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.
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“If the Fed had paid Goldman directly for its CDS contract (assuming Goldman was interested in selling),”
Well, this is almost what happened. After being quasi-nationalized by the US, AIG tried to close out as many contracts as it could. What happened? They got their faces ripped off, by the entire Street.
That does sound like a simpler way to launder bailout loot.
But if the problem is the very existence of “systemically important” entities, it still doesn’t solve anything. It’s still not proposing to break them up, NOW, so that we’d never have to worry again about how to do the bailout next time round.
None of the other phony “reform” proposals do any such thing either.
Only Bernie Sanders had made a real public interest proposal.
http://sanders.senate.gov/petition/?uid=c53f1aca-5881-403e-928b-a25980cb4e0c
A BILL
To address the concept of ‘‘Too Big To Fail’’ with respect
to certain financial entities.
1 Be it enacted by the Senate and House of Representa-
2 tives of the United States of America in Congress assembled,
3 SECTION 1. SHORT TITLE.
4 This Act may be cited as the ‘‘Too Big to Fail, Too
5 Big to Exist Act’’.
6 SEC. 2. REPORT TO CONGRESS ON INSTITUTIONS THAT
7 ARE TOO BIG TO FAIL.
8 Notwithstanding any other provision of law, not later
9 than 90 days after the date of enactment of this Act, the
10 Secretary of the Treasury shall submit to Congress a list
2
1 of all commercial banks, investment banks, hedge funds,
2 and insurance companies that the Secretary believes are
3 too big to fail (in this Act referred to as the ‘‘Too Big
4 to Fail List’’).
5 SEC. 3. BREAKING-UP TOO BIG TO FAIL INSTITUTIONS.
6 Notwithstanding any other provision of law, begin-
7 ning 1 year after the date of enactment of this Act, the
8 Secretary of the Treasury shall break up entities included
9 on the Too Big To Fail List, so that their failure would
10 no longer cause a catastrophic effect on the United States
11 or global economy without a taxpayer bailout.
12 SEC. 4. DEFINITION.
13 For purposes of this Act, the term ‘‘Too Big to Fail’’
14 means any entity that has grown so large that its failure
15 would have a catastrophic effect on the stability of either
16 the financial system or the United States economy without
17 substantial Government assistance.
Introduced by Senator Bernie Sanders of Vermont.
Bravo to Sanders for proposing something so just and practical. He must be immune to snake venom to stay sane and steadfast in the viper pit.
His proposal can’t be exposed to daylight of course. Public interest no longer fits the new economy, new world order (raises the nightmare specter of socialism). But the proximate reason is probably the enormous overhang of over-leveraged debt is still an avalanche poised to bury everything. Trying to unwind just one of the behemoths might trigger the big one, so they just keep pumping furiously to keep the elephant in the room from taking down the house.
This is so brilliant and so simple that to think that the powers that be missed this option is just not possible. They are much smarter than people give them credit for, but must play dumb to sell the con.
So, what was the motive?
It was to convince the world that the US is still a free-market and that the government really did not believe things to be as bad as they were. If they had followed through with this plan, it would have been obvious to the rest of the world would that the mess that the US is currently in had all been preconcieved and was pre-planned to maximize the financial benefits to the US as a whole (think about it, no matter what happens from here on out, there is, in the US, a very nice home for every US family to live in, who pays for it in the end doesn’t matter as much as the fact that there is likely to be a lot less social unrest when people, as a whole, have a nice roof over their heads.)
Welcome to the new world order.
Sukh
Well said. It seems self-evident, but relies on two credulous assumptions: first, that our public servants are acting in good faith and second, that these wizards of finance, despite their interbreeding at GS, were not quite smart enough to have thought of this on their own. Those assumptions seem naive.
Arondoff’s writes that “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,,,,” Could not Geithner have done this in any resolution scenario, and isn’t that why so many people are demanding his ouster?
Thanks for the post!
Maybe I am reading too much into Arondoff’s solution, but it feels vaguely like a function of the CCP: assuming all the contracts and in effect substituting Fed as the counterparty. I do agree that there is a marginal benefit in the improvement of the Fed’s priority, though . . .
Simpler & better: Proceed with normal bankruptcy proceedings. In ’08 the top 10 banks received less in funds from TARP (circa $125 bil) than they had immediately available in cash as accruals for deferred comp. and bonus pool funds. The latter are among the first items to go in BK. As for AIG, it played chicken with Paulson/Bernanke, having rejected a private debt deal [1] on the Sunday prior to its scheduled Monday credit downgrade, which in and of itself almost doubled the collateral requirements on its CDS’s. The proper policy response to AIG was BK pure and simple with a corresponding simple message to the market: the US government will not pay ransom to or negotiate with financial terrorists.
