Tyler Cowen Is Right But Wrong

Tyler Cowen, writing in yesterday's NY Times, made the important point that any new regulatory scheme for financial services should embrace the notion that creditors will be at risk of financial pain and suffering:

THE Obama administration’s proposals to reform financial regulation sound ambitious enough as they aim to bring companies like A.I.G. under a broader umbrella of government rule-making and scrutiny.

But there is a big hole in these proposals, as there has already been in the government’s approach to bailing out failing financial companies. Even as they focus on firms deemed too big to fail, the new proposals immunize the creditors and counterparties of such firms by protecting them from their own lending and trading mistakes.

Why is the prospect of pain helpful?  It focuses the intellect:

That’s because even smart and honest regulators can monitor a financial firm only so well. A firm’s balance sheet doesn’t always reflect its true health, and regulators do not have an inside perspective on the firms they are supposed to secure. We do need more effective regulation, but calls for regulators to “get tough” are likely to prove effective only as long as a crisis lasts.

What the banking system needs is creditors who monitor risk and cut their exposure when that risk is too high. Unlike regulators, creditors and counterparties know the details of a deal and have their own money on the line.

Now, although I completely agree with the prescription, I also think that bad examples make bad editorials. 

In truth, it’s not the shareholders of the American International Group who benefited most from its bailout; they were mostly wiped out. The great beneficiaries have been the creditors and counterparties at the other end of A.I.G.’s derivatives deals — firms like Goldman Sachs, Merrill Lynch, Deutsche Bank, Société Générale, Barclays and UBS.

These firms engaged in deals that A.I.G. could not make good on. The bailout, and the regulatory regime outlined by Timothy F. Geithner, the Treasury secretary, would give firms like these every incentive to make similar deals down the road.

If we are going to prevent an A.I.G.-like debacle from happening again, institutions like these need incentives to be more wary of their trading partners. Any new regulatory plan needs to deal with them in a sophisticated way.

There is a serious question as to just how much of a beneficiary Goldman Sachs was of this bailout.  It has been reported that $16 billion of Treasury funds went to Goldman as part of the AIG bailout, so superficially they were a huge beneficiary.  However, Goldman claims that they had entered into credit default swaps with third parties to protect themselves against an AIG default.  If that is so, then those parties were the real beneficiaries of a bailout windfall, since the US government prevented a formal AIG default and spared them from making Goldman whole on Goldman's prospective losses.

If that is the case,  then Goldman acted responsibly by reducing its exposure to AIG and Prof. Cowen's proposed cure does not make sense:

Instead, the key to effective regulatory reform is to find a credible means of imposing some pain on creditors.

Here is one possibility. The government has restricted executive pay at A.I.G. and banks receiving government funds, but this move fails to recognize that the richest bailout benefits go to creditors. Restricting compensation at these creditor firms would have more force — if it is done transparently, in advance and in accordance with the rule of law. A simple rule would be that some percentage of bailout funds should be extracted from the bonuses of executives on the credit or counterparty side of transactions.

Such a rule would make lenders more conservative, which would generally be a good thing. To make sure that this measure doesn’t choke off economic recovery, a workable plan would impose compensation restrictions only after the economy improves and banks are recapitalized.

Part of the problem is that the government intervention was not a protected event under existing credit default swaps.  Nor would there be any obvious way to calculate a settlement value if the default swap *did* recognize the intervention as a protected event.  In effect, Goldman Sachs prudently held fire insurance on a firetrap building about to burst into flames but the fire department arrived before any sparks actually flew.

Another glaring flaw in the Cowen solution is that it puts the US in the position of attempting to regulate executive compensation at European powerhouses such as Deutsche Bank and Soc Gen.  Bonne chance!

Finally, I am intrigued that Prof. Cowen has abandoned the notion that shareholders ought to discipline management and control compensation.  In an earlier era we would simply let creditors take a loss and decide for themselves how to deal with their own mismanagement.  It does seem to be the case that shareholders have let themselves be cut out of that process, but maybe reforms aimed at bringing them back into it would be more fruitful than enabling the government to act as our nation's compensation committee.

