Financial Reform or a Commitment to Future Bailouts?

It is unsurprising given the melt down in the financial sector that politicians are looking at “reforming” financial regulations. To most people the general idea of regulatory reform should be to prevent conditions form coming about that lead to the meltdown and thereby prevent further bailouts. Problem is it is looking like the reform in question may implicitly promise more bailouts according to Phillip Swagel.

The debate over financial regulation is now focused squarely on the ability of the government to take over a failing financial institution such as a bank holding company or hedge fund—so-called non-bank resolution authority. This is the linchpin of reform because allowing the government to intervene in a crisis will affect investors’ risk-taking behavior from the start—for better or worse. A resolution regime that provides certainty against bailouts will reduce the riskiness of markets and thus help avoid a future crisis, while a reform that enshrines the possibility of bailouts will foster risky behavior and unwittingly make future bailouts more likely. The key choice is thus whether financial regulatory reform gives the government discretion to bail out creditors or instead ensures that these counterparties take losses.

It is the old moral hazard problem and also has a nice dash of time inconsistency as well. If the government does bailout institutions it takes over then investors will be more inclined to take on more risk than they otherwise would. And with a few large institutions the likelihood of a financial meltdown like we’ve seen increases. The time inconsistency aspect of this stems from the fact that unless there are clear rules stating that the government cannot bailout institutions or at the very least the conditions under which a bailout might take place, there will be an incentive to bail out the institutions if everyone acts as if there wont be any bailouts. Think of it this way, suppose the government enacts the Dodd plan and also says, “We will not bailout financial institutions with taxpayer dollars anymore.” Lets further suppose that people behave in accordence with this statement. Then a financial institution fails and is taken over, at that point the government will face a situation where if they bail out the institution it is welfare enhancing than if they don’t. Since investors are forward looking, they can foresee this type of outcome and thus wont take the initial statement about there being no bailouts as being credible.

So, does the Dodd plan have any rules on bailouts? Not that I can see, and Phillip Swagel agrees,

President Obama’s approach, as embodied in Democratic Senator Chris Dodd’s bill, is for discretion and thus for bailouts. Top administration officials state that they will impose losses on counterparties such as lenders to a failing firm. The reality, however, is that the Senate bill gives the government discretion, without a vote of Congress, to put money into a failing firm to pay off creditors. Shareholders will take losses but creditors can benefit from government-provided funds. Regardless of the administration’s intentions, markets participants will understand that the Senate financial regulation bill allows for bailouts, and this will give rise to riskier behavior that in turn makes future bailouts more likely.

I looked through the text of the bill and while it says that loses will be shared according to each participants role in creating the situation that led to any given institutions failure it isn’t clear how exactly this will be done. It will be left to the discretion of various bureaucrats, agencies, and such. In short, it is a discretionary policy vs. one that follows rules. Given this, the conclusion is that Dodd’s plan for financial reform is really nothing but a commitment to future bailouts.

In the fall of 2008, the Lehman Brothers bankruptcy was followed by severe negative effects as short-term credit markets shut down. This is sometimes taken as evidence that bankruptcy is not a tenable outcome for a large financial firm. This is wrong. The disruptions that followed Lehman’s collapse were greatly magnified by the idiosyncratic problem that a large money-market mutual fund broke the buck as a result of losses on Lehman debt. This sparked a panicked flight out of money-market mutual funds, which led commercial paper markets to seize up and in turn begat TARP. This situation would have been prevented only by guaranteeing Lehman debt—that is, by a bailout that the administration says would not be allowed to occur under its financial regulatory reform proposals.

This is the problem with discretionary policy, it is like running up stairs that are collapsing. If you stop, the stairs crumble and you fall. So you run further up the stairs. Problem is that you can’t keep running forever, and the higher you go the worse the fall. Once you bailout one institution (e.g. Long Term Capital Management (LTCM) back in 1998) it is noted by other market participants and it may very well alter their attitude towards taking on risk. The more bailouts, the more and more this shift towards riskier and riskier investments grows not unlike running up a collapsing stairway. At the time, it may have seemed wise to bailout LTCM, but now in 2010 after looking at a horrendous financial meltdown and one of the worst recessions of all times it looks like a very unwise decision. Yes, it may have meant a recession and financial crisis, but it may very well have been far less burdensome as the current one.

And enacting reform that could very well continue the process of running up the stairs is a very bad one. So of course it will probably pass and become law.

FILED UNDER: Bureaucracy, 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. Not to mention the invitation to graft and corruption by this kind of discretionary legislation. Say, have we learned yet who got TARP money?

  2. Scott Swank says:

    What happens when the FDIC takes over a bank? The share holders are wiped out. The creditors take a hair cut.

