Monday, March 15, 2010

Today's Edition of "Legislators Are Stupid and Should Not Be Trusted with Anything Important"

. Monday, March 15, 2010

Jacob Goldstein at Planet Money ponders a potential rainy-day fund for winding up TBTF financial institutions:

In the current system, there's no good way to deal with big financial institutions that are about to go bankrupt and don't fall under the umbrella of the FDIC, which oversees some banks. Exhibits A and B for why this is a problem are Lehman Brothers, whose bankruptcy sent the economy into panic, and AIG, which received a gargantuan government bailout.

Of course, the Treasury and the Fed put more than $100 billion into the AIG bailout alone -- which makes a $50 billion safety fund look a bit paltry. But the Senate bill would also allow the government to collect more fees after a bailout, if $50 billion didn't cover it.

The trust fund would be paid for by financial firms so big or so interconnected that their failure would pose broad risks to the economy. Under the Senate proposal, the Fed would decide which firms fit that description, Bloomberg News reports, and the FDIC would wind down big firms that are about to fail.

This is apparently part of the Senate financial reform plan. The House plan that passed last year included a $150bn plan.

I haven't read the plan because it doesn't really exist yet (and who knows what it'll look like if/when it actually becomes law). But if the plan functions as described then this is a very stupid plan. Why? Well, ostensibly the point of the rainy-day fund is to tax TBTF financial firms so as to avoid using taxpayer money to bail them out when they inevitably go bust. But the banks will simply pass on the costs of the tax to consumers anyway, so either way the bailouts will be taxpayer-funded. Of course it's less transparent this way, which is good politics even if it makes little or not substantive difference. That's not the problem, however. These rainy-day funds will presumably sit around in an account at the Treasury being used completely unproductively until the next financial crisis, which is inefficient but also not the problem.

Here's the problem: the existence of a rainy-day fund provides an explicit TBTF guarantee to banks that pay into it! The fund won't be used to make the investors those firms whole if they collapse, but it will be used to make their counterparties whole. What does that mean? TBTF firms will able to get access to capital at lower cost because those loans will be insured by the Federal government... for free! In the past banks had to sell credit default swaps to insure their risk, but now the American government is willing to use taxpayer funds to do it for them. Because TBTF institutions will get access to credit at cheaper rates, they will be incentivized to lever up even more than they otherwise would, which increases the likelihood of an intervention. Even better: all the TBTF banks will be incentivized to extend tons of credit to each other, knowing that if one of them goes down they all go down, so the government will have no choice but to bail them all out and (presumably) make them whole or close to whole.

Ah, but there was already a bailout guarantee, you say. It's true that there was a strong belief that the government would intervene in the event of a financial crisis, but there was no belief that they would rescue every firm or guarantee any counterparty obligations. There is some argument about whether a "moral hazard trade" existed for TBTF fail institutions (that I won't recount here, but let's just that if it existed it wasn't super-large), but no argument that financial institutions acted as if they counted on government intervention to buy their toxic assets or guarantee their counterparty obligations. (In fact, quite a lot of firms were allowed to fail in the recent crisis, by bankruptcy or forced sale at bargain prices, and many investors and counterparties were forced to take haircuts.) No such uncertainty will exist if this plan goes through.

Rational firms will do everything in their power to get TBTF status so they will be subject to the tax and the counterparty insurance it provides, pass the tax on to their customers, and reap the benefits afforded them by having greater access to capital at lower cost. The government could try to respond by ramping up regulations on capital adequacy ratios or leverage ratios, but how much confidence do you have that that will be successful?

That's what I thought. Better not to invite the moral hazard in the first place.

This is a stupid, stupid, stupid plan. I'm surprised that Felix Salmon hasn't been all over it. (Or maybe he has and I've just missed it.)


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Today's Edition of "Legislators Are Stupid and Should Not Be Trusted with Anything Important"
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