Magazine April 20, 2009, Issue

The Least-Bad Option

Under current conditions, government seizure of shaky firms may be a necessary evil.

 

Peter Wallison speaks with the confidence of a man who has a track record of making accurate predictions. Ten years ago, when Fannie Mae decided to loosen its underwriting standards and jump into the subprime-mortgage market, Wallison accurately observed that Fannie’s excessive risk-taking was a function of its implicit government backing. “If they fail,” he told the New York Times, “the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.”

Having watched the disaster he predicted unfold, Wallison is understandably upset that policymakers appear to have learned nothing from their mistakes. Case in point: Treasury Secretary Tim Geithner has proposed a new regulatory framework to govern “systemically significant” firms, which would include the power to seize such firms if necessary. This would be “a catastrophe for the financial system in the U.S.,” Wallison says. “The worst part about it . . . is this process of designating systemically significant companies. It is going to create Fannies and Freddies in every industry where these companies are designated. It means that these companies will not be allowed to fail.”

Here’s the problem: Even without Geithner’s proposal, the government has already created the perception — and the reality — that systemically significant companies will not be allowed to fail. A year’s worth of bailouts have allowed moral hazard to spread throughout the financial system. Restoring market discipline, if possible, could be a decades-long process. If you accept the depressing but increasingly inescapable conclusion that we have already created a nation of Fannies and Freddies, then the question becomes: How do we best protect taxpayers from the prospect of endless bailouts? Conservatives answered this question with regard to the original Fannie and Freddie by calling for a powerful regulator with the authority to seize the companies if necessary.

That doesn’t mean conservatives should back Geithner’s proposal in every particular, but it does mean that we need to rethink our approach to financial regulation. First, it’s important to look at how we got here. The present crisis in the financial system is the result of compounded failures across a number of institutions. We have seen private financial firms with gold-plated names such as Lehman Brothers, Goldman Sachs, and Citigroup reduced to insolvency or government dependency. The credit-ratings agencies blew the major calls in evaluating the risk of the securities they graded, and the markets and market institutions failed to ensure that investors making multibillion-dollar bets on credit defaults were in a position to pay off if things went south. Away from Wall Street, Main Street mortgage lenders wrote ridiculous loans to borrowers who leveraged their families up like hedge funds.

The political failures were even worse. The regulators were owned by the industries they were supposed to be regulating and took balance-sheet fictions for fact. They couldn’t even identify Bernie Madoff as a thief when they were informed, in no uncertain terms, that he was one. The fundamental problem was — and is — that the political class has been hypnotized by the dream that houses are magical investments with prices that can only go up, and even now they continue to act as if thinking makes it so. Politics warped the real-estate market and the market for securities derived from real estate.

Former senator Phil Gramm argues that regulatory reform should start where the problem started: the housing industry. Democrats have vilified Gramm for championing financial deregulation in the late 1990s, even though the Gramm-Leach-Bliley Act, which allowed financial-services companies to diversify their lines of business, passed the Senate with 90 votes and was signed into law by Bill Clinton. Gramm says deregulation wouldn’t have been a problem if it hadn’t been for government policies that encouraged subprime lending: “There is no question that the catalyst for this crisis was the politicization of mortgage lending,” he says, citing examples like the Community Reinvestment Act — which pressures banks to make mortgages available to people without much in the way of income, assets, or credit — and the explosion of Fannie and Freddie’s subprime portfolio.

“You take subprime out of this equation, and we would have had a financial adjustment, but I don’t think we would have had the financial crisis or the recession,” Gramm says. He argues that reform should begin in the housing industry with minimum down payments, higher credit standards for home loans, and limitations on borrowers’ ability to refinance. “Once borrowers have built up equity in the home, we shouldn’t let them use refinancings or second loans to lower their equity to less than 10 percent of the house,” he says.

Unfortunately, there is almost no momentum on Capitol Hill behind reform proposals aimed at tightening mortgage-lending standards. If anything, there is a bipartisan consensus behind policies designed to reinflate the housing bubble. In any case, housing reforms would not adequately address the larger problem, which is the endemic moral hazard in our financial system created by the bailouts. The government is now a major partner in most of our main financial institutions, so “let the markets sort it out” isn’t going to cut it, and conservatives are obliged to deal with that reality.

One aspect of the new reality is the coming creation of new regulations and new regulators. Going back to a pre-meltdown status quo isn’t politically possible, nor is it desirable. And with the political winds blowing hard in the faces of free-market capitalists, it may be that the best conservatives can achieve at this moment is to identify the least-bad option and work for marginal improvements in the regulatory environment. This does not, however, have to be a net loss, or a permanent loss, for those who cherish economic freedom as an essential component of our overall political liberty. Pre-meltdown Wall Street was a highly regulated place, and post-meltdown Wall Street will be highly regulated, too. But conservatives can, if we act intelligently, come out of this with a body of sensible regulations that do not unduly inhibit trade and innovation but do address the problems of systemic risk in the financial system, fraud, the abuse of accounting practices, and the corruption of our public and private financial institutions.

