Zingales and Hart in the Mainstream - The American Spectator | USA News and Politics
Zingales and Hart in the Mainstream
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…Or at least in the minority of the mainstream. The Weekly Standard‘s Matthew Continetti flags this clip of Paul Ryan discussing the Dodd financial regulation reform bill, in which Ryan invokes the economists Luigi Zingales and Oliver Hart. Zingales and Hart wrote an essay for the new conservative quarterly National Affairs describing a reform approach that would involve market-based triggers for winding down financial firms, instead of regulators’ discretion. 

The idea behind Zingales-Hart is that the credit default swap (CDS) price on a specific kind of debt for financial institutions could serve as an indicator of the firm’s viability. CDSs are a kind of insurance sold on a company’s debt, so the market price of a CDS is determined by the risk that the firm will default on its credit. In the Zingales-Hart framework, when a firm’s CDS price exceeded a certain high level (they say 100 basis points), regulators would perform stress tests on the firm and take it into receivership if necessary, to be folded up in an orderly fashion.

The benefit of this approach would be that the market trigger would remove uncertainty about regulators from the financial markets. In the current financial crisis, a large measure of the uncertainty in the markets was caused by the fact that market actors didn’t know, for instance, what the government intended to do with Lehman Bros. Without the uncertainty regarding discretionary bailouts looming in the background, markets would process events much quicker. 

The liberal financial blogger Mike Konczal notes a problem with this strategy for people who, as he does, believe that market prices don’t reflect all available information, including for CDSs. 

So according to markit commentary, Goldman’s CDS hit at peak at 140bps, and currently is closing around 125 bps, 35 bps wider from yesterday.

So, should we begin resolution powers against Goldman? Forcing it to issue equity out of debt? Hart/Zingales says we should initiate a stress test, but could you even imagine how much of a political nightmare that would be right now with SEC investigations ongoing?

And here’s the question: let’s say there would probably be a mean reversion back to the previous CDS number without resolution authority. But in this new world, who would bring it down to 99bps knowing that at 100bps everything changes? Remember at 100bps you’ve initiating something that has a reasonable chance of death spiraling into a big payout.

This is a valid concern. Furthermore, what is the risk of financial firms manipulating these prices? If your competitor faces a stress test at 100 bps, wouldn’t you be tempted to try and stealthily bid up the price? 

Here’s how I think Zingales and Hart would answer these concerns. First, they directly addressed problems like the current one involving Goldman’s CDSs: 

A potential risk of this proposal is that the news that a regulator is performing a stress test on a bank might scare off the short-term creditors and induce a run on the bank. This problem can easily be fixed by having the regulator temporarily guarantee the bank’s senior debt for the brief period of the stress test itself. With our early-warning system and double layer of protection, the systemic obligations (which in our mechanism are all “senior” debt) will essentially always be paid. So the government is not assuming real risk; it is only defusing the risk of a run. This guarantee can then be lifted when the bank is deemed well capitalized (and more junior debt is issued) or, if the bank is put into receivership, when it emerges from receivership. 

Second, they could just set the trigger higher than 100 bps, which was a number they chose arbitrarily. In their essay, they provided a chart of CDS rates that helped lead them to the conclusion that 100 bps would be a good benchmark. 

As they write,

As the table makes clear, the market early on singled out Washington Mutual and Bear Stearns as the two most problematic institutions. In fact, if one had to predict in August 2007 the five institutions that would go under first on the basis of their CDS rates, one would be correct in four out of five cases. 

And that looks like a fairly robust measure. 200, or even 400 bps would probably have worked just as well to alert regulators.

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