Last week I had a chance to interview Garett Jones, a professor of economics at George Mason University and the BB&T Professor for the Study of Capitalism at the Mercatus Center, on the pending financial regulation reform bills and the recent financial crisis.
Earlier this year Jones wrote a paper, published by Mercatus, that proposed an alternative to bailouts and the financial regulation bills for dealing with troubled banks: speed bankruptcy. The simplified idea behind speed bankruptcies is that failing banks would be subjected to procedures very similar to Chapter 11 bankruptcies, with shareholders getting wiped out and bondholders becoming the new shareholders. What would make these bankruptcies "speedy" is that the terms for this procedure would be written into the banks' bonds, meaning that during a crisis the bonds would automatically convert to equity stakes in the bank once regulators decided that the bank had failed. The goal of such convertible bonds would be to remove uncertainty about regulators' decision-making and prevent discretionary bailouts, and also to recapitalize endangered banks.
I asked Dr. Jones about the fallout from the bailouts of 2008, how to prevent bailouts in future financial crises, and the possibility of speed bankruptcies as an alternative to the current regulatory reform legislation's "resolution authority" that would give federal regulators the ability to take over and wind down financial institutions in crises.
We now have financial regulation reform bills from the House and Senate. What are your general thoughts on the reform legislation?
I have to say, the resolution authority in the bill is not the worst thing I can imagine. I'm so used to politicians doing the worst thing I can imagine that this is a pleasant surprise. They're getting about a third of what I think would make up a sound anti-bailout policy. They certainly have taken some steps in the right direction.
How well does this bill address the problem of banks being regarded as too big to fail?
I think the bill moderately reduces the problem of too big to fail. It doesn't totally reduce the problem. Let me start off with what I think is the best part first.
The best part is the "funeral planning" provision that they've required in the bill -- every few months, every big financial institution in the country is going to have to show the government its plans for how to dismantle it in the event of a financial crisis. So it's a little bit like the bomb maker saying "here's how to diffuse my bomb." It's a little bit like BP saying, "If we build this platform, and there's a catastrophic collapse, here's how we'll cap the well." Because banks are going to have to make these plans, and present them during nice calm economic times, I think that the government regulators will actually probably be willing to really say no to the banks, and say, "No, this isn't a good enough plan. We'll give you six months or a year to fix it, but if you haven't given us a real plan for how to dismantle you if you go bankrupt, then we're going to force you to shrink. We're going to force you to sell off the weirdest, most difficult to bankrupt parts of your firm."
During a crisis, everyone's in favor of a bailout. No matter what they say verbally, they're still going to walk down to the floor of the Senate or the House and vote for a bailout. But during periods of calm we might be able to structure the big financial institutions so that we'll have a better shot at preventing them from becoming un-bankruptable. So I think that's a key strength of the plan.
Right now firms don't have to do this at all. They can just do whatever they want to and they can create a web of financial networks that are so complicated that voters, regulators, and politicians are all terrified of the prospect of sending these firms to a bankruptcy judge, or the FDIC. I think that making plans during a period of calm is a little bit like making the plans for a house -- planning the fire sprinklers or the fire escapes during a nice calm time rather than deciding in the middle of the fire, "OK, here's how we're going to get people out of the building."
If banks make funeral plans in advance, does that make regulators at the Fed or one of the proposed new agencies redundant? Or do they still have discretion over whether banks get bailed out?
That's a huge problem. The question is, they can spend a lot of time creating these plans, but when the crisis hits will they cave, will they get weak in the knees like Paulson and Bush did?
That's really the big question. That's why I think there have to be five or six different ways built into our political system to make sure we don't dive back into bailouts. The funeral planning is one. I think the rest is a lot weaker... much, much weaker.
There is this resolution authority in the bill, which basically says that the government will have the authority to take over a big financial institution just as the FDIC does now, and in a way just as a bankruptcy judge takes over a firm when it goes bankrupt. So they'll have that authority -- the question is will they use it or will they get scared again like they did last time?
Personally, I think there's nothing in that resolution authority that couldn't have been hammered out in the two weeks it took to write the TARP. I don't think it was outdated bank regulations that was keeping us from letting Citigroup fail. The absence of a resolution authority was not the big deal.
