Streetwise Professor

April 26, 2010

The Dodd-Lincoln Frankenstein

Filed under: Derivatives,Economics,Financial crisis,Politics — The Professor @ 3:36 pm

According to this morning’s press reports, Dodd and Lincoln have agreed to bolt together their bills.  The Lincoln bill passed by the Senate Ag Committee would become the derivatives title of the Dodd financial “reform” legislation.  Crucially, according to these reports, the no Federal assistance/derivatives dealer spinoff/Volker plan on steroids will become part of the Senate bill.

Perhaps maintaining the spinoff is simply a negotiating ploy.  Republicans are likely to filibuster the bill, because it is not bipartisan.  Negotiations are ongoing.  One common negotiating ploy is to include outrageous clauses, that one can generously sacrifice during negotiations.

But maybe it isn’t.  Maybe Dodd and Lincoln believe in this insanity.  And it is insanity.

I’ve mentioned some of its scary features.  But I haven’t mentioned all of the frightening implications.  Derivatives markets are intended to provide risk bearing capacity and liquidity.  To do so, those making markets must combine trading talent, valuation expertise, and risk capital.  One of the reasons that dealers came to dominate OTC markets is that they were able to offer this combination.  Crucially, their balance sheets provided the risk capital that made traders more willing to deal with them than other  potential counterparties.  Dealers assemble networks of positions backed by their capital.  There are economies of scale and scope.  Prevent financial institutions from backing derivative deals with their balance sheets, and it will be impossible to exploit these economies.

It is interesting to recall that many financial institutions set up bankruptcy remote, separately capitalized, AAA derivatives trading subsidiaries.  But market participants preferred to trade with banks directly, thereby having recourse to the banks’ balance sheets.  That is, the market once upon a time had a choice to trade on something like that contemplated in the Lincoln bill, and consciously chose not to.

The spinoff clause is therefore likely to impair the liquidity and risk bearing capacity of the derivative markets.  (Perhaps, from the perspective of Lincoln and those of like “minds”, this is a feature, not a bug.)  Moreover, it is likely to result in more counterparty risk, as less-well capitalized intermediaries replace the banks.

I’ve focused on the derivatives aspects of the Senate bills, but there’s plenty more to hate in the Dodd bill.  Let me comment just briefly on the resolution aspects.

The $50 billion dollar “bailout fund” has drawn the most attention, and the most fire, but it’s small beer compared to other things in the bill.

Most importantly, as I’ve noted repeatedly, the fundamental source of too big to fail is the inability of the government to commit not to bail out creditors of a failing or failed institution.  Increasing the discretion of authorities responsible for resolution reduces ability to commit.

And the Dodd bill does just that.  It gives the FDIC and the Treasury and the Fed tremendous discretionary authority to make creditors whole on the taxpayers’ dime.  This discretionary authority is almost completely free from any Congressional check.  Moreover, this authority has effectively unlimited access to the public purse.

To sum up:  instead of constraining regulators’ ability to bail out creditors of big financial institutions, the bill expands their discretion; instead of increasing the credibility of commitments not to bail out by limiting access to government funds, the bill undermines credibility by giving the Fed and the executive branch virtually completely discretionary authority to pay as much as they want to the creditors of large financial institutions.

Sure, the bill also mandates greater prudential oversight, but this is unlikely to be sufficient, as a litany of past failures of such oversight should make plain.  That is tapping on the break, while the measures I just described are flooring the gas pedal.

I know it’s tiresome to hear it yet again, but it bears repeating: the source of TBTF is the implicit subsidy to creditors that exists when the government cannot pre-commit credibly not to bail them out.  The Dodd bill basically says in flashing neon:  We Will Bail Out Creditors!!!  Regulatory discretion plus unconstrained access to the Treasury is a recipe for systemic risk.

If, heaven forfend, the Dodd bill passes, keep an eye on the difference in the funding costs of big financial institutions and small ones.  If my analysis is correct, that difference–which is already substantial–will remain wide, and likely grow.

