Finance Industry Reform’s False Assurances

One of the aspects of Senator Dodd’s proposed reforms is the “Orderly Liquidation Fund”. This fund is to be targetted to be $50 billion dollars and will be pre-funded out of bank profits.

The target size of the Fund shall be $50 billion, adjusted on a periodic basis for inflation. The FDIC shall impose assessments as provided in subsection (o) to capitalize the Fund and reach the target size during an “initial capitalization period” – of not less than 5 years or greater than 10 years from the date of enactment.

My fear is that this fund will create a false sense of security and will be seen by the creditors to these financial institutions as a way to recover at the very least their initial investment or part of their initial investment. As such, it will do little to prevent excessive risk taking which is, in a nut shell, what got us into the mess we find ourselves in currently.

The other problem is the puny nature of the fund. If we have more than one firm fail like we had with the recent crisis the costs are well over $1 trillion dollars, or 20x the size of this fund. It wont be enough to deal with a crisis of the nature that we recently went through. As such, the proposed legislation fails at its own purpose,

Ends Too Big to Fail: Ends the possibility that taxpayers will be asked to write a check to bail out financial firms that threaten the economy by: creating a safe way to liquidate failed financial firms; imposing tough new capital and leverage requirements that make it undesirable to get too big; updating the Fed’s authority to allow system-wide support but no longer prop up individual firms; and establishing rigorous standards and supervision to protect the economy and American consumers, investors and businesses.

The legislation might reduce the chances of their being a financial crisis of the size we’ve just had, but it does not eliminate it. As such, it does not end the possibility of taxpayers having to step in and bailout the creditors of these large financial institutions.

FILED UNDER: Economics and Business, Government, US Politics
Steve Verdon
About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research. He joined the staff at OTB in November 2004.

Comments

  1. Dave Schuler says:

    There are really only two ways to preclude “too big to fail”. One if to prevent institutions from becoming so big that their failure would present systemic risk. That wouldn’t prevent financial crises: a number of smaller institutions could all fail at once. Indeed, that’s likely if they operate in lock step for cultural or regulatory reasons or because they all use the same computer programs and hire the same consultants.

    The other way is to erect barriers that make it very, very difficult to bail out institutions so large that their failure would present systemic risk. Basically, a poison pill. I think that’s pretty unlikely to happen.

    My take: get used to an increasing number of bailouts.

  2. john personna says:

    I think we shouldn’t have a gas tax, because this creates a false sense that drivers pay for our nations highways in some sort of “use fee.”

  3. sam says:

    There’s always the “Chinese Solution”: a very small fund, sustained by financial institutions, for the purchase of the bullets.

  4. john personna says:

    Dave, there are some more possibilities. Leverage limits are discussed. As are stricter measures to keep leverage “on balance sheet.”

    I suppose that last rule, to keep leverage visible and within limits must be workable, because the last defense I’ve heard of it was that it would force innovation off-shore.

    Heh, that’s a victory right, if the blow-up risks leave?

  5. steve says:

    This particular fund, as I understand it, should not prevent a crisis, but should make it easier to resolve a failed institution. Someone has to pay the people who come in and go over the books and decide what needs to be sold off right away and what can go through normal bankruptcy proceedings. The banks would prefer that the failing entity be billed when that happens. I would rather have the money up front. Some of the money could also be used to help keep the financial entity running for a couple more days while this is being done.

    If a Citi or BoA goes down, none of this money is supposed to go to creditors. It is not enough to save something that size. As part of the resolution process, management and the financial entity will go away. Which leaves us with the creditors. If it works as I understand it, the creditors dont have much of a guarantee. In the early resolution stage, what parts of the bank that are sold off will be done so with the idea of keeping the system functional, not aimed at maximizing value. Like what they did with WAMU. The rest of the assets will go to bk court, like they did with WAMU. Creditors dont look like they are guaranteed much.

