A breakdown on handling big failures

A breakdown on handling big failures
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First Published: Wed, Sep 09 2009. 12 30 AM IST

Resolution issues: US treasury secretary Henry Paulson. Joshua Roberts / Bloomberg.
Resolution issues: US treasury secretary Henry Paulson. Joshua Roberts / Bloomberg.
Updated: Mon, Sep 14 2009. 07 46 PM IST
Henry M. Paulson Jr, then the US treasury secretary, gave a little-noticed speech in London in July 2008.
Resolution issues: US treasury secretary Henry Paulson. Joshua Roberts / Bloomberg.
“To address the perception that some institutions are too big to fail, we must improve the tools at our disposal for facilitating the orderly failure of a large, complex financial institution,” he said. “We need to create a resolution process that ensures the financial system can withstand the failure of a large complex financial firm.”
It’s a little eerie now to read those prophetic words, which were uttered months after the Bear Stearns Companies Inc. collapse.
But Paulson never got to the next step. Just two months later, Lehman Brothers Inc. collapsed, sending global markets and our economy into a tailspin.
As we approach the anniversary of some of the most cataclysmic failures in our economic history, we appear to be in perhaps no better position to manage the failure of an investment bank, a hedge fund or an insurance company than we were before.
Absent any legislation that would prevent another 9/15 (as some people are calling it on Wall Street) from happening, our only options are to throw money at problem companies or arrange shotgun marriages to keep them from failing. That hardly seems like a long-term solution.
Timothy F. Geithner, the current treasury secretary, proposed legislation in March that would do exactly what his predecessor talked about— give the government the ability to take over a failing firm such as Lehman Brothers to prevent its collapse from infecting others. Little has happened.
Back then, the Obama administration said it was firmly behind the proposal; senator Christopher J. Dodd, Rep. Barney Frank and other leading Democrats similarly made noises about how they planned to try to pass the legislation by 4 July.
But as the economy has seemingly recovered and President Barack Obama has focused his attention on healthcare and other issues—all of which no doubt merit attention—perhaps the one piece of legislation that could prevent a repeat of what has arguably ruined the lives of millions of people has been left in limbo.
“It should be the first priority of both the Congress and the administration,” said Frederic S. Mishkin, a former governor of the Federal Reserve and an economics professor at Columbia. “The public may be upset about bailouts. But by not having the resolution authority, we actually are making it more likely there has to be bailouts.”
Geithner’s proposal is part of a legislative effort aimed at reforming the financial services industry. As a result, the measure appears stuck in a bottleneck while treasury, the Federal Reserve and Federal Deposit Insurance Corp. (FDIC) battle over other parts.
So what would “resolution authority” look like? It would allow the government to put an investment company into conservatorship, just like Fannie Mae or Freddie Mac, or receivership, the way FDIC does with traditional banks.
The benefit is that it avoids bankruptcy protection, a drastic step that not only spells the end of a financial firm but can lock up trades of various counterparties and freeze markets, similar to what happened after Lehman Brothers filed.
Mishkin said he viewed “the shock after Lehman to be worse and more complicated than the one that caused the Great Depression.”
Making a resolution authority would be complicated—how do you compensate investors as you close out positions or liquidate assets—and is one reason, in fairness to Congress, that the legislation has not advanced.
“Structured correctly, a credible resolution regime could force market participants to realize the full costs of their decisions and help reduce the ‘too big to fail dilemma,’” Mary L. Schapiro, chairwoman of the Securities and Exchange Commission, testified over the summer. “Structured poorly, such a regime could strengthen market expectations of government support, as a result fuelling ‘too big to fail’ risks.”
But without any alternative, we are likely to be forced to continue the practice of ad hoc bailouts, out of fear that bankruptcy will be a worse outcome.
“If you don’t have resolution authority, you have a game of chicken,” Mishkin said, with the financial firms having the upper hand against, us, the taxpayers. “They can basically say to the government, ‘Either you give me the money or you can put me into bankruptcy— and guess what?—you’ll have another Lehman.’”
That means, he added, that treasury has little power to press financial firms to get their houses in order.
As we approach a different anniversary, that of 9/11, there is still no new building in the place of the World Trade Center, eight years after so many lives were lost and businesses destroyed.
Addressing the critical issue of resolution authority in less time could be essential to avoiding another financial crisis.
©2009/ The New York Times
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First Published: Wed, Sep 09 2009. 12 30 AM IST