As I listened to Paul Volcker's testimony before a Senate committee earlier this week, I found myself rather incredulous that he believed some special, additional 'resolution authority' would be able to prevent sudden failures of financial service companies.
I saw this again yesterday morning, as Senator Bob Corker, R-Tenn, reiterated Volcker's belief that, no matter what else the Senate does, they'll create some new entity to put 'banks which are near failing' into some sort of regulatory limbo, to avoid systemic repercussions.
As I discussed this topic yesterday with a colleague, I asked whether he saw things as I did.
To wit, consider Bear Stearns. When Bear went out of business, its financial condition deteriorated in a matter of only days. And the worse the rumors became, the more counterparties began pulling their business. Add to this the fact that modern investment banks are primarily funded with short-term borrowed money from broker dealer desks at commercial banks, and you have situations in which a company can become insolvent literally overnight.
Forget, for a moment, for argument's sake, the fact that Morgan Stanley and Goldman Sachs are now, technically, commercial banks with access to the Fed window.
In markets as far back as 1998, when Long Term Capital Management failed, here is how non-commercial banks become insolvent.
A broker or investment bank takes positions in securities. The positions may be on a trading desk, or they may be, as was the case with First Boston some 20 years ago, underwritten debt from a funding transaction on behalf of a client, e.g., Ohio Mattress.
Suddenly, the securities begin to lose value. A lot of value. Marked-to-market values plummet, destroying the firm's equity deployed to the desk at breakneck speed. Since the firm is highly-leveraged, its counterparties react by either requiring more collateral on losing positions funded with their money, or, if a general lender, perhaps cutting credit lines.
As word begins to circulate, within hours, of the firms' losses and emerging credit pressures, counterparties shun the firm, and clients remove money from accounts with them, so as to not risk its being tied up in a bankruptcy.
Perhaps only a day later, as assets drain from the firm's balance sheet, and trading volumes shrink, the firm's positions, after the 4PM market close, show that it cannot settle all of its trades, because it has lost credit lines, has too little cash to honor its commitments, and cannot quickly borrow enough to fund them.
For any 'resolution authority' to be credible and effective, it would have to have a representative on site, at the firm, observing the insolvency as of the 4PM markets close.
Seeing the inability of the firm to settle its trades and, with resulting trading and other asset values, post a positive equity value by the market open on the following morning, the authority would have to call a halt to all financial flows from the firm, and declare it failed.
That's effectively what happened to Bear, and Lehman. When the end comes, it can be a matter of hours. But notice that only 24 hours earlier, the firm wasn't insolvent. So shutting it would have probably been an illegal government taking of private property.
If what is being suggested is having regulators on site at each major, and perhaps even minor/boutique financial service firm, that can already be done with Fed, FDIC and OTC regulators. It's not a matter of requiring a new resolution authority, but, rather, acknowledging the context in which such closures would have to occur.
Regulators would have to be viewing the firm's books, current financial and trading positions in near-real time.
As I listened to Volcker and Corker, I heard, instead, a sort of semi-languid tone suggesting that someone from Washington would board a plane to visit the troubled firm and see what was going on.
In the real world, there's just not that much time. The unremarked upon reactions of trading counterparties to ailing and failing institutions is what seems to be unacknowledged by legislators and regulators.
There's a fine line between government seizure, without basis, of an about-to-fail institution, and the closure of an insolvent one. But if the government sends clear signals that no financial institutions that fails will, beyond deposit insurance, be assisted in any way, you can rest assured that counterparties will look after their own risks.
The Constitution specifies bankruptcy for failed firms. For some reason, regulators no longer wish to use that option.
As my colleague and I discussed this topic, we wondered why so many people believe that Lehman's failure could have destroyed the US and, possibly, global financial system.
What if, instead of everyone's worst fears, Lehman's regulator simply stepped in and declared it bankrupt, froze its assets, appointed a trustee, and, like Drexel Burnham Lambert years ago, went about the long and complex task of sorting it all out under court protection?
Or Bear Stearns? Rather than let Chase steal the firm, first for about $2/share, then, grudgingly, about $11/share, how about simply letting a bankruptcy trustee and court freeze the firm's assets and begin to settle its liabilities? If there were value remaining at the end, it could be auctioned to the highest bidder.
Not some large bank which extracted a government loss-protection guarantee as it paid a lowest-possible bid to 'rescue' the firm.
It all boils down to expectations. If market participants believe that a failing financial services firm will be allowed to do so, and enter bankruptcy proceedings, then they will take appropriate steps to limit their exposure.
If, however, government officials run around wringing their hands and declaring each possible failure to put the nation's financial system at risk, then market participants will behave differently.
The most effective, disciplined, and efficient method of removing systemic risk from individual financial service firm failures, regardless of their size and nature, is for government to warn market participants that conventional bankruptcy will be the only option, and action, for failed companies.
No government intervention prior to that event. No quick sweetheart sales to large competitors. No stripping off and selling of choice business units. No emergency loans from the Fed.
Nothing.
Do that, and watch how the system's players move to protect themselves from any systemic catastrophes in the future.
Subscribe to:
Post Comments (Atom)
No comments:
Post a Comment