Dear Readers: I was watching the classic movie, “Ghostbusters,” with the Young Prince yesterday, when I heard the following lines from Ray Stanz (Dan Akroyd’s character):
Dr Ray Stantz: Personally, I liked working for the university! They gave us money and facilities. We didn’t have to produce anything. You’ve never been out of college. You don’t know what it’s like out there! I’ve worked in the private sector… they expect results!
(In related news, here is a sure sign of the impending Apocalypse: Couric blasts White House stimulus numbers.)
With that in mind, I have a wonderful essay to share with you today from Professor Athena (a senior executive for a well known and large financial institution).
Unwinding the “Too Big To Fail” Moral Hazard
House Financial Services Committee Chairman Barney Frank has proposed new powers to be held jointly between Treasury and the Fed to regulate the activities and potentially even close down financial institutions deemed a risk to the broad economy. With of course oversight by Congress.
It is interesting on the one hand that these powers have always existed and been ignored in the past. It is also interesting that it is Congress and the Treasury who merged existing “Too Big to Fail” institutions during the 2008 financial crisis, making many banking and financial services firms such as Bank of America and Citicorp even more behemoth threats. These are the same people whose oversight and authority were supposed to regulate FNMA and FHLMC. We should sleep nights thinking they won’t repeat the same mistakes?
Winding our time machine way back to the 1980’s and the thrift crisis that formed the Resolution Trust Corp., where the term “Too Big to Fail” was first coined from the standpoint of systemic financial risk, one would think a few painful lessons were learned. However, that meltdown was the result of interest rate risk, not credit risk. Derivatives were a tiny, fledgling market. China and Pac Rim money wasn’t pouring into New York investment banks and hedge funds like a tsunami. Indeed, hedge funds didn’t even exist. However, some of the risks incurred way back then made those who whispered the words, “too big to fail” vow it would never occur again. It has, and this time it is worse.
There are various ideas which have been proposed as to what the solution is to this problem, lest we see a near-term repeat of last year’s financial system meltdown. While the banking and credit system is currently much healthier than it was a year ago, some serious problems persist. The risk premium which came into credit markets as a result of the Fed allowing Lehman Brothers to file bankruptcy, and also merging two other large primary firms within a short span of time, has not fully been absorbed. Debt markets are yet reeling from insurer downgrades and lack of trust in the ratings agencies. The idea that firms can pay into a “risk pool” won’t work, for very simple reasons. Firms can pay a premium into the pool and continue to over-leverage their firm’s capital on high-risk assets without enough oversight to prevent the systemic risk. They might even judge the “penalty” worth it, because management may have short-sighted goals. They might just be bad risk managers. But, when American taxpayers are the ones ultimately on the hook for such deals gone sour, who can blame us all for feeling angry? However, aiming our anger solely at the investment bankers and hedge fund managers and institutions who did a bad job managing their risk, yet failing to blame Congress for their inherent legislative design of the banking and lending systems along with the lapse of federal regulators to oversee capital at risk is similar to blaming the gun and not the shooter. We should in effect demand they stop selling high-powered rifles to 12-year-olds. What they were literally selling was unlimited risk to 20-something Ivy-Leaguers.
The Obama administration is tackling the wrong problems, and to quote Peggy Noonan’s excellent opinion piece in Saturday’s Wall Street Journal, “the American people are telling him that”. The mess that is the economy is in no small fashion attributable to the “Too Big To Fail” moral hazard. Americans are concerned about health care and putting the government in charge of increased management and oversight of such an integral part of our lives when it is apparent that the federal government failed to learn their lesson on “Too Big To Fail” the first time. Where the “mess” being mopped up in Washington, D.C. is right now from the standpoint of the America people is clear. They didn’t hire a janitor when they went to the polls last November. They hired a chief executive. The administration needs to come up with a solution for this hazard that amounts to more than increased regulatory oversight and more interaction with Congress.
Institutions tottering on the brink of risk should instead be divided and regulated differently, as Paul Volker has suggested. A trading or hedge fund operation does not have the same risk profile as a traditional banking institution that takes in deposits and manages assets such as loans and investments. Expecting them to exist on the same gargantuan balance sheet without some level of obfuscation as to the actual financial risk profile is like expecting Iran to tell the truth about nuclear proliferation. Simple regulatory changes such as reduced leverage for SEC-regulated firms, and mandated monthly independent accounting firm reviews for capital-at-risk posted online could go a long way toward keeping firms honest about the amount of risk they are taking. Take Congress out of the mix of micro-managing the mortgage markets, and set standard industry contracts that no one can deviate from. Mortgages do not need to be complex to work, and for consumers to understand them. Make mortgage companies hold to the same standard underwriting practices as everybody else, and prohibit any campaign financing or “special purpose” loans to members of Congress or their family and associates. In reducing risk, we induce stability and long-term rewards. It’s long past time to unravel a system of ever-larger and more complex financial institutions who are “Too Bit To Fail” but somehow not “Too Big For Taxpayers To Bail Out”.
MUT’s Money News:
Keith Henney has 20 questions for the Financial Crisis Inquiry Commission; I hope to post any answers he obtains.
Bloomberg news: Obama Bridge to Lasting Expansion Risks Going Nowhere (Update1)