Reorganization vs. liquidation
Kevin Drum and James Surowiecki both take Richard Shelby to task for advocating “closing down” banks.”I don’t want to nationalize them; I think we need to close them,” said the Alabama senator. He wants to “bury some big ones.”
For the record, I agree. I think that both Surowiecki and Drum are not being fair to the good Senator. Here’s Surowiecki:
[I]t seems clear that what he’s advocating is liquidating these troubled banks—shutting them down, paying off the depositors via the FDIC or selling them to another bank (though it’s hard to imagine any other bank coming up with the money right now), and then selling off the assets piecemeal, with the proceeds going to pay off as much of the banks’ debts as possible. In this scenario, the banks’ shareholders would obviously get wiped out, and its creditors would also be forced to take a massive haircut. In effect, he’s recommending something like a more orderly version of the Lehman Brothers bankruptcy.
I don’t think that’s clear at all. The question of whether creditors other than insured depositors are paid off by the government is entirely distinct from the question of whether a bank in receivership should be managed as a going concern or liquidated. There’s little dispute that under any nationalization scenario, some or all uninsured creditors would have their claims guaranteed by the state. Whether or not to impose haircuts on junior claimants is a tough call, trading off moral hazard and justice against systemic stability concerns. But even saber-rattling moral-hazard fetishists like me acknowledge that we can’t force all creditors of broken monsterbanks to take the losses or debt-to-equity cramdowns they deserve. Sometimes you have to swallow and pay the ransom. But you don’t have to be nice about it.
Citi, for example, is a recidivist source of systemic risk (not to mention other corrupt dealings). Three times in three decades it has been on the verge of insolvency and required forbearance. Two of those three times, rather than being chastened, it became a turnaround story someone could gloat about. That shouldn’t happen a third time. Citi should be closed and liquidated. The bank should suffer the equivalent of corporate capital punishment, pour encourager les autres. Three strikes.
That doesn’t imply that creditors necessarily takes a loss. It doesn’t imply that all of its operating assets get sold for scrap, or even that all of its employees get fired. It does imply, first and foremost, that the brand goes away, that Citi, like Continental Illinois, becomes a historical cautionary tale rather than a gigantic but still scrappy comeback kid one more time. Secondly, the pieces in which its assets are sold must be small relative to the buyers, so that successor bits are put under the control of larger firms rather than representing mergers of near equals. Corporate culture matters, and some corporate cultures don’t deserve to survive.
Surowiecki has argued on a number of occasions that moral hazard concerns are overstated, that punishing banks usually fails to punish the agents who run banks, and the costs of being punitive outweigh any possible benefit. It’s worth pointing out that there are two sorts of villains: governments and creditors who make available funds without supervision, and the bank employees who steal and squander that money. I agree, unfortunately, that we can’t be as punitive towards creditors as some of us would like to be. But we can deal more roughly with the people who run large banks aground. We have banking crises about once a decade. Each time, it is the same story: mistakes were made but lessons have been learned. Obviously, the bankers say, we would never do this again. Just as obviously they always do. They play the same basic game in subtly different ways.
In a different post, Drum points out that
The fact is that these people did what they did not because they’re stupid, but because the system practically begged them to act the way they did. That’s what’s broken.
That’s true, but it’s not exculpatory, and it isn’t anything new. Subprime loans and CDOs are just a new twist on traditional real-estate booms. European banks are reliving our Latin American debt crisis in Eastern Europe, just hypercharged. This is a nightmare that comes at us over and over and over again. Each time we’ve paid the ransom and shrugged it off.
Drum is right when he argues
[Fi]xing it depends mostly on what kind of new financial regulations we put in place going forward. I guess we’re still in firefighting mode and don’t have time to address that right at the moment, but I’d sure like to start hearing more about it sometime soon. In the long run, figuring out an effective way to regulate leverage, wherever and however it appears, is probably a lot more important than deciding which bureaucratic solution we should use to clean up the corpses currently littering the battlefield.
But you know what? Once the fire is out, the very powerful people who still run the show both on Wall Street and at Treasury, despite having misdirected and skimmed trillions of dollars, will resist structural change. I hope that we do the right thing, and quite sever the guaranteed deposit and payments function of banking from the business of taking investment risk that oughtn’t be guaranteed. That would eliminate the root of the problem, the incentive to take ever greater risks with funds supplied on risk-free terms. But getting rid of a huge subsidy to a well connected constituency is likely to prove difficult. If the structural changes don’t happen, I’d at least like to see a few of the architects of this mess disgraced, and the empires they built turned to dust. It won’t solve the problem, but it might buy us a decade or two. It’d be much better to create institutions whose incentives are aligned with the public interest. But if we can’t do that, we can at least counterbalance temptation with punishment. Neurotic banks are better than pathological banks. Consider it a kind of insurance.