For starters, conservatives should give cautious consideration to the idea of a new regulator with the authority to seize insolvent non-bank financial firms and force them into receivership. Under normal circumstances, this idea would be anathema to conservatives; we would argue that such firms should work things out with their creditors in bankruptcy court. Unfortunately, the collapse of Lehman Brothers altered the political calculus of bankruptcy. On September 15, Lehman submitted the largest bankruptcy filing in American history. The Dow fell 500 points. The federal government had to stop a run on money-market funds, which are generally ranked among the safest investments. The market for commercial paper — loans that most corporations rely on for short-term financing — froze solid. The Fed had to create an unprecedented commercial-lending facility to prevent a broader economic collapse.

In a Wall Street Journal op-ed arguing against the Geithner plan, University of Pennsylvania professors Francis Diebold and David Skeel wrote that the Lehman bankruptcy was so chaotic primarily because nobody thought the government would actually let Lehman fail. If the government had not bailed out Bear Stearns a few months earlier, Diebold and Skeel wrote, then “Lehman and its buyers would not have played chicken with the Fed and Treasury as they did, holding out for a government guarantee of the sales of Lehman’s assets.”

But if moral hazard was the problem back in September, it is even more of a problem now. Key U.S. policymakers have made it abundantly clear that they think letting Lehman go bankrupt was a mistake, and market players will factor that information into their future decisions. This means that letting other large financial firms collapse could have even greater systemic consequences, since everyone will have been counting on a bailout. Bankruptcy does not give policymakers a way to deal with these consequences, while further bailouts would just worsen the moral hazard that led us to this point. Resolution authority — the power to seize these firms and oversee their orderly liquidation — might be the least-bad option.

Geithner’s plan would give this new resolution authority to the Treasury secretary, but the biggest (and most underreported) problem with his plan is that it would also make permanent the Treasury secretary’s authority to make loan guarantees, asset purchases, and stock purchases to prevent firms from collapsing. This would transform the Troubled Asset Relief Program (TARP) from a temporary crisis-management tool into a permanent feature of the policy landscape. It would turn the $700 billion bailout into a blank check.

Stanford economist John Taylor, author of Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis, argues that this would defeat the purpose of the resolution authority. “Something is needed to prevent the bailout mentality that we’ve gotten into,” he says. “You need some kind of a Plan B that the government can refer firms to when it’s tempted to bail them out.” Federal receivership could be that Plan B, Taylor says, but only if Congress takes the bailout option off the table.

Once future bailouts are ruled out, the new regulator could be modeled after the Federal Deposit Insurance Corporation — one of the few institutions that have come out of this mess with their reputations more or less intact. The FDIC works pretty well when we let it do its real job, which is narrowly defined: insuring bank deposits, supervising financial institutions, and managing receiverships. The financial markets’ new sheriff should focus on the stability of the system, not on saving friends and fortunes at politically connected firms and funds. It should be empowered to shut down and sort out risk-inflating, over-leveraged financial operators — not to give them bailout money.

The new regulator ought to have a clear, narrowly defined FDIC-style mandate and the necessary powers to carry it out: namely, the power to force insolvent financial firms into receivership, and to perform haircuts on those firms’ investors and bondholders, rather than on taxpayers. Like the FDIC, it should be funded by a levy on the firms it regulates.

Yves Smith, a corporate financial adviser, believes that this is a more manageable proposition than many realize. For all the bewildering complexity of the instruments traded on Wall Street, she thinks that only a relatively small number of firms will require robust oversight for systemic-risk purposes.

“Everything in life is 80/20,” Smith says, referring to the familiar observation that in many complex systems, 80 percent of the effects come from 20 percent of the causes. “There are very few major credit-market intermediaries, compared to how many banks there are. As for hedge funds, for instance, while they are numerous, many don’t run with leverage, contrary to the popular perception. You’d only look at the levered ones.”

“The Bank of England in 2007 did a financial-stability report and they identified 16 large, complex financial institutions,” Smith says, “the ones they thought could create systemic risk. They were the ones you expect: Goldman, Lehman, Morgan, Barclays, Société Générale, Paribas.” It is essential to identify the right institutions — and it’s not clear that regulators are competent to do so. As Smith points out, the Bank of England watch-list didn’t include Bear Stearns, the firm that ended up being the canary in this collapsing financial coal mine. Bear was overlooked because the B of E, like most of the other players, was paying insufficient attention to credit-default swaps, and Bear was writing a lot of them.

