Corporate Governance

Shock and Awe: From Massachusetts to the Obama ?Volcker Rule? (Part 7 of 10)

By Jennifer S. Taub

Meeting with Oregon Senator Jeff Merkley (D) and Andy Green:

Proprietary Trading: As Senator Merkley had only 15 minutes (before leaving for a press conference), we addressed what interested him. This was proprietary trading. He wanted to understand how this was central to the financial crisis. Merkley commented that the banks were having a good quarter due to their prop trading desks, but "what goes up, comes down." Clearly this was on his mind given the President's emphasis in his 'Volcker Rule' announcement that morning on ending proprietary trading at commercial banks. Andy had a very thoughtful perspective on how to categorize prop trading. In our discussion we added that it went beyond asset classes to also be risk due to the amount of leverage used and the liquidity problems -- using short term borrowing to finance long term assets. Andy also asked about the fire walls between the businesses wondering how that would work.

Too Big To Fail: Andy also asked questions about the benefits of a breaking up the banks (separating commercial banking from investment banking and restoring Glass-Steagall) as compared to the crisis management of  bankruptcy for insolvent financial holding companies. We made the same points about bankruptcy as compared to an FDIC-type resolution authority as we did above: It's not new, it's not a resolution and it's really a bailout (if it's not prefunded by the firms).

Bankruptcy vs. Receivership – the Warner-Corker Approach: We responded to the Warner-Corker plan of a presumption that too-big-to-fail insolvent firms would go through bankruptcy. The plan has been pitched as 'not a bailout'. We disagreed with this positioning. We expressed concerns about the bankruptcy option along the following lines:

1. Not new: We already have Chapter 11 (restructuring). That's what Lehman did. Didn't work out so well and in fact create more market instability, asset prices collapsing and credit freezing. This is not a solution, it's a smokescreen. The time consuming aspects and the complexity make it a poor solution for handling failing systemically important institutions.
2. Not a resolution -- Resolution implies finality and a smooth, successful transition of a firm so that it does not damage the broader system and economy. In fact, 1 in 8 bankruptcies that start as restructurings do not result in a rehabilitated firm.
3. Not a free market solution -- In order for a chapter 11 to happen at all (as opposed to converting to a liquidation), bridge financing -- called DIP (debtor-in-possession) financing is needed. Firms that don't get it, fail. In good market conditions, there are lenders willing to do this in order to get priority. In a situation like Lehman (or GM), this did not exist. So, under this plan, would the US government provide the bridge financing? Isn't that a bailout?
4. Moral Hazard: CEOs get to stay in control and delay for another 180 days (at least) while they figure out a reorganization plan -- they get an exclusive.  With resolution by the FDIC, they  are pushed aside and not in control. This creates an incentive to not face reality when things look bad. Consider Dick Fuld in Sorkins' Too Big to Fail. That is a case study in moral hazard and denial.
5. Creates more consolidation and more too big to fail institutions. Consider (as documented in Sorkin's TBTF) all of the mergers and deals that came about as the investment banks bargained in the shadow of bankruptcy. No one is going to do any kind of helpful lending to a firm in a death spiral unless they get something -- often a big piece of ownership or a full merger and control. So, it's either taxpayer funded financing or  private funding and more consolidation.
6. Forum Shopping: Bankruptcy courts are not uniform in their treatment.

Other Issues/Securitization: Jane discussed the erosion of capital due to the mark-to-market accounting applied to traditional banking (as opposed to trading where it is appropriate).  She also discussed the Bank Holding Company Act of 1956, the One Bank Holding Company Act of 1970. This came up because Andy voiced concerns (that others had raised) re the failure of the S&Ls after the monetary control act eliminated Reg Q.

International Competition:  He was very interested in the problem of international competition. Will the UBS of the world crush the US banks if the Volcker rule becomes law? 

Full post as published by The Race to the Bottom on January 29, 2010 (boomark / email).