Note:
[1] The debt was sufficient for the CDS collateral at the time of negotiation and was also less than the market value claimed by AIG for readily but not immediately disposable assets–subsequent determinations of such asset liquidity value are, of course, completely irrelevant.
Clever,
However one complicating factor is that the Treasury then had to negotiate with N counterparties (GS, DB, SocGen etc) which would take time. Allegedly time was of the essence and clearly an equity injection was the path of least resistance.
Also it doesn’t really address the underlying problem that AIGFP was taking on speculative/naked CDS on dodgy tranches without regards for tail risk knowing that the US govt would backstop them in the event of a default… which they did.
This proposal seems elegant but wrong where it counts in at least two places:
1. If the failing institution’s portfolio of positions is magnitudes larger than the price of simply propping it up as a going concern, than does it really meet the occam’s razor test? What would it take for Treasury or the Fed to take over JPM’s swaps book? Even at marginal rather than notional cost, wouldn’t that be a couple of trillion in one go? Even if, mightn’t the news flow around such numbers cause a run on everything else in the financial universe?
2. Wasn’t one of the big unforseen lessons of letting Lehman go the run on the money markets? How does this proposal address that aspect? Are there different but similarly consequential consequences which would arise from the failure of a different institution? Uninsured deposits overseas (Citi) and geopolitical blowback from same? Cascading collapses in AIG’s asian insurance holdings — would Treasury really want to step on Chinese toes in some unknowable-in-advance manner on that scale?
Break them up while (if) we still can.
I assume the Fed lacks the infrastructure to deal with tens of thousands of contracts with thousands of counterparties on short notice, but perhaps it could sieze the failing institution and its assets, assume its liabilities with appropriate haircuts, and hire the failed institution’s staff in-place into an SPV created to handle runoff and contract closure. Oh wait… sounds like the FDIC!
didn’t the deal that the US struck with AIG put them in a senior position in the first place? I thought that was the whole point of the preferred stock deal which gave the government a 79% stake in the company.
Those who live in glass houses shouldn’t play around with Brics.
You may be right about the elephant. A consequent problem is the mess it left behind as it paraded through the wreckage of the All American Grand Old Circus. And yet another, there seems to be no one to sweep up after the parade’s gone through. Probably have to get the equipment from China.
Fact is — public and private income/expense and asset/liability accounts — the problem that needs to be talked about if it is to be solved is the bankruptcy of the dollar credit system. If it isn’t discussed openly, it won’t be solved.
The dollar will be devalued instead. Who knows how much? 20%, 30%, 50%? There’s a range in there where the US will be a good deal for vulture capital. Plaza II coming up.
The cowardly way for states to deal with these kinds of sustainability issues is to devalue the currency and wipe out a portion of the foreign held debt, the portion the currency is devalued by approximately. That approach undermines the purchasing power, and the employment of the people who live here, and further reduces their living standards. Perhaps in line with the 20% reduction that journalist at the NYT was talking about a couple of weeks ago.
The $23.7 trillion in money,credits, guarantees,facilities given, offered and underwritten for the banks up through the early summer could have underwritten wage and salary income ($4 trillion of the total GDP approx) NOT Wall Street Bonus Marchers or edgie hedgie coupon clipping high flyers, for about 6 years.
Earners would have deposited in the banks,paid their bills, and bought what they needed from businesses which also would have used banks, and the economy could have come back with banks playing their old fashioned role of intermediary. When it takes about $2 of this Bernanke helicopter stuff to stimulate each and every GDP dollar, and there’s still no financial flow through into the economy, it is time to ask if the partners in these three way games are capable of playing at all.
If the US is to retain its world leadership it will need to ‘fess up to the problems it is responsible for, and correct them. Blaming others, who were unfortunate enough to do what the US told them to do, isn’t going to do the trick. Matter of fact, it looks quite ludicrous
I agree. When the government borrows money then that money belongs to taxpayers (who will have to pay it back).
The key point in all this is : stop giving taxpayer money directly to private interests!
However, the situation today urgently requires a way to help people rebuild their personal balance sheets AND also requires a recapitalisation of the banks.
The Namke Debt Consolidation Idea would use the new money (preferably borrowed or – if needed – monetised) to FORCE people to pay down their debts. People would end up with less debt load (money payments) and the entire banking system would get a double effect (less consumer loans on their books PLUS a huge cash infusion).
If you just give people cash in hand then most people will spend it right away. That wouldn’t solve anything. You get inflation, very few jobs and no recapitalisation of the banks.
Last but not least, in the NDCI responsible people would also get their fair share of the money. Remember then? Responsible people who seem to be getting trashed on every stupid program that the government is creating?
