The Deep Divide

Responding to the post by Br. Chris,

I think Matt Taibbi has a point.  Tea Partiers and other small government types were opposed to the bailout and would like to see an end to crony capitalism and the marriage between big business and big government.  In theory, there is nothing wrong with this.  However, the message, as demonstrated by people like Sarah Palin, is ass backwards.  The difference between the way that Matt Taibbi and I look at this is that he thinks she has a pair of iron church bells between her legs and I think she is just talking out of the wrong end of her body.

You mention one reason for this:

 They may be morons, but they aren’t dumb (Dave’s note: moron is probably not an apt description).  They are going to play both sides on this one.  On the one hand, they seed money to the GOP and push them to water down the bill if not kill it entirely.  On the other hand, they give money to the Democrats so that they know if and when the time comes that the Democrats actually pass a bill, they will do so in a way that cements the monopolization of the large existing financial firms.

Of course.  Wall Street throws money at both sides.  They will play both sides off in order to secure the best deal for them, that is, if our lawmakers capitulate to their demands (which is likely).  I find it funny to watch the Right blogosphere go into a tizzy about Goldman’s contributions to President Obama.  They were smart enough to go with the winning horse.  They knew this would eventually become an issue so they played their cards accordingly.  Making a partisan issue of Goldman Sachs is probably stupid anyway since the last Treasury Secretary under President Bush, Henry Paulson, was Goldman’s CEO before taking his position in Washington. 

Second, and most importantly, the attempt to sell resolution authority as a bailout to the Wall Street firms makes absolutely no sense once you understand what resolution authority means.    Rortybomb brought to my attention to a paper written by Raj Date titled The Killer G’s: Resolution Authority, Financial Stabilization, and Taxpayer Bailouts.  It is a very worthwhile read that explains the bailouts of 2008-early 2009 and explains how existing financial reform aims to prevent these situations from taking place again. 

Date describes the three categories of bailouts that were used during the crisis.  The first is the blank check (i.e. direct injections of taxpayer funds into troubled companies a la TARP and AIG).  The second is what he calls the “deathbed conversion”.   Firms were allowed to change their legal status in a way that would qualify them for federal money.  The most notable example of this is Goldman Sachs and Morgan Stanley becoming bank holding companies in order to qualify for TARP money.  The last and perhaps least noticeable form of bailout was liquidity of last resort (i.e. access to the Fed’s discount window). 

Most of the discussion involving bailouts that seem to be dominant amongst the pundit types I read involve discussing bailouts in the “blank check” manner and the moral hazard issues they pose.   From that perspective, I can understand how people can connect the dots between resolution authority and moral hazard given how the 2008-2009 bailouts are (rightly) associated with moral hazard.  However, Date’s paper addresses the moral hazard issue (my emphasis added):

4.1.3 Removing moral hazard

The mere existence of a special resolution regime for certain large firms, and not others, could in theory create its own difficulties. Orderly liquidation almost certainly preserves more franchise value than an uncontrolled de-leveraging followed by bankruptcy. Absent counter-measures, that would create a perverse preference by creditors to lend to the largest and most systemically risky firms, like Goldman, as opposed to smaller rivals.

In light of that risk, the Senate Bill crafts a strikingly punitive resolution regime. The Bill requires that the FDIC, as receiver, act “not for the purpose of preserving the covered financial company”; ensure that shareholders are paid only after all other claims are paid; require that unsecured creditors bear losses; and terminate “management responsible for the failed condition”.

Crucially, the Bill also sets out a cap on the amount that a creditor can receive from the resolution of a systemically important firm. No creditor can receive more than it would have received in a regular-way chapter 7 bankruptcy liquidation.(23) Creditors cannot be better off because of the existence of the resolution authority. Thus, the Bill effectively severs the potential feedback loop from the existence of a special resolution regime to moral hazard among creditors.

(23) – Id. at section 210(d)(2). Note that this maximum recovery also serves as a minimum recovery in those instances that the FDIC wishes to use its discretion to pay certain creditors more than similarly situated creditors, to minimize aggregate losses. In other words, the FDIC can preferentially pay a creditor, but only if similarly situated creditors are at least receiving what they would have received in a chapter 7 bankruptcy. Id. at section 210(b)(4)(B).

I should also note that “claims” in this context include any taxpayers monies that may be spent in the event that the cost of an orderly liquidation exceeds the fund amount.  The repayment of that obligation is senior to any claims by senior debt holders.  Creditors will only get what they would have gotten in a Chapter 7 bankruptcy (from what I understand, given the cost of liquidation, they could very well be worse off making a resolution event more unpleasant).  Shareholders are most likely going to get completely wiped out and management removed.

It is for this reason that I find it almost laugable that Sarah Palin would throw out a zinger like this:

Moreover, the financial reform bill gives regulators the power to pick winners and losers, institutionalizing their ability to decide “which firms to rescue or close, and which creditors to reward and how.” Does anyone doubt that firms with the most lobbyists and the biggest campaign donations will be the ones who get seats in the lifeboat? The president is trying to convince us that he’s taking on the Wall Street “fat cats,” but firms like Goldman Sachs are happy with federal regulation because, as one of their lobbyists recently stated, “We partner with regulators.”

Under these conditions, why on Earth would any company want to be the ones who get seats in the lifeboat?  From the perspective of the firm’s senior management and stockholders, that lifeboat is going nowhere to the bottom of the deep murky sea where it shall rest in its watery grave.  The senior management of these firms have significant amounts of their net worth tied up in the shares that they own.  What incentive do they have to advocate for a resolution authority that would wipe them out?  Why would shareholders want this outcome?  A blank check bailout is far more amenable to their interests and serves as a great motivator to see to that resolution authority fails.  In the event that these firms are subject to a resolution authority, political pressure will not be applied not to get on the lifeboat but to stay off of it.  A concern of mine about resolution authority is whether or not the regulators will be able to enact it at the right time before the markets plunge into chaos.  Given that a systemically significant firm has strong political connections, this could be easier said than done.  This is common sense to me, but it seems that “commonsense conservatives” lack this fundamental understanding of how incentives work.

While it looks on one level (a la Taibbi) that there is some great gulf between Democrats and Republicans on this one, is there really?

 On this issue, yes.  Democrats, albeit imperfectly are looking to create a reform structure that seeks to minimize moral hazard and keep the risk that the taxpayers are going to bear the brunt of the failure of a systemically significant firm to a bare minimum.  Republicans, who have shown they have little to offer more other than misguided talking points about bailouts and the belief that our bankruptcy system can be tailored to accommodate a large scale bankruptcy (recently rebuked by the FDIC), despite their best intentions of minimizing the government’s reach into the financial markets as well as moral hazard, in the event of another broad scale financial crisis, will expose us to the possibility of more 2008-2009 type bailout solutions.  It’s hard not to notice the irony that much of this is done in the name of “free markets”.

I always pity someone who has to negotiate with fools.