    Besides all of this, I still think that the issue is management. The management at all of the places making money in our crisis, like Countrywide, Goldman, Citi etc., were telling their creditors that they were buying and selling AAA products. How would creditors know how risky those assets were? It is also clear, if you read Black’s book, that there was a lot of window dressing going on. I suspect that management was not letting creditors know that was going on. While I think there is a bit of merit to your argument about creditors, I think attention should be focused upon management.

    Steve

  6. Dave Schuler says:

    Dave, there are some more possibilities. Leverage limits are discussed. As are stricter measures to keep leverage “on balance sheet.

    How would either of those preclude the possibility? Reduce the likelihood, possibly, but preclude?

  7. john personna says:

    Given that you ended with “get used to an increasing number of bailouts” I thought an idea which reduced damage was worth discussion, yes.

  8. Steve Verdon says:

    steve,

    If they use the money in this fund like in the LTCM bailout, then yes, the money would absolutely be used to make sure the creditors got out whole or at least partially so. You see, that is the big fear, that the creditors take a big hit and as such leads to a wide spread problem. So, I’d like to see you point to the part of the legislation that says these funds wont be used in that way.

    Not that I’d find that part of the legislation all that impressive. After all TARP was supposed to be fore buying up toxic assets from various financial institutions, and instead it was used to inject capital into banks and let them keep the toxic assets…or given to GM and Chrysler. Our government likes discretion so much, they seem to consider legislation and laws to be….optional for them to follow.

    Besides all of this, I still think that the issue is management. The management at all of the places making money in our crisis, like Countrywide, Goldman, Citi etc., were telling their creditors that they were buying and selling AAA products. How would creditors know how risky those assets were?

    I believe the term is due diligence.

    How would either of those preclude the possibility? Reduce the likelihood, possibly, but preclude?

    Not only that, but I’d be curious to see if we’ve tried to do these things before. Change leverage limits, etc. My guess is that the finance industry would evolve to deal with the increased scrutiny…or more accurately evade it in a legal manner. Arms races don’t just happen in terms of military hardware. They happen in biology/evolution, and they happen in the business world as well.

  9. john personna says:

    My gas tax parallel was kind of lame, but the idea is that if these guys are going to take bailouts (and no one here believes they won’t) then like drivers they should be seen kicking in. It may not be the last dollar paid out, but it will at least be the first.

    I think the banks love it when people carry water on this “false sense of security” meme because they don’t want to pay anything. That’s the whole talking point in a nutshell. They want it to all be on us.

    Now, the leverage thing (politically unlikely as it is) is about peeling a little risk of the other end. It may not eliminate bailouts (as we all agree) but it might make some of them smaller. And it could be written like “leverage beyond x disqualifies”. Add a little risk to the bailee.

  10. john personna says:

    BTW, $50B is such a small amount, it’s possible that this whole argument is put out there by the banks and the politicians as red meat.

    Something for us to argue about that ultimately won’t matter one bit. The real action will be elsewhere.

  11. Steve Verdon says:

    John,

    So I should support what I see as bad policy just so that the banks have to pay for that bad policy…along with the rest of us? Is that your…best argument for this kind of policy?

  12. john personna says:

    I’m trying to puzzle it out.

    Basically the realization that banks would fail led to FDIC insurance. That insurance isn’t perfect but it is well entrenched.

    Are we in a situation where bank-like entities are about to gain a resolution authority but without the fees?

  13. steve says:

    The LTCM bailout was private, not government financed. Not sure it relates.

    “I believe the term is due diligence.”

    How would investors know? They kept so much off the balance sheets. Lehman had a positive balance sheet the day it went under. No one knows total derivative exposure for anyone as far as I can tell. Say I had wanted to buy Countrywide, I didn’t, or Lehman. How could I get an accurate picture of their finances?

    Beyond that, the banks were selling toxic assets to each other. Finding some way to keep managements from taking excessive risks leading to huge bonuses and salaries seems a key issue to me.

    Steve

  14. john personna says:

    I missed this the first time:

    It now looks like almost 30% of the Greek financing will come from the IMF, rather than just a small portion. And since 40% of the IMF is funded by US taxpayers, and that debt will be JUNIOR to current bond holders (if the rumors are true) I can’t tell you how outraged that makes me.

