’t the right thing to do, but if it staves off a total implosion while the financial system is restructured and re-priced, do it. Let the Fed assume its lender of last resort role on a massive scale, but only for healthy banks as the Federal Reserve Act dictates.
By using temporary state guarantees and nationalizations to prevent systemic implosion, you would allow owners of capital to reallocate that capital to sound, well managed institutions at a price that is more rational given the risks inherent to leverage. Furthermore, a higher cost of capital for these institutions would incentivize them to fund their balance sheets with equity as well as debt. The system would become less fragile.
Does this sound farfetched? It shouldn’t. In the wake of Lehman’s collapse our policymakers had an opportunity to pursue exactly this course of action. Financial sector debt was already being re-priced in late 2008 and early 2009 (BAC 7-year senior unsecured debt yielded 15% in early March 2009, for example) and “Too Big To Fail” was dying on the vine. On February 10th, 2009, Treasury Secretary Geithner went before Congress and rolled out a four-point plan to provide aid to homeowners facing foreclosure ($50 billion), remove toxic assets from banks in a public-private partnership scheme ($50 billion), provide grants to restart the securitization markets for consumer loans ($100 billion) and recapitalize the banks ($120 billion). The markets were unimpressed at the size and scope of the “plan,” the S&P 500 Index dropped -4.9% on the day and the Treasury Secretary’s performance became known as “Geithner’s Flop.”
So what did he do in response to this criticism? He came up with SCAP, or the Supervisory Capital Assessment Program, which became better known as “the bank stress tests.” The key element to these stress tests was the implicit guarantee of the 19 systemically important banks’ liabilities – including the equity! – by the U.S. government. The fact that the guarantee was implicit was, in my opinion, a COLOSSAL error and it is the sole reason why the problem of “Too Big To Fail” exists today.
If the government hadn’t guaranteed the banks’ liabilities at all, many large banks would have failed and any tab to the taxpayer would have been presented by the Treasury Department on behalf of the FDIC. We would have been forced to deal with the debt deflationary dynamics resulting from that decision, but if the Washington Mutual experience was any indication then we can imagine that the FDIC would have found “stronger hands” to come in and buy the failing banks’ assets with relatively little disruption. This, incidentally, is very close to free market capitalism.
If, on the other hand, the government had made the guarantee explicit, which is another way of saying if the government had temporarily nationalized the banks, punishment could still be meted out to shareholders and bondholders. Upon spinning the newly cleansed banks back out to the private sector, the explicit guarantee would expire and the pricing of debt and equity would more accurately reflect idiosyncratic and systemic risk. This is a more state-driven approach than the FDIC-driven bankruptcy process, but it does put to rest the issue of “Too Big To Fail.”
Alas, the guarantee was implicit and the big banks have used that guarantee to further enmesh themselves in the financial architecture. They remain “Too Big To Fail.”
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The point of the above narrative is that neither comprehensive regulation nor the empowerment of regulators is sufficient to preventing crises born out of systemic complacency. The former is by nature static whereas financial innovation is dynamic, and the latter is subject to too much political pressure to enforce true discipline on the system. With all due respect to the Minskians for their sophistication, their insights, and their belief in the possibility of consistently altruistic and efficacious public service, I think they’re tilting at windmills.
Give me the frequent, unplanned crises of the 19th century over these once-in-a-lifetime, soul-crushing catastrophes any day. Gorton’s talk, while hardly a rhetorical masterpiece, helped me to articulate the gnawing dissatisfaction I felt at the Conference last week, and for that I am grateful to him.