The Fed’s moral hazard maximising strategy

The reports on the evidence given by the Vice Chairman of the Federal Reserve Board, Don Kohn, to the Senate Banking Committee about the Fed’s role in the government’s rescue of AIG, have left me speechless and weak with rage.  AIG wrote CDS, that is, it sold credit default swaps that provided the buyer of the CDS (including some of the world’s largest banks) with insurance against default on bonds and other credit instruments they held.  Of course the insurance was only as good as the creditworthiness of the party writing the CDS.  When it was uncovered during the late summer of 2008, that AIG had nurtured a little rogue, unregulated investment banking unit in its bosom, and that the level of the credit risk it had insured was well beyond its means, the AIG counterparties, that is, the buyers of the CDS, were caught with their pants down.

Instead of saying, “how sad, too bad” to these counterparties, the Fed decided (in the words of the Wall Street Journal), to unwind “.. some AIG contracts that were weighing down the insurance giant by paying off the trading partners at the full value they expected to realize in the long term, even though short-term values had tumbled.”

An LSE colleague has shown me an earlier report in the Wall Street Journal (in December 2008), citing a confidential document and people familiar with the matter, which estimated that about $19 billion of the payouts went to two dozen counterparties between the government bailout of AIG in mid-September and early November 2008. According to this Wall Street Journal report, nearly three-quarters was reported to have gone to a group of banks, including Société Générale SA ($4.8 billion), Goldman Sachs Group ($2.9 billion), Deutsche Bank AG ($2.9 billion), Credit Agricole SA’s Calyon investment-banking unit ($1.8 billion), and Merrill Lynch & Co. ($1.3 billion).  With the US government (Fed, FDIC and Treasury) now at risk for about $160 bn in AIG, a mere $19 bn may seem like small beer.  But it is outrageous.  It is unfair, deeply distortionary and unnecessary for the maintenance of financial stability.

Don Kohn ackowledged that the aid contributed to “moral hazard” – incentives for future reckless lending by AIG’s counterparties – it “will reduce their incentive to be careful in the future.” But, here as in all instances were the weak-kneed guardians of the common wealth (or what’s left of it) cave in to the special pleadings of the captains of finance, this bail-out of the undeserving was painted as the unavoidable price of maintaining, defending or restoring financial stability. What would have happened if the Fed had decided to leave the AIG counterparties with their near-worthless CDS protection?

“I’m worried about the knock- on effects in the financial markets. Would other people be willing to do business with other U.S. financial institutions…if they thought, in a crisis like this, they might have to take some losses?”

Let’s step back a minute and ponder this.  US banks and shadow-banks (like AIG’s Financial Products Division) took on excessive leverage and excessive risk.   There was not only too much careless lending by US banks, there was too much careless lending to US banks.  When this crisis is over and when, in the fullness of time, the real economy has recovered, we want to see less lending by and to US banks than we saw in the years 2004 – 2006.  How do we get those who provided US banks and other financial institutions with too much funding at too low a cost to behave with greater prodence and caution in the future? Presumably by making sure that they pay the price for their reckless financial decisions.  The counterparties of AIG who had been unwise enough to buy insurance against default on debt instruments they held, by acquiring CDS written by AIG should have been told to eat it.

So, like Mr. Kohn,  I too am worried about the knock- on effects in the financial markets of the Fed’s actions.  I, however, am exceedingly worried about the Fed’s bail out (at full face value) of the counterparties of AIG.  I am deeply worried that other people may, as a result of this, be willing to do business with other U.S. financial institutions on the same ludicrous terms that brought us the current crisis.  And why wouldn’t they be happy and relaxed about once again taking wild and crazy bets?  They now know that, should their bets fail, in a crisis like this, there is some sucker-institution in Washington DC that will make sure that they don’t have to take some losses.