Yes, sure the resolution authority gives them the power to take banks over and sell off bits and pieces, and it gives the government the power to borrow some money on good collateral to keep the company running for a few weeks. So maybe that's enough of a safety blanket to allow the government to say, "OK, we'll resolve a failing bank next time. We caved last time but maybe we'll do it this time."
I just can't tell. This really is about predicting what people are going to do when the next crisis hits. It's ultimately going to be voter rage that prevents us from having another bailout, not some piece of legislation.
Does that mean that, for instance, it was a waste of time to have that recent heated debate in the Senate over whether the resolution authority should get $50 billion in funding up front from the banks, with Republicans calling it a "permanent bailout" and Democrats defending it? Was that a meaningful argument?
Not really. No, I think that was a lot of sound and fury. Fifty billion dollars was a nice big round number that Republicans could get mad at. I can't imagine it really rattled financial markets that much to learn that they weren't going to have the $50 billion supposed slush fund to play around with, because the government will have unlimited authority to borrow as long as they can say they're using the banks' good assets as collateral.
For an example, Citigroup right now, I'm guessing, has at least a trillion dollars in assets that a judge would say was good collateral. Half of Citigroup probably looks OK on paper. Fifty billion dollars is only one-twentieth of that. Clearly there's plenty of authority for government borrowing built into the current resolution authority. As it would have to be! The government would have to hold Citi for a week while it dismantled it. It's got to have the authority to go and do some borrowing, even if just for a week.
The real question is whether we are building a system where, after a couple of days or maybe a couple of weeks, we've decided that the bondholders, the people that have actually lent money to the bank, are going to lose money. What we've done instead is created a world where every single big bank in the country is Fannie Mae and Freddie Mac. Nobody's writing it on paper, nobody's saying in public that these bonds are guaranteed by the government, but everybody knows deep down that they really are.
If you're a big financial institution you know you're too big to fail. You know you're basically like Fannie and Freddie in that you can issue debt that is not openly, but implicitly guaranteed by the government. Just like Greek debt is implicitly guaranteed by the French and German governments right now.
If the current Senate bill had been law in September of 2008, would things have shaken out differently?
No, I think that regulators would have been terrified and would have said, "We can't let anybody lose money here." They would have said, "A lot of Citigroup's bonds are owned by Chase. A lot of Chase's bonds are owned by Bank of America. A lot of Bank of America's loans are owned by Wells Fargo. They're all connected." They would have said, "We can't cancel any of these debts. We can't tell any of these people they're not going to get their money paid because the whole structure might come down."
I think that claim is wrong, and I think it's a fear that makes them unwilling to use anything that looks like normal bankruptcy. They feel like everybody who's dived into the firms so far needs to get everything back, or else the whole system might collapse. That's really what they're afraid of. They're afraid that if anybody loses, if anyone out there gets repaid only 80 cents or 90 cents on the dollar, that the whole economic system could collapse. They're really afraid of someone out there losing a dime or a nickel on the dollar. They're going to find one way or another to tell the American people that we're going to have bailouts again.
We saw this happen with the money market funds. One fund in September of 2008 broke the buck. Reserve Primary Fund said, "Oh, we only have enough to repay our depositors 98, 99 cents on the dollar, we're sorry." And all of a sudden the feds came in and guaranteed them. Losing 5 cents on the dollar -- that was enough to make the entire financial world panic. This is after stocks had declined 20 percent. People really do feel differently about bonds and bank deposits than they do about stocks. Politicians just don't seem willing to embrace bankruptcy on a wide scale.
Has that always been the case? Or was it a product of insufficient regulation regarding bailouts during the Bush years?
I think it's a pattern. Bailouts for massive firms are a grand American tradition. Usually they're only involved in politically connected fields. Or, they're banks. Citi had a backdoor bailout during the Latin American financial crisis. Many Wall Street firms got bailed out during the Long Term Capital Management Crisis. And then, Bear Stearns got bailed out in the spring of 2008. We saw this pattern of bailouts. We would need something pretty big to break that pattern, I think.
Basically, when the next crisis comes around, a little law on the books isn't going to be enough to prevent a panicked Congress from either passing their own law or going to the Fed and saying, "Please buy up shares or bonds, or whatever, from distressed firms." So this is really a political commitment problem. This is really a problem of getting politicians to make a commitment and to keep a promise. That's pretty hard to do.