I WOULD FEEL BETTER IF MY NEXT IDEA WAS PRECEDED BY A REPEAL OF THE LAW OF UNINTENDED CONSEQUENCES, BUT...

Following the Lehman bankruptcy debacle it appears that there are two big problems with the bankruptcy mechanism - creditors around the world freeze accounts and seize assets pending some clarification of their eventual status, creating immediate strains; and some creditors have immediate losses, prompting plenty of other similarly situated creditors to flee to T-bills and await developments.  (With Lehman, losses at the Prime Reserve money market fund froze the commercial paper and asset-backed lending markets.)

My notion is that the government could legislate into being a new legal concept (an "Intervention Event") under which an organization such as AIG could be reorganized and its obligations would be met, subject to a mandatory haircut on certain obligations.  So, the government could inform Goldman Sachs that it (and other creditors) would be receiving 95 cents on the dollar in some future bailout, thereby inflicting a loss on Goldman sufficient to catch their attention but not nearly enough to financially devastate them and further disrupt the financial system (No systemic risk!  Fingers crossed.)

Let's also note that if Goldman's new and improved credit default swap documentation recognized an Intervention Event, Goldman would be made whole by its swap providers.

The obvious problem with this approach is that it presumes that regulators will successfully manage to expect the unexpected and that creditors trying to salvage the last 5 cents due to them won't freeze funds and otherwise disrupt the markets.  And if the unexpected does occur, well, we sail into uncharted waters - hardly a conservative proposal, but there it is.

WHO AM I TALKING TO?  The fact that Goldman had protection via credit default swaps made them a difficult party with whom to negotiate relief for AIG.  If Goldman had volunteered to accept some discount such as 80 cents on the dollar, it may well have been the case that their default swaps would not have compensated them.  Which suggests that creditors meetings need to be expanded to include the default swap providers, not just the nominal creditors.  Because creditor meetings are not already sufficiently complicated...

Comments

[steve sturm]

per your point on Goldman's hedging of their AIG exposure, how solid were those hedges, were those trading partners able to back up their exposure, or were they as weak as AIG? And even if Goldman believed they were covered, it probably made them happier to get the money from the government (via AIG) than try to collect it from their hedges.

[Charlie (Colorado)]

It would seem that if these securities had been traded on an open-outcry market, and the leverage and exposure of the various parties had been visible, the various investors would have been able to make risk-appropriate decisions about the values.

Having some kind of international agreement on accounting standards and how big bankruptcies are processed might help too.

Add to that some kind of insurance program to formalize the way the government has tried to deal with systemic risks, so that the costs aren't entirely borne by the Federal budget?

[Danube of Thought]

I gotta confess. After a career as a business litigator, handling many cases involving securities transactions, accounting disputes, and a few bankruptcy trials, I simply don't have a clue as to what is going on with this stuff now.

[Rick Ballard]

"I simply don't have a clue as to what is going on with this stuff now."

A rather desperate attempt to restore confidence in a failed regulatory system through the manufacture of a new regulatory epicycle is my bet. Newton and Kepler still haven't shown up.

[clarice]

Well, DoT, it's only YOU. Everyone else grasps it completely and thoroughly. (LOL)

[Jane]

Dot,

I'm so lost I can't even finish reading it. Of course that rarely stops me from talking about it on the radio. I just repeat some really smart comment Rick or Charlie or Rich makes and figure I'm on safe ground.

If we start taking calls, I'm toast.

[clarice]

Try the old Obama Uhhmm ehh in that event, Jane.

[Jane]

Ahhhh, that would work - either that or I'll start talking Austrian which I am fluent in.

[DrJ]

I'll start talking Austrian which I am fluent in.

I'd personally suggest Swedish -- as in the Swedish Chef. That'll confuse 'em.

[Ignatz Ratzkywatzky]

The idea that regulation is the key to solving anything other than an event which has already transpired and will not be repeated is IMO a little crazy.