The banking and financial industry only needs a few simple things to work :
1) Glass-Steagall
2) Tobin tax (tax on speculators flipping assets)
3) Recourse laws (what I call a slice and dice law – you can only securitise to one level and no asset can be less than 5% of the security)
4) the uptick rule for stocks
5) mark-to-delta (mark to market is too extreme when the market malfunctions). Base the declared and booked asset price on the 3 month moving average to smooth the volatility
6) the existing bankruptcy laws (Chapter 11 and Chapter 7)
All of the above reduce pricing risk. When you reduce pricing risk, then you can price things faster and more accurately. It takes time to cut a deal (determine a price) and it takes time to unwind a deal (determine a price). The above suggestions give everybody time to react rationally.
The Namke Debt Consolidation Idea is just something that is needed now – in the current situation in the USA and England.
This is the challenge that President Obama is facing. He is trying to be a “community organiser” and not a leader. His economic team keeps giving him policies that are grotesque and (as we can see from the results of each policy) catastrophic.
If you are interested, the idea is (poorly expressed) at http://emsjuwel.com/business
When will President Obama put down his foot and say – Enough! No more taxpayer money directly to private interests! Taxpayer money belongs to taxpayers!
all the best from
Namke von Federlein
Yep.
Agree completely.
“How responsible grownups are going to deal with particular creditors and counterparties.” is only a pimple on the ass of the real elephant in the room — a scam, non responsive to the will of the people, ‘rule of law’. You are throwing pearls at arrogant, elite, intractable, swine.
The solution at this point, without question, is going to be “highly disruptive” anyway. Best get on with the process now while you still have some resources to do so. The ‘resolution authority’ is in the people. Your remedies must be directed towards them, not the arrogant, elite, intractable, swine.
Deception is the strongest political force on the planet.
AFAIC Arondoff’s solution is not new… it’s come up in discussions I’ve had since this thing began, and I’ve read similar proposals in several places.
However IMO this suggestion is a move in right direction (not nearly far enough) towards identifying and acting upon acknowledgment of first causes… I say this is a principle.
Just for kicks, a definition of principle (since I see it used regularly to describe opinions some wish to foist, but have no fundamental foundation), from Websters:
I’ll add what (IMO) is best addendum to the definition that I’ve ever read, from Bucky Fuller’s SYNERGETICS II (from memory):
My point is that, indeed, bailing AIG was further removed from cause in this domino of fraud. But Goldman was not that far up the foodchain: they knew these mortgage bonds were headed south, continued to sell them as AAA, valued them hugely above any sensible valuation, and pulled political levers to CYA when it all came tumbling down.
To get to 1st principles, I’d move up to top of food chain. I would’ve cut out FED bailouts to every single fraudster: individuals, companies, lobbying houses, K-street… all of ’em. I’d name names, push ’em out of the food chain.
I would then use TARP funds to make the innocents (managed retirement funds, institutional bond holders,…) whole.
I then would convene several groups of best and brightest from econ/energy/agriculture/water infrastrtucture (for starters), and charge ’em with a task similar to Manhattan project. I’d seed it w/fed funds, and grow it with the same… get going what we really need as a society for the future, but which our
fixedfree market economy ignored with all it’s faux catch phrase bamboozlements masking theft.I’d cut out WS from funding this, do it directly: FED $$ >> needed projects w/no middlemen. I’d have fed gov ownership until sufficient momentum took hold, then spin ’em off as private companies w/a new, built from the bottom, funding mechanism that aimed to guarantee (as much as possible) accurate determination of value. And I’d get as many capable citizens, of which there are many and now on the sidelines, involved.
So on and so forth…
That’s the problem w/smoke & mirrors… lies & fraud of this magnitude, layers upon layers of deceptive complexity: it’s dizzying deconstructing it all. It’s a mess… that’s why we have words like that, ’cause that’s what it is: a mess!!!
So kudos to Arondoff for beginning to move in right direction. It’s a start… but only a start.
d4winds has it right — bankruptcy is the preferred option. At most, the US government should be a DIP lender — senior secured, with little chance of loss.
The proper course would have been to isolate AIGFP. Put it in Chapter 11. Zero out the shareholders. The face amount of the loans made by unsecured lenders are reduced and the unsecured lenders become shareholders in a contemplated new entity at the face amount of their new loans.
The face amount of loans granted by secured lenders are reduced and the new loans become unsecured debt. The only secured lender becomes the lender to the debtor-in-possession. The lender to the debtor in possession is the Federal Reserve System (the lender of last resort).
At some point it would become apparent that a surviable enterprise could not be created. At that juncture the Chapter 11 filing would be converted to Chapter 7 and a liquidation of remaining assets would proceed. Not a dime of Taxpayer money should have been applied.
In Chapter 11, AIGFP could have taken the position that as all CDS contracts are ‘executory’, they may be rejected. Once rejected, the counterparties would then become claimants in the bankruptcy proceeding.