  15. Steve Verdon says:

    The LTCM bailout was private, not government financed. Not sure it relates.

    It was private money yes, but government driven. Further, this money is going to come from financial institutions, so I can see there being an argument that the American taxpayer is not financing this. So, I’d say it totally relates.

    I know you like to pretend it didn’t have any impact on setting precedents for excessive risk taking, but that view is just flat out wrong. The government basically twisted a few arms and got a “private” bailout for LTCM.

    “I believe the term is due diligence.”

    How would investors know?

    Uhhmmm going to guess here, its called research. You check it out. Look at it. Examine it. You just don’t the other guys word for it.

    They kept so much off the balance sheets. Lehman had a positive balance sheet the day it went under.

    Then I’d argue it is a failure to do proper due diligence.

    Finding some way to keep managements from taking excessive risks leading to huge bonuses and salaries seems a key issue to me.

    First you don’t cover the downside losses…which brings us back to LTCM rather nicely. When the creditors walk away from a debacle like that due to a New York Fed Bank lead bail-out (or bail-in if you want to go with that guy at the economics of contempt) is basically says, “Its okay, excessive risk taking will be covered some how….” Now the Feds have just upped the ante by saying, “Now, we’ll bail you out by pledging the full faith and credit of the American taxpayer.” Its a logical progression. I asked once before, was it a huge leap that the Feds would leap in if private bailouts weren’t enough, and the answer is an unequivocal, “YES!!!!!11!!one!!!eleven” You can’t argue no, because they already have. And they bailed out not just finance institutions, but car companies as well.

    BTW John,

    Given that you ended with “get used to an increasing number of bailouts” I thought an idea which reduced damage was worth discussion, yes.

    Lets suppose that prior to the crisis we could expect bailouts once every 10 years. Then after we go to once every 5 years. Now even if Dodd’s proposed reform reduces the likelihood of bailouts we oculd still go to once ever 7.5 years…we are still getting more than we would have otherwise gotten. And it certainly isn’t eliminating bailouts.

    Basically the realization that banks would fail led to FDIC insurance. That insurance isn’t perfect but it is well entrenched.

    Yes, and people don’t look into the bank now. They just figure, what the heck I’ll get my money back no point in checking how the bank is really doing. Insurance carries with it a type of moral hazard. One way around that is to not offer full insurance. The FDIC offers full insurance.

    Are we in a situation where bank-like entities are about to gain a resolution authority but without the fees?

    If you go back and look at my problems with the proposed legislation it isn’t that there are proposed reforms, but that it largely depends on discretion. Technocrats love discretionary policy because it lets them do pretty much what they want, but discretionary policy carries with it all the problems typical found with insurance as well as a strong incentive to go back on policy announcements down the road, and ultimately leading to sub-optimal outcomes.

    In short, bad policy is…wait for it…bad policy.

    So now the question is….why do you have a problem with somebody saying, “Hey, have you thought of this potential problem with the policy?”

  16. john personna says:

    I’m aware of the FDIC moral hazard. I’ve had a few banks fail from under me, and I haven’t lost a dime. I could pursue max CD returns and not worry.

    That’s why I suggest a 90% coverage to get people like me to care again.

    Are we in a situation where bank-like entities are about to gain a resolution authority but without the fees?

    If you go back and look at my problems with the proposed legislation it isn’t that there are proposed reforms, but that it largely depends on discretion. Technocrats love discretionary policy because it lets them do pretty much what they want, but discretionary policy carries with it all the problems typical found with insurance as well as a strong incentive to go back on policy announcements down the road, and ultimately leading to sub-optimal outcomes.

    In short, bad policy is…wait for it…bad policy.

    So now the question is….why do you have a problem with somebody saying, “Hey, have you thought of this potential problem with the policy?”

    I didn’t actually disagree with the “discretion” sections. We saw failures in discretion in this last cycle, as Chris Cox snoozed his way through SEC tenure, similar top level lapses occurred in bank/thrift supervision.