Unless the counterparties pay the full price for their hubris and recklessness, they will be back for more.  It is therefore tragic that central banks and governments everywhere are going out of their way to protect and shelter the unsecured creditors of the banks (holders of junior and senior debt among them), by raiding the tax payer or the credit and reputation of the central bank.  Significant mandatory debt-to-equity conversions and large write-downs of (haircuts on) the claims of other unsecured creditors should be an integral part of any financial assistance package.

Whenever I suggest that the tax payer should not bail out unsecured creditors when a financial institution is about to go belly-up, someone yells ‘Lehman Brothers’ as if that is enough to turn the unsecured creditors into sacred cows.  It is not.  A simple but (to me) quite persuasive ‘event study’ by John Taylor of Stanford University, “The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong” suggests that it is not the inability of the US authorities over the weekend of September 13-14 2008 to come up with a rescue packege for Lehman that started the cardiac arrest in US and global money markets and financial markets.

Quoting from Taylor (the spread referred to is the 3-month Libor-OIS spread)

“…the spread moved a bit on September 15th, which is the Monday after the weekend decisions not to intervene in Lehman Brothers. It then bounced back down a little bit on September 16 around the time of the AIG intervention. While the spread did rise during the week following the Lehman Brothers decision, it was not far out of line with the events of the previous year.

and

On Friday of that week the Treasury announced that it was going to propose a large rescue package, though the size and details weren’t there yet. Over the weekend the package was put together and on Tuesday September 23, Federal Reserve Board Chairman Ben Bernanke and Treasury Secretary Henry Paulson testified at the Senate Banking Committee about the TARP, … . They provided a 2-1/2 page draft of legislation with no mention of oversight and few restrictions on the use. They were questioned intensely in this testimony and the reaction was quite negative, “… it was following this testimony that one really begins to see the  rises deepening, as measured by the relentless upward movement in Libor-OIS spread for the next three weeks. Things steadily deteriorated and the spread went through the roof to 3.5 per cent.

…  identifying the decisions over the weekend of Sept 13 and 14 as the cause of the increased severity of the crisis is questionable. It was not until more than a week later that conditions deteriorated. Moreover, it is plausible that events around September 23 actually drove the market, including the realization by the public that the intervention plan had not been fully thought through and that conditions were much worse than many had been led to believe.

I believe the Lehman collapse was mishandled by the authorities.  They committed two egregious errors, one one of commission and one of omission.  The error of commission was saving the unsecured creditors of Bear Stearns, an investment bank that was even less systemically significant than Lehman.  This implanted the belief, among market participants and observers, that only shareholders were exposed to serious risk in America’s internationally visible banks.  The error of omission was that, despite the fact that Bear Stearns had been in terminal dire straits in March 2008, there still was no Special Resolution Regime (SRR) with Prompt Corrective Action (PCA) for Investment banks in September 2008.

Why was Lehman not forced to become a bank holding company (the fate of Morgan Stanley and Goldman Sachs later that year), so it could be SRR’d and PCA’d by the FDIC? With an SRR, the systemically important bits of Lehman could have been kept alive on government life support, with the shareholders and the unsecured creditors suffering the fate intended for those with exposure to insolvent institutions.

While the demise of Lehman and the destruction of most of its unsecured creditors was an unnecessary surprise, it was still the best option available to the authorities, given the absence of an SRR.  Markets and market participants are educated only by painful example.

The cardiac arrest followed the realisation, well after Lehman went kaput, that (1) most of the internationally recognisable US banks were insolvent or would be but for past, present and anticipated future government financial support; that (2) many other non-bank financial institutions (AIG) and shadow-financial institutions (GE) were either insolvent or at death’s doorstep; and that (3) the government was not on top of the issues and the Congress was deeply divided and irresponsible.

The logic of collective action teaches us that a small group of interested parties, each with much at stake, will run rings around large numbers of interested parties each one of which has much less at stake individually, even though their aggregate stake may well be larger.  The organised lobbying bulldozer of Wall Street sweeps the floor with the US tax payer anytime.  The modalities of the bailout by the Fed of the AIG counterparties is a textbook example of the logic of collective action at work.  It is scandalous: unfair, inefficient, expensive and unnecessary.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

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