If Drum is right that…
when it’s over, guess what? Pretty much all the same people will be in charge. A few senior executives will be out of jobs, but that’s about it. And the ones who replace them won’t be much different.
…then God help us. There is no amount of money we can throw at a banking system that can’t be “tunneled” or “looted” away. If we end up with similiar people, with a similar worldview and culture running broadly similar institutions, it won’t be long before the nightmare on Wall Street is back. No wonder Citi never sleeps.
We can pay off the creditors of these behemoths, because, by design, we really have no choice. But there’s no reason not to cut ’em up and shut ’em down after we do so. Let’s bury ’em, Senator Shelby.
I would agree with Warren Buffet that retribution is not the right priority at this time.
March 9th, 2009 at 8:57 pm PDT
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it seems that the ultimate strategy is going to be to punish money ie cause inflation
March 9th, 2009 at 9:48 pm PDT
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I’m not so sure that there shouldn’t be some forced debt-to-equity conversion for the bond-holders, with the equity going to support the “bad bank”. The only issue here is who will get wiped out in terms of causing further systemic damage, which would require further government/taxpayer bail-outs, (i.e. pension and insurance funds, as well as other banks). In that respect, rather than sparing bonds, which after all are risk capital, further supports, guarantees, and forbearances might be extended to those entities who might be hurt, but nonetheless involve essential functions and must be maintained systemically. But “capital markets” in general should not be given blanket guarantees, even if it means that solvent banks would have difficulty with further bond offerings and might require temporary government loans or guarantees. The fantasy that private capital will come to the rescue and save-the-day for hapless government officialdom will have to be foregone, together with the fantasy that this will be over soon and government take-overs will be quickly and readily privatized. It’s rather a matter of maintaining the functional workings of a financial system, while the whole financial system and its regulation is rethought, restructured (in terms of practices such as securitizations and derivatives), reconfigured (both in terms of the size of allowable institutions and in terms of regulatory agencies), and the whole financial sector DOWNSIZED, (partly by raising capital ratios permanently and tightening risk-weighting criteria, while rendering both countercyclical by automatically raising
/tightening them during booms, all of which would reduce profitability on banking capital and thus reduce “temptation”). Hopefully, there are secret teams of G-men in sealed basements trying to figure out the incidence and effects of bank bond-holdings. But this would be a 3 to 5 year period of substantial government maintenance and ownership, with the resolving and recovery of “bad bank” assets perhaps taking longer. But to my mind, at least, it would be the most functionally efficient and equitable (to the tax-paying public) approach to resolving and recovering from the global financial crisis, one that doesn’t consist in bribing wealthy elites with further unearned rents.
March 9th, 2009 at 10:19 pm PDT
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I’m sure this comment will reveal the depth of my ignorance, but I’ll throw it out there.
I think Taleb has also stumped for separating the deposit taking part of banks and the risk taking part – one guaranteed and the other left to market forces of risk/reward. Isn’t this essentially a 100% reserve backed banking system? Isn’t that what the (crazier)Austrians have been advocating forever? I don’t actually know the answer to this question, I’m still learning here. How would this be different from a 100% reserve system? And in that case, why do we need a federal reserve? Or FDIC? All the money is in the bank whenever you want to go get it. There are no threats of bank runs anymore and the “banks” make money from fees, like old time checking accounts.
Also, it seems to me that banking crises come about because banks are inherently highly leveraged institutions. Thus, they make lots of money in the boom and lose more in the bust. But if we separate the “storage of deposits” function from the risky lending functions of banks, then wouldn’t we have the same problem? Whoever takes over the risky lending functions will make lots of money during the boom. They will become large and “systemically important”. If they fail, we will all suffer because asset prices will crater, pension plans will run out of money, etc, etc. Isn’t this the justification for bailing out investment banks? Nobody had deposits there. It seems like the essence of the recurring crises is leverage and the collapse thereof, not the fact that the leverage is in banks.
March 9th, 2009 at 10:24 pm PDT
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Steve – I suspect that the “systemic stability concerns” you cite as a reason to absolve uninsured depositors and other creditors of their responsibility and pick up the tab for their losses are part of a package deal perpetuating the system you suggest must be reformed, but next time – always next time.
You refer to this, but you seem to think you can separate the ingredients of this toxic soup, despite all of the evidence to the contrary.
Until enough people acquire a direct stake in preventing future abuses, they will recur, as they always have.
I’m still puzzled by your willingness to _impose_ massive losses on those who didn’t obtain direct benefits via inflation and/or taxes, while you seem to think that _allowing_ (it is not “imposing”) losses on those (creditors) who benefited directly strictly verboten.
March 9th, 2009 at 10:50 pm PDT
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Steve: “Sometimes you have to swallow and pay the ransom. But you don’t have to be nice about it.”
