Sunday, March 7, 2010

Burning Down the House

Bob Teitelman, Editor in Chief of M&A industry rag The Deal, released an editorial from this coming week's magazine last Friday. In it, he takes aim at the vaunted "resolution authority" which many politicians and regulators have been hawking as the solution, if not to all our collective ills, then at least to the prospect of some bumbling financial behemoth taking the vapors again and collapsing in a rubble strewn heap all over our economic picnic. In addition to the fabled "Volcker Rule," resolution authority took pride of place as the other key pillar in the Obama Administration's recent late-game reversal in the political reform stakes.

Suffice it to say, Mr. Teitelman does not appear to be a fan:
Resolution authority, in short, is the Maltese Falcon of regulatory reform. What is this strange bird? Simply put (though nothing here is simple), it's the legislative authority to wind down a financial firm. In fact, this definition is about as far as anyone ever gets on the subject, except to add sagely that we're talking wind-down, not bankruptcy, which as we all know, despite General Motors, is an interminable process involving lawyers and thus to be avoided, like reading terrorists their rights. Resolution authority is fast, decisive, authoritative. Resolution authority means banks can fail in ways that don't upend the global economy, particularly its sensitive consumer parts. Past this point, details get murky. In its grandiose form (as if its normal form isn't ambitious enough), the mere presence of resolution authority will scare the crap out of stockholders, creditors and counterparties and make them do their job, which is insuring that banks don't go all suicidal, blow themselves up and force regulators to do their jobs. That may be wishful thinking. We're talking a plaster bird here, not a splinter of the True Cross.

In addition to his patent irritation that no-one has bothered to put any flesh on the bones of this proverbial unicorn, Mr. Teitelman takes exception to the idea of resolution authority for two other reasons. First, as he correctly points out, it is not clear that active resolution of a large, globally interconnected financial institution would actually stem financial contagion among its myriad counterparties, investors, and stakeholders or—what is another way to say the same thing—that it would not trigger preemptive global panic by the mere threat of its imposition on some tottering colossus. Second, he also correctly notes that actual imposition of this authority to "wind down" (i.e., shutter, untangle, shit-can) a major financial entity would require impressive quantities of political and regulatory will, moxie, and, for lack of a better word, courage. I think few observers would disagree that these qualities have been in demonstrably short supply in Washington, D.C. for, oh, the last six hundred years or so.

But where The Deal's Editor sees flaws and shortcomings, Dear Reader, Your Disputatious Correspondent sees features and benefits. I like the fact that the proposed resolution authority is currently vague and undefined. I think it should be written into law in as vague and undefined a manner as possible. That would make it much more effective in combatting the next (inevitable) financial crisis.

You look puzzled. Allow me to explain.

* * *

For one thing, vagueness will offer regulators flexibility.

I think, based on his previous writings, that Mr. Teitelbaum would agree there is almost no chance—zero, none—we can devise any sort of regulatory regime that can effectively prevent financial crises from recurring on a regular basis. It is the nature and history of global finance that it periodically suffers meltdowns of varying severity and duration. It seems woven into the very fabric of a complexly-interlinked financial system operated by fallible human beings that it is destined to fly off the rails every now and then, and moreover usually just about the time we have convinced ourselves it will never derail again.

But it is important to realize that each financial crisis is unique. Bank crises, real estate bubbles, stock market bubbles, currency crises: each of the little disasters which spring upon us mostly unawares seems different in kind from its predecessors, with different causes, characteristics, and effects on the global (or domestic) economy. I have no reason to believe this variability is a necessary trait; that is, each succeeding financial crisis must differ in kind from its forebears. But history certainly gives ample evidence that major crises in the financial sphere are each sui generis. Perhaps the reason for this is as simple as the fact that our lifetimes are too short for us to recognize recurring patterns.

Be that as it may, the key point is that we should not expect to be able to anticipate how or when a crisis will next hit us. Nor should we presume we will need the same tools and techniques to fix it that we used the last time. Being overly specific in terms of what regulators are and are not allowed to do is anathema to prudent planning, for we really cannot know now what tools and techniques they will need to use then. This is one of the fatal flaws of the bloated financial reform legislation wending its way through the fetid bowels of the U.S. Congress now, by the way: it is so detailed, comprehensive, and all-encompassing in its attempts to regulate the last crisis that it is almost certain to be of little use for the next one. (As well as adding, in its futility, to the stultifying deadweight burden of misguided and ineffectual financial regulation already on the books.) In contrast, legislation granting regulators resolution authority should be general and abstract enough to give them great leeway in the specific tools and techniques they are allowed to use when they stare down the next disaster.

If there's one thing the recent financial clusterfuck should have reminded us, it's that beautiful, complex, and comprehensive models of behavior aren't worth the paper they're written on if their underlying assumptions are wrong. This is true whether the model in question is a mortgage-backed securities program that fails to consider that real estate prices might go down or a thousand-plus-page piece of legislation that assumes our next crisis will look exactly like the last one.

* * *

For another thing, vagueness will offer regulators discretion.