    Here’s the last bank the FDIC took over so far this year (unless I missed one).

    http://www.fdic.gov/news/news/press/2010/pr10088.html

    But does the FDIC have the regulatory authority to take over Morgan Stanley? Nope.

    So what we need is a law that allows FDIC-style takeovers of these large financial institutions. That is one of the things (roughly speaking) what this bill provides, but I wouldn’t call that a bail out.

  3. Steve Verdon says:

    Scott,

    Yes it is. If the creditors get a hair cut by having the Feds come in vs. what they would otherwise get then its a type of bailout and could very well promote excessive risk taking.

  4. john personna says:

    If we could realistically change the course of our Bailout Nation, I’d be on board. The problem is, I can’t pretend. I can’t say “oh, I’ve got maybe 5 or 10% of the voters who will really stick to their guns the next time depression looms and when their job is on the line.”

    I’ve got be real. I know, we all should know, that Americans only talk tough between bailouts. Which is why all this talk of making bailouts “more likely” is silly. Of course we’ll do them, the next time a big player fails in some novel or traditional way.

    And so, a bill to make bailouts orderly, and to make the bailees pay for them, is the best we can do. Realistic policy has to work the the majority sentiment.

    Possibly the best way to do this with a small Tobin Tax, just something to charge the players as the make and take the risks.

  5. john personna says:

    BTW, remember that the government didn’t bailout LTCM. That should not have sent a message that the government had deep pockets. It should only have said that the government would strong-arm players to clean up their own mess … not a bad sentiment, if we’d held that line.

  6. steve says:

    “Yes it is. If the creditors get a hair cut by having the Feds come in vs. what they would otherwise get then its a type of bailout and could very well promote excessive risk taking.”

    I have not had time to read the bill, but it was my understanding was that not only shareholders, but also management get wiped out and the company will no longer exist. So, I have three questions.

    1) Who will give creditors this better deal? Is there something in the bill that uses government money to make creditors whole or take less of a hit? Even in a bankruptcy judges make decisions which will favor some creditors over others.

    2) One advantage of resolution over a conventional bankruptcy is its speed. There is less uncertainty. Credit is not frozen. Is there some value in this rather than letting a BK court work through creditors over the course of a few years? (Much of Lehman is still not settled)

    3) When it comes to financial entities, I am most concerned about the risk taking of management. Management has shown itself, at the offending institutions, capable of taking huge risks in order to enrich themselves. They have also been able to hide information from shareholders or misrepresent data. If management is destroyed in the process and the company no longer exists, I will be willing to accept this is not being a bailout. Why do you consider it a bailout if creditors get what MIGHT be a better deal? Remember, it could also be a worse deal.

    Steve

  7. Drew says:

    Please.

    The Clinton Administration orchestrated the bailout of Goldman Sachs’ problem with Mexican bonds in 1995, and similarly in the Asian crisis, and then the Russian problem.

    This was not “Americans” unable to stomach bailouts. There was plenty of opposition. This was the Clinton/WallStreet nexus, in particular Robert Rubin, at its crony capitalism worst.

    And the truth is that the Feds capital infusion into LTCM enabled the big Wall Street houses to get their capital out as LTCM was liquidated in an orderly fashion.

    Get your head out of your ass and the facts straight, odo. These were signals of government deep pockets that any dope could read. Well, apparently, most dopes.

  8. john personna says:

    Sorry Drew, I’m the one that can post links, and not just insult:

    Tyler [Cowen] argues that by saving Long-Term Capital Management (LTCM), regulators missed a golden opportunity to teach the markets a much-needed lesson in moral hazard:

    With the Long-Term Capital bailout as a precedent, creditors came to believe that their loans to unsound financial institutions would be made good by the Fed — as long as the collapse of those institutions would threaten the global credit system. Bolstered by this sense of security, bad loans mushroomed.

    The problem with this argument is that no taxpayer money was put on the line for LTCM — it was a “bail-in” involving a consortium of LTCM’s 14 largest creditors, all Wall Street banks. If no taxpayer money was put on the line, how could the LTCM rescue set a precedent that “loans to unsound financial institutions would be made good by the Fed”?

    You’ve also got your head turned around a bit on “unable to stomach.” I’m saying Americans love bailouts, regardless of what they are willing to say between them.

    There are better examples than LTCM, in fact, note that LTCM is not even on this bailout history.

  9. john personna says:

    (I’m not really sure why some conservatives like to focus on LTCM and ignore the long history. Maybe Drew reveals the motivation when he talks about this “Clinton/WallStreet nexus.” LOL, if you need that to organize your world then I guess you’ll latch on to what you can.)

