My chat with Nicole Gelinas, part one

January 14, 2010

I recent sent a few email questions to Nicole Gelinas, author of the phenomenal must-read, must-own  After the Fall: Saving Capitalism from Wall Street and Washington.  Her answers were so thorough and valuable that I could not bring myself to cut them much. So I am running a question or two a day for the next several days. Enjoy!

What do you think about the Obama approach to financial reform as displayed in the House version of the bill, starting with Too Big To Fail?

If you look at the House bill, it has hundreds of pages on how to wind down a failing financial firm in a consistent, orderly fashion, which seems great. But then, there’s a section that negates it all. That section says that the FDIC, which would be responsible for winding down failed financing firms, could, with the Treasury Secretary’s approval, “make additional payments” to “any claimant or category of claimants of a [failed] financial company if the [FDIC] determines that such payments … are necessary or appropriate to … prevent or mitigate serious adverse effects to financial stability or the United States economy.”

In effect, then, the bill would enshrine into law for the future all of the random things that Washington done over the past two years, from the government-engineered Bear, Stearns rescue to the AIG bailout.

Why does that matter?  We got into this mess because of “too big to fail.” A quarter-century ago, the nation got its first “too-big-to-fail” bank: Continental Illinois of Chicago. The Reagan administration stepped in to guarantee all of its creditors, not just FDIC-insured depositors. The comptroller of the currency went before Congress and said that Washington would never let any of the biggest 11 banks in the nation go under (engendering jokes about which bank was twelfth).

It was a straight line from there to here. When Washington subsidizes something, it gets more of it. Washington subsidized financial-industry debt with this implicit government guarantee, and it got more financial-industry debt. Smaller banks and investment firms had to compete on an unfair playing field — spurring them to take more and more risks.

It’s popular to say that the credit crisis was a failure of free markets. But it’s really an object lesson in the government’s power to distort a fundamental element of the economy without anyone noticing!

What about dealing with systemic risk?

In their desire to create a “systemic risk regulator,” they’re confusing “systemic” with “omniscient.” In Washington’s view, the crisis occurred partly because regulators weren’t smart enough and didn’t have enough discretion to act across markets when they did see potential problems. As Fed chairman Ben Bernanke said last week, we need “better, smarter” regulation.  But in reality, regulators thought that they were too smart – impossibly smart. In America and abroad, they thought that they could determine in advance which kinds of debt securities and derivatives instruments would be perfectly safe, and which were dangerously risky.

They enforced wildly disparate borrowing limits (capital requirements) for different securities based on those predictions. Regulators’ determination that triple-A-rated mortgage-related securities were as safe as Treasury bonds, for example, left the entire economy vulnerable to an error by a few people: government officials and ratings analysts.

What about discretion? In 2000, the Federal Reserve counseled Congress forever to take away regulators’ discretion to enforce borrowing limits and trading rules on financial instruments such as credit-default swaps. They had it – they surrendered it.

The most dangerous “systemic risk” is the one we don’t see. Washington can best protect the economy by setting consistent borrowing limits. Regulators can acknowledge in the debt markets, for example, that they don’t know whether a mortgage bond will perform better over 30 years than a bond that backs a power plant’s construction.

Bottom-up rules to assess risk, not a top-down systemic risk regulator, are how to end “too big to fail.” AIG couldn’t fail because the credit-default swaps that it held were exempt from consistent borrowing limits, trading rules, and disclosure requirements. So when it teetered, nobody knew where the risk lay. Bailouts became inevitable because of the panic that this opacity helped cause.

But Washington likes top-down solutions. So we’re on track to get regulators who will try harder to do the impossible. And lenders to financial firms will fail to enforce market discipline, because they know that the firms are still too big to fail.

On the plus side, I liked much of Treasury Secretary Tim Geithner’s proposal to bring unregulated derivatives onto exchanges and clearinghouses – again, look at AIG. But Congress has shot it through with loopholes.


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Again, this country is faced with a crisis, and we turn to the least knowledgable people, in our midst,to construct a solution = the Congressional know-nothings. We wonder why, every ten years, we’re looking back wondering what the hell that Congress of ten years ago was thinking – e.g. does the Alternative Minimum Tax ring a bell; how about the endless list of stupidity and unintended consequences by the management of Fanny Mae and Freddy Mac? One of these days we’ll learn to find a way to force them to focus on a problem and fix it, without allowing it to be bastardized by countless uninformed amendments that end up exaccerbating the problem rather than fixing it. Ten years from now we will rue the day we let this Congress do what it is doing, and the sad reality is, we’ll deserve everything we get.

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