People are generally too cautious or too intelligent to jump into the same idiotic scheme as they have just gotten out of.
But they are seldom too cautious or too intelligent to jump into the new and improved scheme which the regulators are inevitably utterly blind to, since they are furiously fortifying a wall to prevent the assault of the last bubble which has already popped and will not return.
Regulators fight the last war more assiduously than generals do and markets are always ahead of them.
We had a housing debacle in the late 80s/early 90s and erected barriers to it ever happening again. Instead the market found ways around the barriers and the resultant bubble was worse than the first.
Sarbox and FASB were supposed to cure accounting scams. Instead they either didn't help transparency at all or actually made things worse, possibly a lot worse.

IMO, regulations promulgated to stave off the last crisis are often worse than doing nothing.

[Neo]

Financial crisis, not armed terrorists, greatest threat to U.S. security

The current international financial disaster brought on by Wall Street has created 25 million unemployed around the globe. People everywhere are mad as hell at both their leaders and America.

[Charlie (Colorado)]

IMO, regulations promulgated to stave off the last crisis are often worse than doing nothing.

Except when they aren't.

[Ignatz Ratzkywatzky]

Except when they aren't.

Yes, that would be indicated by the plainly visible qualifier 'often'.
I try not to make unsustainable, absolutist statements or give hectoring lectures, especially outside my area of expertise.
Others might find that course profitable as well.

[Thomas Collins]

Don't worry, DOT and Jane. Noone has a clue. Noone has even begun to absorb what deals, public or otherwise, were cut at G20. There is only one thing on which we can be certain. That one thing is that Paul Volcker is the only American who can deal with the Euro and Asian cutthroat financiers (in the finance ministries, central banks and multi-national corporations) and still have the US leave with its pants on. And Volcker apparently has been marginalized.

[PMII]

I feel much better after reading some of today's comments. I've raed and read and read. Everytime I think I understand, I see something else...

In the end it will be under-regulation to some and over-regulation to others...

And oversight is only a word not an action....

[jimmyk]

I don't for a moment believe that GS was 100% hedged, and I was asking here a couple of weeks ago why they and other AIG creditors were being made whole by the taxpayers. The haircut suggestion makes more sense than trying to cap compensation after the fact. If the idea is to avoid the spillover costs of systemic failure, cover only enough losses to avoid those costs. It seems pretty clear now that AIG just had a bunch of blank checks with the taxpayers signatures, and happily paid off its counterparties 100%. I now breathlessly wait for Charlie to assert that this was all absolutely necessary.

[cathyf]

In the end it will be under-regulation to some and over-regulation to others...

That's just asinine. What matters is what the regulations say. When the regulations say that minorities with crummy credit scores are not deadbeats while whites with the same credit scores are, is that over- or under- regulation?

[Jim Rhoads a/k/a vjnjagvet]

It is disgusting that those politicians arguing that the financial crises was caused by "underregulation" of the financial markets have (at least) two goals:

1. Blaming Bush -- By foisting on the 95% of the population that, like them, doesn't understand financial regulation the meme that the Bush Administration's laissez faire policies bear all of the blame.

2. Deflecting the real blame -- By covering up their direct responsibility for the breakdown of the US housing market and its financial underpinnings. All of those funky debt instruments were devised to spread the known risks of sub-prime lending legislatively encouraged by the left side of the political spectrum.

It is even more disgusting to me that this crowd is being pretty successful in achieving those goals.

[RichatUF]

Jim-

I would include a number 3 on your list: the oil shock of 2008. It dug into consumer spending, wrecked the auto sector, and exported about $450 billion of capital out of the US.

[Thomas Esmond Knox]

What kind of a creditor was/is Goldman Sachs? Had they loaned money to AIG, or did they hold a valid claim on an insurance contract with AIG? I suspect the latter.

The most valuable asset that AIG has is its licences to operate as an insurance company in the US and many other countries.

If AIG reneged on its obligation to pay a valid claim then it would be in breach of its licence to operate.

If I was AIG, I would pay those creditors first. If it does that, it has a good chance of survival. Otherwise none.

[rhodeymark]

Hmmm - notice a name missing on that list? A rather LARGE player that mysteriously avoided AIG counterparty risk (did I call it risk? Silly me.) Or at least has so far avoided exposure. Check out this table, and see who is worth more dead than alive. GM avoiding bankruptcy has a lot more than the UAW at stake.
LUN