  10. c.red says:

    It is the old moral hazard problem and also has a nice dash of time inconsistency as well. If the government does bailout institutions it takes over then investors will be more inclined to take on more risk than they otherwise would. And with a few large institutions the likelihood of a financial meltdown like we’ve seen increases.

    While I agree this sounds logical, I’m not so certain it is actual reality. It does not seem that there is anything that will keep financial managers from taking outrageous risks to get a few (billion) dollars more, with the intention of passing the risk to someone else on down the road before the inevitable collapse.

  11. Steve Verdon says:

    While I agree this sounds logical, I’m not so certain it is actual reality. It does not seem that there is anything that will keep financial managers from taking outrageous risks to get a few (billion) dollars more, with the intention of passing the risk to someone else on down the road before the inevitable collapse.

    You do realize you just described the problem of (financial) moral hazard right? Was that supposed to be a criticism or support?

    John Personna,

    The problem is that whether tax dollars were used or not, it set a precedent that if you lend to one of these big financial institutions and things go bad the Fed will organize a private sector bailout protecting the creditors. So why not lend, there is only upside, no downside.

    From there is it a big leap that if you get enough of these failures that the Fed might try to keep things from going too far by stepping in and pledging the full faith and credit of the American taxpayer? I argue no, not a big leap.

    (I’m not really sure why some conservatives like to focus on LTCM and ignore the long history. Maybe Drew reveals the motivation when he talks about this “Clinton/WallStreet nexus.” LOL, if you need that to organize your world then I guess you’ll latch on to what you can.)

    We’ve had bailouts for quite sometime, yes. I’ve pointed out other bailouts that precede LTCM (both Chrysler and the Saving & Loan), so your point here is not really valid. But notice, I’ve also said in the past that bailouts are likely to get bigger over time, and look at your link…they have!!

    Thanks, I doubt you intended to support my position, but you have very nicely.

  12. c.red says:

    You do realize you just described the problem of (financial) moral hazard right? Was that supposed to be a criticism or support?

    Neither, or both possibly. You’ve given a good explanation of something I have no problem admitting very little understanding of and I’m interested in the discussion.

    Assuming there is no way to really mitigate the risk-taking; which is worse letting the crash happen, or assuming the responsibilty? I would almost say that it is going to have to be determined on a case by case basis and would think it would be very difficult to set up hard and fast rules.

    Some sort of FDIC-type organization may at the very least be able provide some separation between the truly outrageous funds and the ones that are only somewhat risky.

    I am curious, in the derivatives market what is the practical difference between a creditor and share-holder?

  13. c.red says:

    Regarding bailouts in US History. I remember reading about Colonial Bonds issued during the Revolution and whether the Federal Government would assume liability when the states defaulted. Hamilton was for it, I think Jefferson and possibly Adams opposed, but Hamilton won and we have our tradition of bailouts.

    There have been any number since then, including any number of railroads, arms factories, States and Cities. Didn’t the government basically nationalize the steel industry for ten years at one stretch? In some sense that could be taken as a bailout.

  14. john personna says:

    Steve, you are trying to restate what I’ve said, and then make it your-point-not-mine:

    We’ve had bailouts for quite sometime, yes. I’ve pointed out other bailouts that precede LTCM (both Chrysler and the Saving & Loan), so your point here is not really valid. But notice, I’ve also said in the past that bailouts are likely to get bigger over time, and look at your link…they have!!

    I said up at the top:

    If we could realistically change the course of our Bailout Nation, I’d be on board. The problem is, I can’t pretend. I can’t say “oh, I’ve got maybe 5 or 10% of the voters who will really stick to their guns the next time depression looms and when their job is on the line.”

    I’ve got be real. I know, we all should know, that Americans only talk tough between bailouts. Which is why all this talk of making bailouts “more likely” is silly. Of course we’ll do them, the next time a big player fails in some novel or traditional way.

    Now you’re proving to me a history of bailouts? Whatever.

    My point was that LTCM was a bad example, and it is. It didn’t cost taxpayers anything, and there are plenty of examples on my links which did cost us … lots.

  15. john personna says:

    (To reduce moral hazard I don’t think the government should make anyone “whole.” I think for instance that the FDIC insurance should only cover 90% of your deposit. With that haircut a per-institution limit is probably not required.)

  16. Steve Verdon says:

    John,

    It is my point. I’ve noted the history of bailouts and how they’ve been getting bigger over time.

    Yes, you are right nothing can be done to stop it. No policy you come up with will stop it. Because Wall Street and Washington are profiting from our crony capitalist system.

    c.red,

    Risk is fine so long as it is appropriate given the potential rewards and losses. Bailouts, even ones with “haircuts” reduce the losses and thus increase the desire for risk.