One argument we've heard often recently is that the financial crisis was at least in part caused by the emergence of a "shadow banking" sector that went completely unregulated. Was the problem really a political commitment problem, or was it a problem of an outdated regulatory system?
I think the fact that we had a lot of new financial regulation is part of the reason we got ourselves into a bubble. I think [Yale economist Robert] Shiller is right when he says that whenever a new era comes along people think that the laws of economics have been repealed. He's right that financial innovation caused this optimism and this euphoria, which means we were a lot more likely to get some kind of a bubble. We saw that with the Internet -- the Nasdaq is still nowhere near back to where it was during the tech bubble years -- and we saw it happen with mortgage lending. People thought that high-tech finance and computer models could guarantee that nobody would ever lose money on a mortgage again. I think that Shiller is right that you're more likely to get into a wave of optimism as a result of these new era innovations. But the questions is, does that make things any harder to wind down at the end? And there, I don't think so.
The current crisis really is just a good, old-fashioned collapsing bubble. What happened fundamentally in the financial crisis is that home prices went up, so households and banks borrowed a lot of money based on that fact -- that home prices were high and they thought that there was very little chance that they'd ever go down. Both households and banks got in trouble when home prices actually fell.
I think that all this talk, about credit default swaps, derivatives, and the shadow banking sector, is just a diversion from that simple fact. We had a bubble with a lot of debt underneath it, and once it turned out that homes weren't worth nearly as much as we thought, then all of a sudden that meant that homeowners were upside down and they owed way too much on their mortgages. And banks were upside down and their own firms, owing way too much. So households and banks were in the same boat.
It's a very simple story, and I think everything else -- the Fed's low interest rates, Fannie and Freddie's easy lending to the poor -- made it more likely for something bad to happen, but once it happened it was a good old-fashioned debt bubble that burst. And we've got a lot of people who aren't going to get as much money as they thought they were going to get, and the question is who is going to get less now.
In a normal bankruptcy regime, it's the debt holders who get less. The people who have a Citi bond would be told, "Oh, your 10 grand bond will only be repaid at seven grand." Instead, the person who's going to get less now is the American taxpayer. They're having to chip in to bail out Fannie, Freddie, AIG, and all the rest. They're the ones who end up paying the bill.
So how do you prevent regulators from failing? How does speed bankruptcy address that problem?
This idea that's been around for a long time in free market circles, of subordinated debt, is really part of the solution. Another name this goes by is convertible debt. It's debt that, when some event happens, automatically turns into shares. The idea is to put all of this on autopilot, so when a crisis hits there's no politician who has to vote on turning bonds into shares, there's no regulator who has to make this decision. It all happens on its own.
It would work like this: major financial institutions would be forced to issue 10 or 20 percent of their value, 10 or 20 percent of their liabilities, in the form of debt-to-equity convertibles. They would be bonds that, when share prices fall by a certain amount, or perhaps when lending markets seize up, or some objective criteria are met, it would be written into the bond itself, as a matter of law, that these bonds automatically convert into shares. The reason that helps firms, then, is that the bank knows when a crisis hits, and it's really hard to get their hands on a lot of money, at the very least they won't have to be making all these doggone interest payments anymore. Their interest payments will be cut way, way back when a crisis hits. And that's one of the huge problems for firms in financial crises - they don't have enough profits, so they can't finance anything.
I like to call these "crisis convertibles." They're usually called contingent convertibles-Cocos. When the crisis hits, at the very moment the bank wishes it could get its hands on some easy cash flow, it has it. There are a lot of ways you could set up the triggers, I don't know if you want to hear about that. But the basic principle is, I think, a sound one from the point of view of economics and the point of view of law.
What makes it good economics is that politicians are committing in advance, just with the funeral plans, that when the crisis hits, someday -- who knows when that day will be -- that's the day that the bank will be able to get out of its debt commitments without a bunch of attorneys getting involved.
And what makes it good law is that it's known in advance, so it's taken out of the hands of judges and politicians. The TARP is a classic example of "legislate in haste, repent at leisure." I hope our national repentence causes a real change of heart, and requiring banks to issue crisis convertibles would be a good step on the road to recovery.
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