Robert Johnson, former chief economist to the Senate Banking Committee, submitted testimony to a House Financial Services Committee hearing on OTC derivatives. His written testimony is to be posted today.
While his remarks are worth reading in their entirety, one bit that caught my attention was his discussion of TDTR, or “Too Difficult to Resolve.” Many readers and economists such as Willem Buiter have argued, forcefully, that it is essential to develop what Buiter calls a “special resolution regime,” which is a fancy way of saying a specific set of rules and practices for putting big financial players into bankruptcy.
I expressed concerns about dealing with the difficulties of Too Big Too Fail institutions yesterday, saying (in effect) that many of the appealing-sounding ideas (including some I had favored, like putting credit default swaps on an exchange) were not workable or would not solve the problem (for instance, as Satyajit Das explained at some length, the amount of initial margin it would take to deal with “jump to default” risk would make credit default swaps uneconomic. No one is willing to kill CDS, which would be the effect of such measures. An undercapitalized exchange creates a concentrated point of failure, an AIG waiting to happen. And even though we would love to shut that casino down overnight, having looked into it is some depth, the cure would probably be at least as bad, if not worse than the disease. The best of the bad choices on offer is to regulate them like insurance, ideally more intrusively, and take affirmative measures to contain the market, particularly restricting the writing of “naked” short exposures).
Many readers were unhappy, but shooting the messenger does not change the fact that this is an even bigger problem to tackle than most realize.
From Johnson (note the link is not live yet, for some reason; Johnson was updating his testimony):
It would not be too strong to say that the architecture of derivatives regulation and market structure is the heart of Too Big to Fail policy.
Absent a drastic simplification of derivative exposures and a transparent and comprehensive improvement in the monitoring of those positions when imbedded in large firms, complex derivatives render these behemoth institutions Too Difficult to Resolve (TDTR). I say that because, the policies of resolving troubled financial institutions, so- called enhanced resolution powers, cannot be invoked unless government authorities have the capacity to assess and understand the entanglements of derivatives exposures throughout the financial sector and the economy at large. Resolution powers themselves can be quite useful and should be passed into law as a part of the financial reform you are considering. The ability to undertake “prompt corrective action” vis a vis bank holding companies and financial services holding companies, as the FDIC can now do vis a vis failing banks, would diminish the probabilities of a cascading bankruptcy or other disruptive panic.
Yet opaque, complex entangled derivatives exposures would serve to deter the authorities from invoking those powers and taking over a failing institution for fear of setting off a system wide calamity of magnitudes that policy officials can dread but not understand or estimate. Complex entanglements through derivatives exposures discourage government officials who are the risk managers on behalf of the citizens of our nation from invoking and using those powers. The spider web of complex opaque derivatives renders enhanced resolution powers impotent.
It is in this respect that complex and opaque derivatives exposures at large financial institutions contributed mightily to a policy of induced forbearance, as we witnessed in the first quarter of 2009. That experience, as we have seen, was very demoralizing to our citizens who have put their faith in philosophies that emphasize the use of markets as a mechanism for achieving social goals. The inhibitions that authorities experience in applying market discipline to large financial institutions and their managements tend to undermine belief in the use of markets.
What makes induced forbearance of TDTR institutions even more troubling is that their potential creditors would understand that they will not have their debts restructured when government officials are deterred by complex derivative exposures from taking a TDTR institution into receivership and restructuring the entity. This would create the perverse impact of reducing the risk premium on the unsecured debt of these institutions, lowering their funding costs, and giving them incentive to take more risk. It would also create a competitive advantage for TDTR firms that encourages an increase in their market share relative to those firms who had to pay more for funding because their creditors would fear that their bonds could be restructured in the event of solvency problems. TDTR financial institutions are enabled to get larger and larger by wrapping themselves in a spider web of complex derivatives and thereby inducing authorities to make ever-larger scale gambles on forbearance. Forbearance is a two-sided coin. Firms can continue to lose money rather than return to health. This is not a tolerable state of affairs for taxpayers who are held hostage by the fear of resolving complex intertwined institutions.