    I kind of thing that stricter regulations will encourage less snoozing in the future … but a lot depends on whether Chris Cox (or a facsimile) is reappointed.

    I really joined just to talk about the fees, and the meme that bank-line entities shouldn’t have to pay any.

    I think they should, perhaps through a Tobin tax on market transactions.

  17. Steve Verdon says:

    1. A Tobin tax will likely just move activities off shore…and out from under U.S. regulations. And to what point? The goal is to reduce excessive risk taking, how is that related to volume of transactions? Are you just tossing out ideas hoping something sticks? If so, you’d make an excellent politician.

    2. Stricter regulations just lead to more “innovation” to avoid them. OTC derivatives were precisely that, a way of dodging regulatory over sight. Toss in a solid dose of regulatory capture (Rubin, Greenspan, Levitt, Summers, et. al.) and the questions becomes why? Why keep piling on more and more regulations? It reminds me of the definition of insanity, “Doing the same thing over and over again, but expecting different results.”

    Really, so far pretty much everyone is under the street lamp looking for their keys they lost over on the dark street, and honestly believing they are going to find them.

  18. Steve Verdon says:

    BTW John, the 90% coverage thing is a good idea. Some people at least would start looking. Now, do you think it will pass? Of course not.

    What are you some kind of pie-in-the-sky theorist here? Why don’t you wish for a magic pony? Talk about not being able to see how things are going to go? You call economists on the carpet for not being able to predict the future? Get real.

    Now come up with something that will do the same thing, but still give people 100% certainty they will get their money AND that we have no more bank failures.

    What…you can’t do it? Well…I’ll be dipped in shit!

  19. steve says:

    “. Stricter regulations just lead to more “innovation” to avoid them.”

    Lack of regulation leads to innovations taking advantage of that also. Btw, I thought we had decided fairly explicitly to not regulate derivatives. If they are being regulated why do we need a clearinghouse and an exchange?

    Steve

  20. john personna says:

    1. A Tobin tax will likely just move activities off shore…and out from under U.S. regulations. And to what point? The goal is to reduce excessive risk taking, how is that related to volume of transactions? Are you just tossing out ideas hoping something sticks? If so, you’d make an excellent politician.

    A too-large Tobin tax would change the wrong behavior, it is true. As to where I got this, I’ve been listening to economists ;-). It seemed sensible enough to discuss.

  21. john personna says:

    What are you some kind of pie-in-the-sky theorist here? Why don’t you wish for a magic pony? Talk about not being able to see how things are going to go? You call economists on the carpet for not being able to predict the future? Get real.

    Heh. Isn’t your whole thread here about things that will never happen? What makes you special …

  22. john personna says:

    To recap:

    – we both think bailouts will keep happening
    – we both think that we can only reduce odds

    our differences are that

    – you think less regulation will bring less bailouts
    – you think that players shouldn’t pay beforehand

    but, congress isn’t going to listen to either of us. They might slap Wall Street’s hand in way that offends you, and I’ll be upset that it’s only a light tap.

  23. Steve Verdon says:

    A too-large Tobin tax would change the wrong behavior, it is true. As to where I got this, I’ve been listening to economists ;-). It seemed sensible enough to discuss.

    Are you kidding me? Let me see Bakker likes it so it can fund health care. How Hell does that reduce excessive risk taking by financial institutions?

    Kuttner looks at short term trades. I specifically asked how do we link trade volume with excessive risk taking. Here’s a question how long did people hold credit default swaps? Were they traded rapidly or not? If the answer is no, then the tax is merely a revenue generator. Maybe we need the revenue, but that is not relevant to issue at hand.

    Heh. Isn’t your whole thread here about things that will never happen? What makes you special …

    1. No. I’m offering nothing here in this post in terms of solutions (mainly because I’ve given up, I don’t think there are solutions, we’ll continue our corporatist ways until the end…whatever that maybe).

    2. I was turning your schtick around on you. Figured what is good for the goose is good for the gander.

    – we both think bailouts will keep happening
    – we both think that we can only reduce odds

    Yes, and not sure.

