Allow me to propose a simple principle that the next president and Congress could follow as they devise a new financial-regulatory regime to replace the one that failed so bad.
Allow me to propose a simple principle that the next president and Congress could follow as they devise a new financial-regulatory regime to replace the one that failed so bad:
If an activity is important enough to justify a government nationalization to prevent a default, it is important enough to be regulated. The regulators need to know what risks are being taken, and by which institutions, in time to act before a crisis develops.
Had the government bothered to do that in years past, it might not have faced the decisions it faced this past week. First, it let one big firm go down, and then it became scared enough to nationalize another one to keep it afloat.
Now, showing no sign of embarrassment over how bad they failed before, the current crop of regulators seem to be unified in their determination not to let the markets force them to make a similar choice on some other big financial institution.
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The result is a campaign against those who bet that the financial system was crumbling.
If the government is forced to decide whether to save another firm, it will face the same question it faced with AIG and Lehman Brothers. Would this failure cause systemic damage to the financial system?
Lehman did not measure up because its chief executive, Richard Fuld Jr., simply was not reckless enough as he ran Lehman into the ground.
Lack of foresight
Had he had the foresight to make a lot more bad bets in the derivatives market, the government would have feared financial chaos and might have nationalized Lehman, just as it nationalized AIG, Fannie Mae and Freddie Mac. Or it would have subsidized a takeover, as it did for Bear Stearns.
The Paulson-Bernanke Doctrine is not “too big to fail.” It is “too reckless to fail.” If you get your company into enough trouble to threaten the financial system, Ben Bernanke, the Federal Reserve chairman, and Henry Paulson, the Treasury secretary, won’t let you collapse. It may be that they miscalculated.
Lehman’s default caused a money-market fund to suffer losses, and scared investors into pulling their money from similar funds. If those funds cannot find buyers for their assets, there could be more defaults and more failures.
The Paulson-Bernanke Doctrine was born not of theory or ideology, but instead from improvising as each new crisis erupted.
The Fed’s briefing on the nationalization of AIG did not start until 9:15 p.m. on Tuesday night, which is not a sign of carefully thought-out decisions. When they met with congressional leaders Thursday night to seek a plan to get cash to banks before they fail, it was almost as late. If these nationalizations smack of socialism, it is closer to the Marxism of Groucho than of Karl.
The Cox Proviso to the Paulson-Bernanke Doctrine is that the rules will change, and change again, if that is needed to avoid another failure.
On Wednesday, Christopher Cox, the chairman of the Securities and Exchange Commission, announced new rules on short-selling. The market plunged anyway, and that night he was back with a news release saying he would ask the commission to force short sellers to publicly disclose their positions.
By Thursday night, after Sen. John McCain denounced him for not doing enough about short selling, he was talking of banning the practice.
Had the SEC gone over the records of Lehman and Bear Stearns with the vigilance it now promises for the shorts, we might not be in this mess. But that was then, and it is clear that anyone betting against the big banks now is fighting not just the Fed, but the SEC and Treasury as well.
It is a sad commentary that the authorities are most worried about a market that they were unwilling to do anything about when it was growing and growing. That market is credit-default swaps.
Credit default swaps are a way of transferring the risk of owning a bond. If I own a bond issued by General Motors, and have also purchased a credit default swap on GM, then I am covered if GM defaults. I can recover my losses on the bond from the institution that sold the swap to me. There are now many more credit default swaps outstanding than there are bonds for them to cover.
The theory that beguiled legislators and regulators was that the market could regulate itself. Each bank would be careful to deal only with counterparties it could trust, and so the whole system would be trustworthy. But even if you believe that, remember that most swaps are good for five years.
It is worth remembering that AIG’s credit standing did not fall even after it was caught helping other companies rig their financial statements.
Nor was it hurt by evidence it had fudged its own numbers. Discovering that a company is run by people with what we might call flexible integrity should have been a red flag.
But who would have looked? The insurance subsidiaries were regulated by state insurance departments, and activities of the parent were not their focus. Had anyone suggested an aggressive audit to see what other games AIG was playing, I am sure that neither the Fed nor the Treasury would have thought they had jurisdiction.
In letting Lehman default, the authorities wanted to send the message that they were not going to bail out somebody every weekend, and the damage from a big brokerage failure could be contained. They may have been wrong on both counts. I doubt anyone in government thought to wonder if a money-market fund would have to “break the buck” because it owned Lehman debt. But that did happen.
It is not easy to forecast the reverberations of one big failure, and the Fed may not have done it well. But the biggest errors in Washington, D.C., were made long before AIG arrived at the Fed with its hat in hand, and long before short sellers began to think banks were in trouble.