Back-Door Resolution Authority

Tyler Cowen quotes from Robert Pozen’s yet-to-be-released book:

“In my view, the adverse repercussions of Lehman’ failure could have been substantially reduced if the federal regulators had made clear that they would protect all holders of Lehman’s commercial paper with a maturity of less than 60 days and guaranteed the completion of all trades with Lehman for that period.”

Back when people cared about these things, I wrote a couple of posts on the issue of selective protection of creditors.

The point I was trying to make at the time was that it should be at least conceptually possible for a regulator to determine what the ripple effect of default would be and impose haircuts in such away that systemic failure did not result. This would provide a middle way between bankruptcy (complete uncertainty and panic) and blank-check bailout (100% taxpayer guarantee, no losses by creditors). I was envisioning this in the context of government receivership, but I also had this tentative idea:

“I think that the government could let AIG fail, if – and this is a big if – it can first identify which creditors and counterparties would be hurt, determine which of those cannot be allowed to fail (which should not be all of them), design a program to provide them enough capital directly, and announce everything on the same day. The net cost to the taxpayer cannot be higher than under the Too Big To Fail strategy, which implies a 100% guarantee for all counterparties and creditors.”

But if I am interpreting Pozen correctly, he is suggesting a more elegant way to achieve the same objective. Once the government has determined which liabilities and exposures will have systemic ripple effects (he says short-term CP and outstanding trades), it could just announce a guarantee on those liabilities and exposures and let everything else go into bankruptcy. Now maybe they didn’t have time to make such a determination the weekend before Lehman failed (although arguably they had since March to figure it out), but by the time Citi and BAC and the last AIG bailout rolled around arguably they did. I’m not enough of a markets person to be sure this would work, but it seems like a viable proposal.

By James Kwak

12 responses to “Back-Door Resolution Authority

  1. Or we could just have a planned economy that works (or are we too dumb and greedy to be able to make it work?).

    Much better than our Rube Goldberg Device Economy(RGDE)

    Let’s all meet on Larry Ellison’s yacht (not sure which one yet) next week to discuss further.

  2. Sorry, make that Paul Allen’s yacht. Much cooler:

  3. I don’t want to be too critical here because maybe selective protection of creditors is a good idea that could solve some problems down the road. But first of all there would be so many cries of “Unfair!!!” from the creditors it would be a mess. And there are so many complications involved in this you could nearly write a book on it (maybe that’s what Robert Pozen did).

    My main thought on it is this: Isn’t this like looking at a fatality of DUI in the hospital and saying “Well if we had used better sutures and antiseptics he never would have got that infection, and we could have saved him. Let’s try to forget it with some liquor at the bar.” ??

  4. “I think that the government could let AIG fail, if – and this is a big if – it can first identify which creditors and counterparties would be hurt, determine which of those cannot be allowed to fail (which should not be all of them), design a program to provide them enough capital directly, and announce everything on the same day. The net cost to the taxpayer cannot be higher than under the Too Big To Fail strategy, which implies a 100% guarantee for all counterparties and creditors.”

    The above would be impossible to know in days of time with the level of book-keeping that is presently being used by banks. However, if the book-keeping used in complex industries before computers, 50 years ago, had been properly programmed into computers it would be simple to know.

    The irony is that if the Industrial model of book-keeping had been computerized, Lehman and the rest would never have gotten into the position they put themselves in in the first place. Today’s meltdown is a book-keeping software issue, pure and simple. And our society of cultures will remain in a stressful state until the proper book-keeping is restored to its historical standard.

    There is no other language to control the fairness of commercial trade.

  5. Any such plan is an “event of default” under ISDA derivative contracts and will result in the seizure of collateral posted to counterparties. This is why the regulators want front door resolution authority.

  6. The suggested solution only pushes TBTF off one degree. How is this productive? Goldman, surely, with all it’s alumni in government, would still be considered TBTF, even though it should have failed due to its bad bets with AIG (bad allocation of capital is *the definition* of a bad bank.)

    Now, why was the Contract Clause included in the U.S. Constitution?

    Because Hamilton (of whom I am not an unqualified fan) and others recognized that enforceable contracts are crucial to guarantee the open flow of funds and capital, without concern of government meddling or private malfeasance.

    Further, let us consider the 14th amendment:

    “nor deny to any person within its jurisdiction the equal protection of the laws.”

    Are TBTF to be granted special “private relief” under the laws? Well, they already have, so I guess I should rephrase: are TBTF going to continue to be granted private relief under the laws?

    The expectation that this is so certainly would explain the capital inflows into the surviving investment banks. If every counterpart to my trade were backed by the full faith and credit of the U.S. government… Hell, even *I* could make money in the derivatives market.

    The government is now deciding who capital should be allocated to, both in its spending and in who it declares TBTF. Necessarily, the government is allocating capital to the actors that help preserve the current politicians in the government: the bankers and various special interest groups. It is only by chance, and a rare one at that, that the capital is allocated efficiently to a useful activity. Consider the first time home buyer tax credit: this drives up the prices of entry level homes, sending a signal to home builders to build more homes which, in turn, keeps more people in the home construction business than is necessary (we have far to many homes as it is.) So we are perpetuating the distortion of the home market, and putting of the retraining desperately needed for construction workers and others currently misallocated to the production of homes. But only for a bit. Just like with cash-for-clunkers, new home demand will collapse once the program ends, and everyone will wonder what happened.

    If the system is so fragile, maybe we need a new system. One based on, say, the actual long run production of capital and consumer goods, rather than the trading of mathematical baseball cards.

    Cheers,
    Carson Gross

  7. Cheers Carson – totally agree with you in this:

    “If the system is so fragile, maybe we need a new system. One based on, say, the actual long run production of capital and consumer goods, rather than the trading of mathematical baseball cards.”

  8. Sounds like returning to an old system to me.

  9. Carson Gross: “we have far too many homes as it is.”

    Really? Why do you say that? I do want to know.

    Do you also think that we have far too many homeless?

    If so, how do you reconcile those two beliefs?

    Many thanks. :)

  10. Btw… this boat is not registered in the United States. How come? Is Paul Allen an american citizen? Is there some benefit to registering it somewhere else?

  11. Not the most timely or direct numbers, but back in April of 08 there were 18.6 Million vacant “homes,” of which 2.3 million were for sale, and 4.1 million were for rent.

    http://www.marketwatch.com/story/record-number-of-homes-sitting-vacant-us-says

    “Annual homeless prevalence was estimated at between 1.58 million (based on October/November four-week count) to 3.49 million (based on February seven day count).[8] Most, though not all, advocates use the higher estimate of over 3 million, especially since homelessness is thought to have risen since 1996″

    http://en.wikipedia.org/wiki/Homelessness_in_the_United_States

    Their definition of homelessness is limited to those that don’t have adequate night-time housing, so a more liberal definition would have much higher numbers.

    Don’t know if the vacant homes include 2nd homes, and doubt if it includes vacancies in multi-unit buildings.

    Any way you slice it, though, more than enough existing housing to go around.

  12. Carson Gross

    Shhhh, that’s my trick: I call late 19th century capitalism “a new system” so that people don’t realize how revanchist I am. :)

    Cheers,
    Carson