This will have two salutary effects. It is well known that financial institutions—like sophisticated businesses everywhere—are expert at structuring their business practices to satisfy the letter of the law, while evading its spirit and intent with maximal effect. The more specific laws and regulations become, the easier it is for these institutions and their in-house and outside counsel to find their way around them. Should legislation authorizing resolution authority be too specific—in the tools, techniques, and processes regulators are allowed to use in identifying and winding down financial institutions in distress—then you can bet your bottom dollar those firms will exploit this fact to skew the game in their favor. In contrast, purposely vague and undefined resolution authority will not offer its potential objects as many preemptive opportunities to evade its intended jurisdiction or consequences.

In addition, regulatory discretion would foster what I would view as a healthy increase in uncertainty among financial institutions and their stakeholders. Should, for example, a regulator have the authority to unilaterally abrogate, modify, or suspend any and all prior contracts or securities arrangements entered into by a financial institution undergoing resolution—as some might suggest—you can just imagine how much more cautious investors, lenders, and counterparties would become in their dealings with any financial institution potentially subject to such a regime in the future. The cost of funding financial institutions would undoubtedly rise, as investors become sensitized to increased contractual risk.1 Firms in obvious distress would see their cost of financing skyrocket and their counterparty business dry up, as no-one with a contractual claim could rest assured it would receive exactly what it was otherwise entitled to in a resolution wind up. But then again, firms in obvious distress see that happen anyway. The point is that regulators charged with cleaning up the mess would not have their hands completely tied by contractual arrangements entered into by others when the failing company was healthy.

Now I will be the first to admit that giving such broad discretion to a governmental entity over nominally private business matters is a very serious and potentially dangerous precedent. Capitalist western democracies rely heavily on the rule of law and the sanctity of contracts to undergird the social contract. So there must be strict limits on regulatory discretion. For one thing, resolution authority must not be invoked against a financial firm—and the full array of powers it authorizes must not be exercised—without a clear and present danger that not doing so could cause severe negative consequences and externalities to the financial system as a whole. Second, the actions of the resolution authority must be completely open to public scrutiny both during and after the process (with reasonable, if temporary, confidentiality granted in cases of potentially market-moving information). Lastly, there must be no immunity for officials who execute such actions from inquiry, investigation, or even prosecution. Timely and necessary discretion must be allowed, but abuse of authority cannot be tolerated.

* * *

In the halcyon days of my dissolute youth, before the transformation of this country into a nanny state had truly begun, many public schools used to have large, two-handed axes and coiled up firehoses situated in prominent locations, for use in case of fire. Normally these tools were displayed behind protective glass, upon which "IN CASE OF FIRE, BREAK GLASS" was printed in large red letters. There was a reason these cases contained an axe and a hose, rather than a scalpel, an eyedropper, and a 500-page manual on building codes. When the elementary school was burning down, you didn't worry about the damage you might cause by smashing in doors, knocking down walls, or soaking the library books with water. You worried about stopping the fire, preventing its spread to other buildings, and getting the students and teachers out before they burned to death.

By the same token, I'd rather have committed, well-meaning regulators equipped with the tools and the authority to liquidate failing financial institutions as quickly and as flexibly as possible.2 There will be plenty of time during the cleanup to determine whether anyone's legal or contractual rights were trampled in the general melée, and to decide what compensation, if any, they deserve because of it. That will also be the time to scrutinize the behavior and actions of regulators, to make sure any abuse of authority is discovered and punished, and to fine tune the rules and tools they use based upon what we learn from the crisis.

Legal rights and the sanctity of contract are key pillars of our economic system, and critical components to its ongoing health. That being said, they must take a back seat—if only temporarily—to more important values when those latter are threatened in an emergency. I don't know about you, Dear Readers, but I don't want lawyers for the Teachers Union or the school mortgage lender following firemen around with restraining orders and injunctions when they are trying to put out a fire at my childrens' school. Like firemen, regulators confronting a financial emergency must have the freedom and the tools to do what they need to do. It may be scary, but we'll just have to trust them to do the right thing. When it's all over, we'll take a really close look at what they did to make sure it was both necessary and appropriate.

And who knows? Perhaps a little less certainty will make our global financial institutions more careful about starting fires in the first place.

1 Alternatively, one could view such an increase in the industry's cost of capital as a belated recognition of some of the economic costs of the externalities which the financial industry inevitably imposes on society through its behavior, and the capitalization thereof into those firms' cost of funds.
2 My analogy addresses Mr. Teitelman's two other objections, as well. Just because you cannot prevent all fires, or even prevent each and every fire from spreading to other buildings, does not mean you should give up fighting fires altogether. By the same token, financial regulators should not abandon the attempt to control and prevent financial contagion simply because the task is difficult and occasionally impossible. As far as courage goes, moreover, ask yourself how brave your average fireman would be if he had no tools or water to fight fires. I cannot prove a counterfactual, but I suspect even Hank Paulson and Tim Geithner would have fought harder for the taxpayers' interests in the Lehman and AIG affairs if they thought they had the authority to do so.

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