Let Big Banks Fail, but Save Finance

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Suppose NYU Prof. Nouriel Roubini is correct and US financial losses from the credit crisis are going to exceed $3 trillion dollars. Imagine then the two choices before us: One, allow U.S. taxpayers to take the hit. Socialize the entire loss, and allow the owners of these assets to enjoy a great windfall at the taxpayers’ expense. The second option is to allow 10 or so large financial institutions to fail. Fail utterly and completely, wiping out stockholders, preferred share-holders, and debt-holders.

The taxpayer, through self-interest or ignorance, might be very tempted to let the giants of finance, the folks who made the loans in the first place, suffer their just desserts. Besides buying the assets, the executives at these financial behemoths had the bad taste to get very rich while, to quote one of them, the music played.

The populist view has a populist appeal, and this is perhaps why the government is struggling with all the different manifestations of socializing the risk. The “bad bank” seems to have lost momentum after the congressional watchdog panel overseeing TARP released a report showing that Treasury’s last foray into the toxic asset buying business quickly turned $254 billion into $176 billion.

So, rather than buy the assets, the latest idea is to “guarantee” them, in an attempt to lure private investors into a “Public-Private Investment Fund.” We are all Credit Default Swap traders now! For a credit default swap is precisely what an asset guarantee is. And the next Nobel Prize in economics awaits the clever economist who can figure how to price a guarantee without pricing the underlying asset. Save the effort, it cannot be done. Figuring out the pricing of guarantees is no less vexing than pricing and then buying bad assets. It’s simply sounds like less of a taxpayer rip-off.

Of course, what the populist argument misses is the systemic collapse that would be risked by letting these large banks fail. The world economy, and the global financial system, is so intricately and massively interconnected that if one, let alone 10, of the big banks were to fail, the domino effect would crush the global economy. This may not be true, but even a small chance against such a massive risk makes the outcome so unthinkable that nobody will seriously consider it.

The big banks kind of have us where they want us, don’t they? If we allow the free market to punish them, we all go down together. It’s a form of financial mutually assured destruction. And we thought they were stupid for buying all those super-senior tranches of subprime CDOs.

Ideally there would be a way to allow market discipline for those who took bad risks without destroying what is left of the financial system. There is.

Consider what a fortunate thing it is to have so much of the current bad assets concentrated in so few hands. In a country with 10,000 banks, it is likely that a large percentage of the truly toxic assets are in the hands of a dozen or so players. As we saw with the subprime losses, of the first half trillion dollars, U.S. banks made up about half the total. Of that half, 10 institutions made up for 90% of the losses. If you go through the list of big losers, what strikes one is the top-heaviness of the list. In another stroke of luck, from the taxpayers’ perspective, 4 of the top ten, and 15 of the top 25, are not even U.S. institutions.

The Financial Stability Fund that Geithner unveiled yesterday would be targeted at the weakest players. Those banks that stress testing reveal are most in need of capital. This approach is exactly wrong. Perversely, Geithner vows to avoid the mistakes of Japan in the 1990s. But propping up bad banks is precisely what Japan did.

We don’t need to inject still more capital into weak banks in order to avoid systemic collapse. There is a solution to the dilemma of contagion. A remedy that does not involve buying the bad assets, or guarantying the bad assets, or guarantying the bad debt of the owners of the bad assets, or buying preferred shares in the owners of the bad assets… And the solution might be inexpensive.

Start by identifying the basket cases, the 8 or 10 or 12 that the FDIC must surely know are insolvent. Together they hold a bulk of the losses already realized and, presumably, yet to come. Announce they will no longer be the beneficiaries of any further government assistance. It is possible that they will all fail in short order. But the system need not collapse.

The government will effectively put these institutions into receivership. Equity holders and preferred stockholders will likely get nothing (including, alas, we taxpayers who own what Henry Paulson purchased for us). Importantly, bondholders will also suffer, and receive only what’s left in the final bankruptcy. Here the 8 cent recovery on Lehman unsecured debt is somewhat frightening, but bondholders are presumably sophisticated and any fixed income fund that still has more than 20% in financials is either crazy or PIMCO.

Systemic collapse can be avoided because the government will simultaneously announce two important measures. First, and least controversially, depositors of all forms, shapes and sizes will be promptly and unconditionally guaranteed by the US government. This seems to require little justification.

Second, all counterparties of failed banks will now face the US government on the other side of their trades. That is, the U.S. will guarantee repurchase agreements, derivative transactions and other counterparty claims of anybody, foreign or domestic, that has a transaction on with these banks. Systemic collapse avoided.

Clearly, we are dealing a windfall to some institutions that should perhaps be punished for not doing their homework before, for instance, entering into a long dated FX swap with Citibank. But not doing so really would risk systemic collapse. When AIG was saved, it was not, we hope, simply to save Goldman Sachs and Morgan Stanley. Systemic collapse is a domino effect primarily transferred through derivative transactions. The numbers are indeed staggering; the OCC reports over $182 trillion in outstanding notional amounts as of last June. And there exists the possibility that the failure of a dozen large players would take us back to the financial Stone Age.

Even well managed community banks, thrifts and municipalities have interest rate swaps on with the big banks. The municipality that hedged its interest rate risk with Citibank thinking it faced an entity one notch below AAA should not be punished.

The second reason the plan is viable is cost. There is no way to know how much more we will spend buying or guaranteeing bad assets. If Roubini’s number is correct, we are in the early stages of this game of letting good money chase after bad. If we are to dole out these funds $350 billion at a time, we could be playing for a long time and still have insolvent banks.

It is difficult but not impossible to figure out what such an overarching guarantee of counterparty claims might cost. But it may not be that expensive for the government to step into this role. Importantly, while the banks do not know, or pretend not to know, the value of their toxic assets, they know exactly what their counterparty claims are, to the penny. This information is routinely shared with regulators now. If by some stroke of bad luck these big banks are all off sides and under-collateralized in their derivative claims, the plan can be quietly abandoned.

But it is unlikely to be terribly expensive because generally the big banks do a reasonably good job of managing both net market risks and counterparty risks. So if Citibank has a bunch of counterparty trades on with small, shaky institutions, it probably has sufficient collateral against the trades. One might discover also that the bulk of the derivative transactions outstanding are among the banks on the hit list. Indeed according to the OCC the five biggest banks represent about 90% of net industry credit exposure. This would be a good thing, because derivatives are after all zero sum transactions. Theoretically, the taxpayer has a decent chance of coming out flat.

Over the summer there was some silly talk about how the taxpayer might actually make a profit on Paulson’s investments. After all, Warren Buffet was buying the same types of preferred shares. That argument was and remains nonsense. Last week’s revelations that Treasury seems to have quickly lost $78 billion should silence the optimists. It’s time to cut losses.

At the very least we need to recognize the inefficiency of addressing the crisis from the asset side. Trying to fix this problem by inflating assets is either futile or extremely expensive. The assets do need not to be propped up, but quickly written down. If we can do it while protecting the financial system, why would we delay?

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