Never Skip Peter Wallison, Even When He is (a little) Wrong
This is among the most sober and well-argued pieces we have seen on the flaws of the administration’s financial reform proposals. We thought we might end up disagreeing more strongly when Wallison pulled out the old chestnut of the “moral hazard” supposedly created by too-big-to-fail. We have always been skeptical of the moral hazard explanation of bankers’ behavior. The possibility of a government bailout hardly compensates for what executives stand to lose when their firms collapse. Dick Fuld, who drove Lehman into the ground, lost almost a billion dollars in the process.
But Wallison sees that moral hazard is not really about the behavior of bankers but of the creditors who fund the banks: bond holders and counterparties. It is because too-big-too-fail releases these players from their watch dog responsibilities, Wallison argues, that the banks get funded to do irresponsible things.
There almost has to be some truth to this, but we think it is exaggerated. Smart money managers are very careful about counter-party risk. Arguably Bear collapsed because its counterparties were so careful they pushed Bear out of the overnight money market prematurely. Wallison argues that Lehman’s creditors held on too long precisely because the precedent of Bear reassured creditors they would be taken care of. That’s an empirical question; our guess is that there is something to the claim. But once again Lehman’s collapse, though probably inevitable, was precipitated by counter-parties running for the exits.
The bottom line, however, is that Wallison is right on every count in his indictment of the current proposals. The crisis was not caused by deregulation: over the past twenty years banks have been more regulated than ever. Centralizing authority over all too-big-too-fail institutions under the Federal Reserve (or the FDIC) is hardly an improvement: neither of those agencies were any help in steering their current subjects, commercial banks, away from danger. Designating some core set of institutions as too-big-to-fail and establishing a special resolution procedure for them if they crash will certainly increase moral hazard not reduce it.
One point Wallison does not make, is that this special resolution process will give the government more ongoing political leverage over the banks than ever and (as Wallison has pointed out in the past) such political leverage was the real cause of the mortgage crisis, as the federal government forced the banks to revise lending standards downward.
We would add one point. The failure of creditors and counterparties to be good watchdogs does imperil the credit system. And it is government’s job to establish rules for the safety and soundness of that system, upon which, after all, the currency of the Unites States depends. The best way to activate these sleepy watchdogs is to give them more information: All of the big banks, commercial and investment banks and others of sufficient size to threaten the system should be required to disclose all their investment positions, in detail down to the CUSIP numbers of the bonds they hold, on a regular basis, not less often than once a week.
As we argue in Panic, if this rule had been in place in 2004, the bank’s creditors might have cut them off years earlier than they did. Since most of the worst loans were made from late 2005 through early 2007, cutting the banks credit earlier would have reduced the crisis to a speed bump.
Tags: Andrew Redleaf, bankers, banking crisis, banking deregulation, capitalism, Mortgage Crisis, Peter Wallison, Regulation, Richard Vigilante, Whitebox
