Felix Salmon

Putting insolvent banks back on their feet

By Felix Salmon
September 24, 2009

Paul Volcker, in his testimony today, talks at some length about the necessity that the government has a new form of resolution authority:

I also believe an approach proposed by the Administration and others should be supported. The basic concept is to provide a new “resolution regime” for insolvent or failing non-bank institutions of potential systemic importance.

The problem here is the “non-bank” part of Volcker’s proposal. Since he explicitly excludes “banking and insurance organizations already subject to substantial official regulation”, it’s not obvious how many companies would be covered by this proposal — GE? Citadel? One or two others, tops?

The real question, which Volcker ducks in his testimony, is the government’s willingness and ability to use its existing regulatory powers to force some kind of debt-for-equity conversion at banks. You can’t use the bankruptcy regime for this, because banks can’t declare bankruptcy without failing: as Jesse Eisinger pointed out to me in an IM conversation, bankruptcy is cashflow positive for most companies, but it’s cashflow negative for a bank.

It would have been great if the government could simply have forced some kind of debt-for-equity conversion at Citi and Lehman and AIG, perhaps combined with some kind of governmental liquidity support. Yes, there would have been a nasty ding to the credit markets, especially since many bondholders aren’t allowed to hold equity. But the financial system would have been put on a much more sustainable footing going forwards, and the choas of Lehman’s bankruptcy might well have been avoided.

So yes, I’m all in favor of a new resolution regime. But let’s get serious about applying it to banks before worrying about whether we should apply it to a handful of systemically-important non-banks as well.

(Related: John Gapper on the Volcker testimony. Recommended.)

3 comments so far | RSS Comments RSS

If you start requiring bonuses to be paid in locked-up subordinated debt, when you force a debt-to-equity conversion, you could at the same time reconstitute what was a publicly-traded corporation back into a partnership. If it’s going to be owned by the employees anyway.


“It would have been great if the government could simply have forced some kind of debt-for-equity conversion at Citi and Lehman and AIG, perhaps combined with some kind of governmental liquidity support.”

As I understand it, a lot of the buyers of bank debt were mutual funds. Forcing them into debt-for-equity swaps would simply have caused a lot of funds to break the buck, forcing the government to pay up the difference or face an uncontrollable run on mutual funds. I’d love to be wrong about this, but if I’m not, it looks like a big source of instability in the market (as others – including you? – have already pointed out) were the mutual funds – systemically important, lending to risky institutions rather than to the government for the slight pick-up in yield. If we’re going to reform the financial system, we must start with the mutual funds.

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I believe the chaos of Lehman’s bankruptcy resulted primarily from the fact that Paulson changed horses mid-stream. He bailed out Bear – he bailed out Fanny and Freddie – then apparently his concerns for being known as “Mr. Bailout” forced him to let Lehman head into the current of chaos on its own.

And it failed.

And every financial institution then knew that Lehman’s fate would be their own without a federal bailout. They were all teetering on a foundation built sky-high on leverage.

So panic ensued.

Now it appears we’re doing everything in our power to create a regulatory framework that will have no teeth, no power and nothing much to regulate, after all the exclusions are considered. What we’ll end up with is a financial sector riddled with moral hazard, but acting with the same propensity for risk as before – because they know the feds will be there to pick up the tab for their failure…. TBTF is even bigger today than one year ago.


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