There is of course a conceptual link between the derivatives and bailout provisions.  Big derivatives dealers will take on too much risk, to the extent that they are subsidized via the TBTF features of the bill currently slouching towards passage.  But the right way to address that problem is not to hive off derivatives trading from the banks that get the implicit subsidy.  If they can’t take advantage of the subsidy via derivatives trading, they’ll just take advantage of it some other way.  Believe me, there are an infinite number of ways that smart bankers can exploit the subsidy to the fullest; close off one way, they’ll find another.  The better way to go is to take measures to reduce, and substantially so, the TBTF subsidy.  This the Dodd bill does not do: in fact, it does the opposite.

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  1. Where exactly does the Dodd bill give discretion to bail out creditors on the taxpayer dime? What section?

    Doesn’t the Miller-Moore amendment in HR 4173 give the FDIC authority to impose haircuts on secured creditors? It’s not in the Dodd bill yet, but I heard its going to be proposed as soon as the Dodd bill hits the floor.

    What is your feeling on Miller-Moore? It seems like it would be pretty disruptive of clearing and repo.

    Comment by gcoaster — April 27, 2010 @ 2:08 pm

  2. Virtually every time government takes the chance to do a massive overhaul, the little guys get trampled. Small and mid size banks will get crushed. We will be left with the big guys.
    Something does need to be done, but this bill is not it. However, I keep thinking the Democrats think they are Naval commanders, “Damn the torpedos, full speed ahead.”

    How long until the next financial bubble? The market will remain irrational longer than anyone can remain solvent.

    Comment by Jeffrey Carter — April 27, 2010 @ 10:42 pm

  3. No wonder Blankefein is urging the Senate to end the TBTF quagmire – tactfully asking them to go ahead with the bill. How sneaky! But I am sure he cant help if if senators are such fools. Or more cynically is there more than meets the eye? Are senators willingly bedding Wall Street and favor them with this legislation while publicly appearing to do the opposite?

    Comment by Surya — April 28, 2010 @ 12:35 pm

  4. Jeffrey Carter – did the “little guys” get trampled when the government passed regulations in the 1930s? Or were they more trampled since the 80s when deregulation set in? It is obviously the latter. It seems to me that the skeptics of the benefits of regulation can remain irrational longer than this country can stay solvent.

    Surya – I doubt Goldman wants to spin off its swaps trading desks. Please please please point out something in the legislation that favors “Wall Street” (whatever that term really means).

    Comment by gcoaster — April 28, 2010 @ 2:16 pm

  5. @gcoaster–Section 204 authorizes FDIC to make whole the creditors of a covered financial institution during an orderly liquidation; 210(n)(9) gives the FDIC a line of credit that it can use to support failing firms it controls, providing another mechanism to pay creditors; Section 1155 gives the FDIC authority to guarantee debt of (allegedly) solvent institutions if regulators deem a liquidity crisis exists. All of these give substantial discretion, plus access to basically unlimited $.

    Re Miller-Moore–I’m just concerned about giving regulators discretion in these matters. Moreover, I seriously doubt that FDIC will impose such haircuts in the breach. But the mere fear or rumor that they might could, as you suggest, cause a lockup in the repo market, and in clearing and settlement.

    The ProfessorComment by The Professor — April 28, 2010 @ 4:56 pm

  6. Section 204: I have no doubt that Shelia Bair will do everything to wipe out creditors or purported creditors (the latter in the case of repos and clearing/settlement). Has there been any action during the past 2 years that leads you to believe the FDIC would abuse its discretion? The FDIC is a very different institution than the Fed or Treasury, and I doubt it would bail out creditors, especially when Section 204 says there will be a *strong presumption* that creditors and shareholders will bear the losses of the failed company.

    Section 210: The line of credit is written against the Orderly Liquidation Fund, which is NOT taxpayer funded. And the use of the line of credit is limited to 90% of the fair value of the financial company’s assets.

    Section 1155: Guarantees are predicated on consultation with the President AND that Congress doesn’t disapprove of the guarantee.