    – you think less regulation will bring less bailouts
    – you think that players shouldn’t pay beforehand

    I’ve made no policy recommendations. My lack of posting isn’t just being busy its more a malaise due to the fact that I see nothing changing for the better. I see us sticking with this same rotten corrupt system. As such, my posts are going to be more along the lines of, “Okay, but there is this pitfall, that problem, and this will likely end badly too.”

    I go back to Lord Acton:

    “Power tends to corrupt and absolute power corrupts absolutely. All great men are almost always bad men….”

    I like that second part in particular, too bad it frequently gets left off.

  24. john personna says:

    We all (should) want our financial markets to efficiently allocate capital to fruitful enterprise. The more efficiently, the better. The fewer the manias and panics, the better.

    Some critics of the financial sector think that it has sucked up too many minds and resources scouring for secondary bets, multi-generation derivatives, which don’t really allocate to productive enterprise.

    That’s arguable. A generation of physicists who became quants could have become funded as physicists who became product-entrepreneurs.

    So they like a Tobin tax to reduce the churn and froth. A 0.25% tax seems pretty mild to me (certainly compared to the VATs some propose), and it might help.

    I agree that not much is likely to happen, but I’d really hate to see the TARP recipients get away with a free hand and no new fees. Talk about moral hazard.

    For the MBS and their derivatives, the lynch-pin was probably that people still believed the ratings agencies and their lies. Maybe that’s over now, and no ratings regulation is needed. People just won’t believe AAA ratings for a generation or so.

  25. Steve Verdon says:

    John,

    Speculation can be good or bad. It can add to a mania or it can work to keep markets working efficiently. As such, it isn’t clear that churn or froth is necessarily bad.

    Also, you can’t regulate efficiency. If we could the Soviet Union, Cuba and North Korea would all be extremely efficient and out producing us on some level.

    The moral hazard associated with TARP is probably too late to fix, and we’ve already set the precedent and no politician is now going to be very credible in saying, “Sorry no bailouts you messed up.”

    And the market is also a regulator itself. If you mess up you go out of business and lose money. Oddly our government is working over time to thwart that part of the market which causes distortions.

  26. john personna says:

    Speculation can be good or bad. It can add to a mania or it can work to keep markets working efficiently. As such, it isn’t clear that churn or froth is necessarily bad.

    Do you think high frequency trading improves capital allocation? The part of it, that is, that isn’t simple front-running?

    Beyond that is the good argument that over-active markets tend to propagate noise rather than signal.

    Also, you can’t regulate efficiency. If we could the Soviet Union, Cuba and North Korea would all be extremely efficient and out producing us on some level.

    I think you’d be better off choosing some regulated, market, economies for your examples.

    The moral hazard associated with TARP is probably too late to fix, and we’ve already set the precedent and no politician is now going to be very credible in saying, “Sorry no bailouts you messed up.”

    And the market is also a regulator itself. If you mess up you go out of business and lose money. Oddly our government is working over time to thwart that part of the market which causes distortions.

    I started a recent comment by saying that if anyone could actually stop the bailouts, I’d be on board.

    But, given that we can’t do that, I want to pair the support to the financial industry with some fees on the financial industry.

    To me that beats the moral hazard in this “free lunch.”

  27. john personna says:

    Ah, a good read today on economics slow acceptance of fairness.

    It’s possible that fees on Wall Street are for me a fairness issue.

  28. Steve Verdon says:

    Do you think high frequency trading improves capital allocation? The part of it, that is, that isn’t simple front-running?

    Beyond that is the good argument that over-active markets tend to propagate noise rather than signal.

    I don’t think the answer is clear cut. I think it can improve efficiency, and sometimes can harm it. Which is the most dominant? I don’t know, but it seems we should try to find out before we do something. As Bill Clinton put it (paraphrasing) we might want to make sure the cure isn’t worse than simply living with the problem.

    I started a recent comment by saying that if anyone could actually stop the bailouts, I’d be on board.