Smith argues that, in a perfect world, the central bank would be the place to locate a systemic-risk regulator. But given the culture of the actual Fed, as opposed to an ideal Fed, she agrees that a regulator with qualities similar to those of the FDIC is a relatively attractive option. “We need to form some kind of group, whether it sits at the FDIC or it’s a separate group that coordinates strongly with the FDIC, that understands these complicated products and has the authority to go in and kick the tires.”

Taylor, the Stanford economist, points to another danger of vesting the Fed with the authority to regulate systemic risk. “Probably the biggest danger is that the Fed would lose its independence,” Taylor says. The Fed needs to remain relatively free from political pressure in order to make the often-unpopular decision to raise interest rates and curb inflation. “If we lose the ability to keep inflation in line,” Taylor says, “we’ve lost a great deal of the reason to have a central bank.”

But the FDIC has problems of its own, namely that its funds and its mission are being appropriated for the wider bailout. The Financial Times’s Willem Buiter argues that this isn’t only bad policy, it’s possibly criminal: “I believe that the raids by the U.S. Treasury on the FDIC and on the Fed are illegitimate and, in the case of the FDIC, quite possibly illegal.” The FDIC has $22 billion set aside in its insurance fund to cover possible bank failures in 2009, and it can tap a $30 billion line of credit from the Treasury in an emergency. There are $7 trillion worth of deposits in U.S. banks, and the FDIC ensures most of that.

So what to do instead? Gramm says the power should be split between the Fed, the FDIC, and the Treasury secretary: “If you’re going to cede that kind of power to any agency, I would give it to the Federal Reserve. Require a vote of the board, and then require the concurrence of the FDIC and Treasury.” It may not be ideal, he says, but “the reality is that the Fed is already actively involved in these joint decisions, whether that’s a good idea or a bad idea.”

Replacing the bailout mentality with a sort of streamlined bankruptcy procedure would probably reduce the burden on the taxpayer, but it would not eliminate it. “You would need funds for temporary liquidity,” a former Treasury official says. “A line of credit at the Treasury, a debtor-in-possession loan — some kind of substitute financing.” Given that taxpayers would still be exposed to losses, the new regulator would need the authority to curtail risk-taking at systemically significant firms.

There are several ways policymakers could go about doing this. Rep. John Campbell, a California Republican who sits on the House Financial Services Committee, described one option the committee has discussed, which could be called the antitrust approach. “If you become so big that you become a risk to the entire financial system,” he says, “then you need to be broken up into parts so that you don’t threaten the system.” (Campbell did not endorse this idea; he said it is one he is considering.)

Rep. Scott Garrett, a New Jersey Republican who also sits on the committee, thinks this would be a bad idea: “I certainly would have a natural resistance to artificial limitations on the size of firms. You might be putting a limitation on a firm whose size is beneficial in other areas of the economy.” Nor would such a limitation reduce systemic risk: “The savings-and-loans created a huge problem,” he says, “but that wasn’t because one or two firms were too large.”

Campbell described another idea, which we think is a better approach: Once a firm is deemed “systemically significant,” it would encounter a new tier of regulation, including things like stricter capital requirements. There are plenty of problems with this approach: How do we determine which firms are “systemically significant” and which aren’t? How do we account for financial products that haven’t been invented yet? These questions illustrate the shortcomings of regulation as an alternative to market discipline, but unfortunately, our government’s actions in response to this crisis have impaired the market’s workings to the point that we are willing to consider tighter regulation as an alternative.

Then there are some relatively noncontroversial changes, such as requiring a real insurable interest for credit-default swaps — which are, in essence, insurance. Under the current rules, you can buy insurance for a bond in which you have no financial interest, like buying a life-insurance policy on somebody you don’t know. Smith, the financial adviser, offers a few other straightforward suggestions: Get as many instruments onto exchanges as possible, in order to ensure that traders are adequately capitalized and that positions can be unwound without cash infusions from the government. She also argues that accounting reforms — coupled with a few vigorous criminal-fraud prosecutions — would help restore investors’ confidence in corporate bookkeeping.

Above all, however, we should keep in mind that regulation is always a poor alternative to the workings of the free market. Peter Wallison makes the point that all of our current regulations failed to prevent the present crisis and that there is no reason to think new regulations will prevent the next one. “The fallacy underlying all of this is that regulation prevents risk-taking and loss,” he says. “It doesn’t.” The most important goal, he says, is to destroy the impression that any firm is too big to fail.

We’re sympathetic to that goal, and we also realize that anyone who disagrees with Peter Wallison does so at his own peril. Nevertheless, it is going to be a long time before we get Uncle Sam out of the banking and insurance businesses, and it will probably be longer still before we get the kind of broader economic liberalization we need to restore functioning to the market. Conservatives do not have to set aside our values, but we do have to get our hands dirty dealing with the actual problems in front of us, with the institutions we have, under the limitations of the political realities of the day.

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