    Miller-Moore: The FDIC would probably impose haircuts, but I doubt it would f with repos (after the Lehman mess) nor clearing (given stated policy objectives).

    I’m sorry but you seem to be overstating your case. Maybe you could provide some citations of where the bill allows the Fed / Treasury to bail out firms as you discussed in your post.

    Furthermore, it would all possibly be moot if one of these crises happened again and the Congress/President passed a new law giving the Fed / Treasury / FDIC authority to do whatever it wants similar to last time. Which, sorry to say, is more likely than not!

    Regarding your post today re Section 106 – Do you want the clearinghouses, swap desks, etc bailed out, or give regulators the authority to bail them out? If so, how is this not at odds with your concerns here?

    Comment by gcoaster — April 29, 2010 @ 12:51 pm

  7. @gcoaster.

    1. Will Sheila Bair be head of FDIC for life? Is she immortal? The law will far outlast her tenure.
    2. Your naivete about the political economy of bailouts is quite affecting. Unrealistic, but affecting. Historically, the FDIC has almost always protected creditors. What’s more, in the event of a big financial institution lurching towards failure, if you think that whoever is the head of the FDIC is going to play Horatius at the Gate and fend off the Treasury, the Fed, the White House, Congress, etc., you’re not thinking straight. Nobody–even your fair Sheila–is going to want to be known as the person that repeated the Lehman mistake and brought down the financial system, especially when all the creditors (which will include money funds, etc.) will be howling that the system will collapse if they are not protected.
    3. All the pretty language you cite won’t mean much in the breach. The point is that there is regulator discretion, and access to money. When the next big institution teeters, it will be all too easy to cave.
    4. I much prefer a rule driven process walled off from the public purse implemented by non-political appointees. That is, a bankruptcy, or bankruptcy-type process.
    5. How creditors read these provisions is also important. They may not believe that 100 pct bailout is inevitable, but they will put a pretty large probability on receiving a good deal of protection–more than they would receive in bankruptcy. Which is sufficient to induce them to lend at rates that do not reflect the true risk. And that’s the root of the problem.
    6. Re 106, there is a difference between the Fed acting as lender of last resort (LOLR), and lending against good collateral as Bagehot recommended years ago on the one hand, and a bailout on the other. That’s specifically what I mentioned in my post, and that is very different from a bailout. As I also said, the way Bernanke has acted has gone far beyond these traditional LOLR functions, and that’s probably the source of confusion. So no inconsistency to the extent the Fed acts as a responsible LOLR; 106 bars that as well as irresponsible bailouts .

    The ProfessorComment by The Professor — April 30, 2010 @ 9:20 pm

  8. Fine, the regulators will discretion to access the resolution fund – but that fund is *not taxpayer funded,* so my point remains and your assertion that this bill leaves open the possibility of taxpayer funded bailouts.

    It’s very cute that you think we can construct some comprehensive, rigid resolution system that accounts for possibilities and contingencies before hand. We in fact cannot. Therefore, we must give the regulators some degree of discretion, whether we like it or not.

    Regarding 106 – I see very little difference between subsidizing these firms and bailing them out. Subsidizing them is just a backdoor bailout. At least you seem to be consistent in not wanting to give the Fed discretion as who it acts as LOLR to – but of course we would again run into your faulty premise of the possibility of spelling out all rules before the fact, or, if it was possible, the willingness/ability of adhering to such rules.

    BUT ANYWAY – hate to hammer this home but back to the original topic – there are no taxpayer funded bailouts, unless you can cite another section and selectively read it outside of its context! I wonder how these comprehensive rules you imagine would be administered if you would have people following your example and selectively reading them to get to the result they favor.

    PS – Bankruptcy judges are appointed so don’t enshrine them! (sure by appellate judges, but of course those judges are political appointees so…)

    Comment by gcoaster — May 2, 2010 @ 3:46 pm

  9. Argh – didn’t finish my thought there in the first paragraph – should be:
    “…your assertion that this bill leaves open the possibility of taxpayer funded bailouts is false”

    Comment by gcoaster — May 2, 2010 @ 3:48 pm

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