Streetwise Professor

March 1, 2010

Getting the Diagnosis Right Before Prescribing the Cure

Filed under: Derivatives,Economics,Financial crisis,Politics — The Professor @ 8:22 pm

AEI’s Peter Wallison’s opinions on matters related to the financial crisis and financial regulation are highly and positively correlated with mine.  He has an excellent oped in today’s WSJ which echoes my views on the real source of moral hazard and too-big-to-fail: namely, bailouts don’t directly distort the incentives of bank executives and equity holders, but they do seriously distort the incentives of those who lend to banks:

The same failure to understand the power of moral hazard is what makes the administration’s call for a resolution authority most inapt and troubling. Although the administration has argued, and some in Congress believe, that moral hazard and too-big-to-fail would be curbed by a resolution authority, the opposite is true. Both would be enhanced.

This is because the principal danger of moral hazard—the key to its adverse effects on private decision-making—is its impact on creditors and counterparties. The fact that shareholders and managements will lose everything in a government resolution is largely irrelevant. What really matters are the lessons creditors draw about how they will be treated. And it is clear creditors will be treated far more favorably in a government resolution process than in a bankruptcy.

To understand why this is true, consider the administration’s reasons for preferring a government resolution process. The claim is that large, interconnected firms will drag down others when they fail. The remedy for this is to make sure their creditors and counterparties are fully paid when the takeover occurs. That’s why the Fed made Goldman Sachs and others whole when it rescued the insurance giant AIG. It’s also what distinguishes a government resolution process from a bankruptcy, where a stay is imposed on most payments to creditors when the bankruptcy petition is filed.

Creditors will realize that by lending to large companies that might be taken over and resolved by the government, their chances of being fully paid are better than if they lend to others that might not. Thus a resolution authority will enhance moral hazard not reduce it—and as creditors increasingly assume that large firms will be rescued, the too-big-to-fail phenomenon will grow, not decline. In the end, a resolution authority becomes, in effect, a permanent Troubled Asset Relief Program.

Exactly so.  The effects of this can be far-reaching.  For instance, it can make it rational for banks to take on excessive leverage.  Moreover, it can distort the types of leverage banks use; it tends to favor short-term debt and fragile capital structures, because it is that kind of debt that provides the greatest systemic risk, and hence is most likely to induce the government to ride to the “rescue.”

On these lines, note that the widespread belief that the government stood behind Fannie and Freddie debt allowed these entities to grow immense and highly leveraged.  Funny, isn’t it, that even though F&F are gulping down government money in quantities that make AIG look like a piker (another $15+ billion last quarter for Fannie, with NO end in sight), that this goes largely unnoticed, and draws nothing of the outrage that the AIG bailout does?

Wallison also expresses skepticism about the importance of contagion and interconnection in driving the financial crisis:

Then there is the proposal to give a government agency the authority to take over and “resolve” failing financial firms. Here, the administration has pointed to the chaos that followed the bankruptcy of Lehman Brothers in September 2008. To prevent that kind of breakdown, the administration says all large and “interconnected” financial firms in crisis should be dealt with by a government agency, rather than by a judge in bankruptcy proceedings.

The term “interconnected” is important here. It implies that when one large firm fails it will carry others down with it, causing a systemic crisis. But that is clearly not the lesson of Lehman. Although the company went suddenly and shockingly into bankruptcy, none of its large financial counterparties failed. The systemic significance of “interconnectedness” proved to be a myth.

There seems to  be a tendency to attribute any simultaneous implosions among financial firms to a contagion effect.  I think it is more plausible, however, that the observed correlation in distress reflected correlations in investment strategies across financial institutions, making them simultaneously vulnerable to a common shock.  In the event, it was exposure to real estate prices.

Look at the week or so beginning September 7, when the Feds took over Fannie and Freddie, followed by the Lehman collapse and the AIG bailout.  All of these were heavily exposed to real estate prices.  The most heavily damaged survivors, Citi, Merrill, and BofA most notably, also had big exposures.  Before them, it was Bear.  It wasn’t a single bad firm dragging healthy ones to which it was interconnected down with it; it was an epidemic of financial sickness caused by exposure to a single, common pathogen that simultaneously brought many firms low.

It is important to understand the relative importance of contagion and correlated solvency shocks in contributing to the crisis.  Most of the proposed “solutions” seem motivated by a belief that the crisis was a chain reaction made possible by excessive interconnectedness.  If this diagnosis is wrong, the prescriptions are likely to be either useless, or positively harmful.  The same is true with the diagnosis of the true source of moral hazard underlying TBTF.  Unfortunately, as Wallison suggests, we seem to be misguided here as well.  This doesn’t bode well for avoiding the next crisis.

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