    But, given that we can’t do that, I want to pair the support to the financial industry with some fees on the financial industry.

    To me that beats the moral hazard in this “free lunch.”

    And my post points out that you aren’t going to get that, at least it is very unclear. This whole thing is going to basically create a fund like was used with LTCM. It is going to make that kind of signal for excessive risk taking the norm. There is nothing in there that says the creditors have to take a haircut. It is all left up to the discretion of various political appointees.

    Ah, a good read today on economics slow acceptance of fairness.

    Homo reciprocans. You’re a bit late. More here.

    That article is crap by the way. Other’s have worked on this such as Herb Ginitis and Samuel Bowles. Some professors at GWU also did an experiment of dropping an open envelope with cash and that had a stamp and address, all one had to do to “return” the cash was seal the envelope and send it. Surprisingly to the authors, their economics course had the highest rate of returning the cash.

  29. john personna says:

    I don’t think the answer is clear cut. I think it can improve efficiency, and sometimes can harm it. Which is the most dominant? I don’t know, but it seems we should try to find out before we do something. As Bill Clinton put it (paraphrasing) we might want to make sure the cure isn’t worse than simply living with the problem.

    That sure reads as a weak defense of the poor investment bankers. All they’ve done is pull down hundreds of billions in socialized losses … let’s be “safe” and leave it that way.

    And my post points out that you aren’t going to get that, at least it is very unclear. This whole thing is going to basically create a fund like was used with LTCM. It is going to make that kind of signal for excessive risk taking the norm. There is nothing in there that says the creditors have to take a haircut. It is all left up to the discretion of various political appointees.

    Again, we are just coming off hundreds of billions in taxpayer funded bailouts, and you are off about LTCM again. What could be your motive?

    Homo reciprocans. You’re a bit late. More here.

    That article is crap by the way. Other’s have worked on this such as Herb Ginitis and Samuel Bowles. Some professors at GWU also did an experiment of dropping an open envelope with cash and that had a stamp and address, all one had to do to “return” the cash was seal the envelope and send it. Surprisingly to the authors, their economics course had the highest rate of returning the cash.

    I enjoyed that article about economics being slow to accept fairness in human nature.

    I didn’t say that was my first notice. Heck, I’ve dropped dozens of references to Pinker’s Blank Slate, Thaler’s Winner’s Curse, and Dugatkin’s Cheating Monkeys and Citizen Bees in my time here.

  30. Steve Verdon says:

    That sure reads as a weak defense of the poor investment bankers. All they’ve done is pull down hundreds of billions in socialized losses … let’s be “safe” and leave it that way.

    It isn’t meant to be a defense of anyone, it is pointing out that you just want to do something to do something, and to Hell if it actually addresses the issue. Or as your mother probably put it, look before you leap.

    Again, we are just coming off hundreds of billions in taxpayer funded bailouts, and you are off about LTCM again. What could be your motive?

    But why are we coming off of hundreds of billions in taxpayer funded bailouts? I argue that one reason is the bailout of LTCM. Promising to repeat that action again and again strikes me as a dumb move.

    I enjoyed that article about economics being slow to accept fairness in human nature.

    All sciences are slow to accept change. You can’t just have a spiffy idea and expect people to change on a dime. Not going to happen. In any science. Ever. Not in biology, not in physics, not any of them. Ever. Sceinces are conservative in that they aren’t going to change until there is sufficient evidence to change. There are dozens of examples of this in all scientific fields. And of course there is just human resistance to change, I think it was Paul Samuelson who said progress in economics is made one death at a time. I think that is true of all sciences.

    And the article is bad because lots of people are doing work in this area now. The article is about a decade out of date. Once you start publishing in Nature and the like your ideas are rapidly approaching mainstream.

  31. john personna says:

    It’s just funny Steve. You keep coming back to the one bailout of the bunch that didn’t cost us anything. Again, LTCM isn’t even on this big bailout timeline.

    If you focus on LTCM, and forget about the hundreds of billions that we taxpayers have sent to those other companies, you might not be in such a hurry for the recipients to pay us back, right?