In real life, I suspect those prepared to pay a ransom don’t want to risk antagonizing the extortionists, so if they are not nice about it, they are at least neutral. It seems that the only way to discourage would-be extortionists is to impose punishment on them or their kind.
I think the biggest problem with this analogy is that the scale of the current extortion attempt is such that paying the ransom may very well cause much more damage to the victims than making an example of the extortionists. That’s obviously very different than extortion attempts where lives are at stake.
If you’re prepared to argue that the consequences of allowing creditors to take losses will result in a depression that will cost lives, I dare say you ought to be prepared for the possibility that a much larger and longstanding depression could result from a massive bailout. Then consider that the money that would go for a bailout could go to mitigate suffering and enable recovery.
The above doesn’t apply if you believe that massive inflation, even if short lived, has little cost, notwithstanding plenty of evidence to the contrary from around the world.
March 9th, 2009 at 11:50 pm PDT
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“to create institutions whose incentives are aligned with the public interest”. That’s the real problem! And that’s why you need now brand new good banks (that also do good). If we run a simple cost benefit analysis the costs to the society and financial markets of not liquidating the troubled banks are far higher, and increasing, than the benefits of the status quo or keeping them alive. Unfortunately people keep discussing nationalization or not, who should take the haircut and if bondholders should be punished or swap debt to equity. People always focus on trying to do things right instead of doing the right thing. It’s a problem of knowledge management and sometimes intellectual honesty.
March 10th, 2009 at 5:42 am PDT
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re “Sometimes you have to swallow and pay the ransom. But you don’t have to be nice about it.”
To continue your analogy, police authorities and the FBI do not pay ransom, or, if they do, it is with marked, recoverable money designed to expose culpability for subsequent maximal retribution.
more general comment:
Throughout this financial crisis, there seems to be a belief, which you echo, that broad-based financial stability/health and the well-being of private creditors to these large institutions are the same. Yes, there are clean-up costs to be borne by someone. Why that someone should be the taxpayer (or saver if the taxation is imposed later with inflation) who will not herself be subjected to such leniency and subsidies for irresponsibilities of far lesser and narrower import is the question you must address. To argue externalities is to be facetiously apologetic for borderline criminality. All bankruptcy events involve externalities (and Citi, e.g., has already been through 3 of them, though none has been declared as such.) They happen. We have laws and established case law for them.
The Conservative solution–Conserative in the sense of Sir Edmund Burke–is Chapter 11/FDIC receivership for the holding company/commercial banking subsidiary. This is the same solution famously imposed on Indymac, Continental of Illinois, and hundreds of S&Ls. Other solutions are a vain attempt to forestall the inevitable bk–Citi is prominent example–or to repackage it stuffed with subsidies and stripped of the rule of law, law developed expressly for preserving contending property rights and obligations and minimizing unintended consequences.
March 10th, 2009 at 5:46 am PDT
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if taleb had been a trader last year instead of in 1987 he would have made scads of money being long puts and would be a pariah for being the guy who made millions while the banks went down. it is inconsistent to excoriate these people while elevating taleb to any kind of pedestal. is nobody thinking before they speak?
March 10th, 2009 at 7:21 am PDT
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Like many homeowners, the U.S. in aggregate has a debt-to-income ratio that is higher than guidelines, and is already having trouble making the payments on the teaser rate, and will have a whole lot of trouble making the payments when the rate resets (i.e., goes up).
Converting bad debts into Treasury obligations under these circumstances is not wise.
March 10th, 2009 at 2:51 pm PDT
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This is factually incorrect – the reports on CEE loans by the BIS was misinterpreted by various media. Take a look at the report issued by the Erste Group
Main points
– the combined total of $1.7T (being a wrong number) is still less than some western european countries (like UK’s $4T)
– Majority of CEE banks are foreign owned, so if a local subsidiary of an Austrian bank loans money to a local company using local resources in local currency, it is still counted towards the $1.7, while clearly NOT being a foreign loan.
– Example: For Czech republic the real foreign lending is only 1/7 of what those reports said.
– Using same logic, those reports concluded Austria lent 60-70% of it’s GDP. Wrong again.
March 10th, 2009 at 4:34 pm PDT
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Oops, forgot to add text: The Erste report
March 10th, 2009 at 4:35 pm PDT
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Mr. Wadman,
What can I say I love your blog. Keep up the great posts. I will be linking to your two latest articles on SimoleonSense. Thanks again.
Best Regards,
Miguel Barbosa
March 11th, 2009 at 4:33 am PDT
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While I love Mr Waldman’s blog as well, I love the commenters (no offense Steve). The quality of comments here is consistently first rate.
Today’s award to d4wind’s “general comment”. Superb, sir. With brevity and clarity, you have stated what normally takes me 3+ minutes to say. By which time the audience has dwindled to my wife and son :-((
March 12th, 2009 at 1:02 pm PDT
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