Of late, the Treasury, House, and Senate have put forward proposals for how to resolve large financial institutions. The problem is that none of them seem to deal with the elephant in the room, namely, how the responsible grownups are going to deal with particular creditors and counterparties. For better or worse, bankruptcy procedures are well established, even if they do not fit large complex financial firms very well. The key element is that either freezing counterparty positions or forcing them to take large haircuts could be highly disruptive, which is what a resolution process is supposed to avoid. The lack of attention to mechanics is troubling and suggests that these efforts in the end will amount to window-dressing.
But Dan Arondoff offers an appealing, streamlined alternative:
There was another way to resolve the collapse of Bear and AIG without having to bail out their bondholders. The impetus and justification for the intervention, recall, was to prevent a default on contracts to counter parties that might have a devastating systemic impact. But the very same funds that were injected into the firms as equity to be used by the firms to pay its counterparties, could have been made available directly to those same counterparties if the Fed or Treasury had announced a willingness to purchase the contracts directly from the counterparties. Let’s take AIG. The Fed purchased $85 billion of stock –for 80% of the equity -that was immediately used to pay off CDS counterparties like Goldman Sachs. Once having injected the funds, the Fed became an equity holder in AIG, with a claim junior to all bondholders, both secured and unsecured. If the Fed had paid Goldman directly for its CDS contract (assuming Goldman was interested in selling), then the Fed would have averted a possible collapse of Goldman and acquired a claim on AIG – the Goldman CDS contract -that was senior to the equity holders and possibly senior to some debt holders and equal to some others. The Fed would have achieved a superior collateral position. AIG could have then undergone a normal bankruptcy. The Fed could have reduced taxpayer exposure further by setting its purchase offer for AIG claims at lower than 100% face value if it deemed that a lower payout would not risk financial meltdown,,,,The same principle would have seen the Fed offer to purchase Repo contracts from Bears’ counterparties.
Government does not need resolution authority over investment banks or bank holding companies. All that is required is authority (if it does not already exist) to offer to purchase contracts from counterparties of failing banks. It can then pursue collection of its claims in a normal bankruptcy process. This will resolve much of the moral hazard issue, as equity holders and bondholders will not be bailed out. It will reduce taxpayer exposure and the policy is credible.
This is an interesting idea, and I’d offer a refinement: that the resolution authority would be required to buy the claims out at current market value, but could provide a total cash disbursement up to the face value of the instrument. The resolution authority could structure that overpayment to be either debt or equity.
Reader comments very much appreciated.