Had this latter process been followed, then the settlement of claims would have resulted in very substantial haircuts to the face amount of the contracts. Quite probably there would have followed a cascade of counterparty failures, all of which would be settled in the bankruptcy court.
What would also have become very clear is the extent to which AIGFP had over sold CDS and related derivatives. In that clarity we might have seen that the sales of CDS by AIGFP were witting and that AIGFP was incapable of honoring most, if not all of the contracts. The magnitude of AIGFP’s malfeasance would have been apparent and the path to prosecution for fraud would have been self evident.
That is what enrages me. A massive fraud has been perpetrated and there is not a peep from the Justice Department about an inquiry.
It is not the Justice Department it is the Just-Us Department.
yes….
but pick one of 3
1/ AIGFP was the proverbial turkey here. They were the laughing stock of hedge funds, who knew these clowns would underwrite naked CDS no matter what. They were incompetent.
2/ AIGFP was going by the agency ratings. If an agency was rating a CDO tranche AAA, then they were safe writing a CDS on that tranche. They were naive.
3/ AIGFP was underwriting these naked CDS KNOWING FULL WELL THEY WERE FULL OF CRAP. And that they would blow up eventually being backstopped by the US govt. In that case they were CRIMINAL.
Pick your poison. “Do not assume malice where incompetence will do”.
The issue is not the design of a good solution. There are lots of them. However, no solution that actually fixes anything will be appealing or approved by the new plantation owners: The Bankers. So nothing of any consequence will pass.
I think this is a terrible idea. Consider the case of two institutions, X, and Y. X is modest in size, while Y is huge. You would like to buy a CDS or similar investment. In your opinion X is solid while Y is shakey. Who do you invest with?
If you invest with X, your counterparty is X, while if you invest with Y, your counterparty is, in effect, the Federal Government. Of course, you choose Y.
Smaller institutions will be forced to get large enough to be covered by this guarantee. If they remain small, they will not be able to compete.
With all due respect, that horse has left the barn and is now in the next county. The capital markets business has become increasingly concentrated since the early 1980s.
At least part of the problem is that the US government is now implicated in crony capitalism. The solution proposed does nothing for that. The problem with allowing the systemically destructive institutions to fail is two fold. (1) The counter parties risk having their collateral tied up in court for years and (2) Paradoxically, the collateral might be impaired (exposed) as a consequence of the bankruptcy. Are these business risks that are foreseeable? If market participants were compelled to foresee these risks then too big too fail might become too big to succeed as counter parties might demand premiums from those institutions.
Why buy a CDS? You own a bond, its rate of interest is 6%. That rate is reflective of an above average potential for default. You love the 6% but can’t bear the risk. You buy a CDS, what it costs makes your total return only slightly less than 6%. You are prudent, or are you?
Implicit in the premium for the CDS should be the consideration that the event of default will occur. But the decrease in total yield, bond plus CDS is 5.5%. Is that .5% enough to cover the probability that the party that sold you the CDS will be able to perform.
What has transpired? People have deluded themselves that they get the yield and still have a safe investment grade security. Bunkum !!! Big yield equals Big Risk!!
CDS equals counterfeit currency.
Yves: Why did you offer the refinement?
None of this works as long as there’s a revolving door between the public sector and the TBTF institutions. Open a nice retirement community with a golf course and pool, and the deal is that if you ever sign off on Federal spending above a certain amount, you move there rent-free when you’re done with your government job. No investments, no real estate, and if you write a book or make a speech the money goes to the Treasury.
This of course should have been the best and most obvious solution.
But, Golman wanted some compotitors eliminated so the result was the outrage we are still asking for answers and criminal prosecution for.
About; AIG and possible CDS-buy/sell instead of being a
major share-holder!
I agree to the author´s idea BUT in this case I think
it is possible that Goldman/FED did their DD and came
to the conclusion that AIG should be a going-concern-
firm without going bankrupt after the CDS-exposure where
solved with tax-payer´s money. Conclusion: AIG as one
of the biggest insurance-companies in the world would
in the future pay their money back as the firm earn their
way back and then also being sold as a final pay-back.
BUT: Did they really do the DD or did they just do what pleased Goldman? It stinks nevertheless! Not just from moral hazard!
Is this the smoking gun that proves, as we all suspected, that Bernanke, Geithner, Summers, Obama are all either quite stupid or guilty of fraud on the American taxpeyer?
I don’t see how anything in this proposal benefits any of these people. I doubt if they will even respond. What can they say?
Yes, this does seem a better solution. But what exactly is the bargaining leverage that the Treasury would have in demanding haircuts holders of bonds or derivative contacts with AIG? In the instance covered above, Goldman Sachs has all the leverage, since they know the Treasury *must* keep them from failing, or else they would not be making any kind of offer in the first place. The problem is that there is any institution too big to fail.