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Can the market help solve the market's problems?

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Christopher Papagianis, a former special assistant for domestic policy to George W. Bush, has a smart critique of the Dodd bill's approach to executing systemically important, failed banks. His critique, essentially, is that it doesn't do enough to hurt creditors. It wipes out management and shareholders, but the folks who've loaned the bank money might still survive. That could lead them to prefer to invest with systemically important banks, making the too-big-to-fail problem even bigger. And we don't want that.

One way to handle this would be to attach the Miller-Moore amendment that passed in the House. If you're a creditor due to get your money back from a giant, failing, bank that doesn't have the money to pay you, you're losing 20 percent of your investment. Sorry, dude.

Papagianis goes in a different direction, arguing for an idea proposed by Chicago's Luigi Zingales and Harvard's Oliver Hart that would use credit-default swaps to measure risk. The CDS market did a much better job detecting stresses in banks than regulators did. So Zingales and Hart want to make the CDS market into a tripwire: If the CDS spread on a bank moved above 100 basis points (what that means isn't as important as the fact that it's a clear, objective number), regulators would have to enter the picture and begin stress-testing, and if that went poorly for the bank, converting debt to equity. (For a fuller explanation, head here.)

I like this idea. In fact, I argued for it in a recent Newsweek column, and I brought it up in my interview with Sen. Mark Warner. But as Mike Konczal points out in a critique of it, one of the preconditions is that credit defaults swaps move onto an exchange. I can back Mike up on that: When I spoke to Zingales about his idea, he said it required CDSs to be on exchanges. But Republicans have opposed putting the CDS market on an exchange. It's emerging as a major fault line in this debate.

So if Papagianis's take is going to emerge as the "smart conservative" position on resolution authority (and Reihan Salam is trying to make that happen), someone needs to persuade the Republican Party to get on board with its necessary preconditions.

Graph credit: CreditSlips.com.

By Ezra Klein  |  April 15, 2010; 4:48 PM ET
Categories:  Financial Regulation  
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Next: Reconciliation

Comments

Hmmm... 100 seems a bit stingy. I can imagine a bank's management is going to be very annoyed if protection is ever offered at 100 1/2. Does this mean that a hedge fund can short the bank's stock and then offer to buy protection on the bank just over 100 to force a negative psychological event? I can imagine a lot of banks could break 100bps without having a problem.

Arbitrary limits don't make much sense. I like forcing creditors to take a haircut more, or for that matter let them be wiped out entirely. A senior unsecured bank note would then actually be a senior UNSECURED bank note.

Posted by: justin84 | April 15, 2010 5:40 PM | Report abuse

Ezra,

I had a post on the Hart and Zingales idea when it first came out last May (It was in Mark Thoma's links.). I see some problems with it. Here's a key one from that post:

The CDS may be a poor measure of the large financial institution's probability of failure absent government assistance, because the market will price the CDS to include the substantial likelihood that the government will pump in taxpayer money if the large financial institution (LFI) would otherwise go under.

Even if the LFI were being run in an extremely risky way (because management was taking advantage of the "heads I win, tails you lose" taxpayer backup likelihood), the CDS could still be very low priced, if the market knows the government is likely to bail the LFI out.

Even if the LFI would almost surely go bankrupt without government assistance, the CDS might not be particularly low priced if investors think it hardly matters; the tax payers will almost surely give the LFI billions to keep it from bankruptcy.

at: http://richardhserlin.blogspot.com/2009/05/will-cds-really-reflect-well-what-hart.html

Posted by: RichardHSerlin | April 15, 2010 5:54 PM | Report abuse

Ezra, did you hear the story on the latest This American Life by the Planet Money team? Awesome (in a depressing way).

Posted by: AZProgressive | April 15, 2010 5:54 PM | Report abuse

I'm beginning to see why the financial reform effort is way harder to explain or discuss than health care reform.

Health care reform, there were fairly well defined criteria: cover more people (ideally all people) and prohibit certain unfair practices of insurance companies. Oh, and don't add to the deficit.

With financial reform, the goal is... to somehow prevent anything this bad from happening ever again. WTF?!?

It brings to mind Dr. Peter Venkman's line from Ghostbusters:

"Get her!" That was your whole plan, huh, "get her." Very scientific.

Posted by: billkarwin | April 15, 2010 6:31 PM | Report abuse


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Posted by: 898551828 | April 16, 2010 8:52 AM | Report abuse

I should add, because my May 2009 post did not make this clear, that I do support having some strong smart "objective" limits on shadow banks, of any size, LFI or SFI, things like leverage limits. Clearly we've seen that Republican regulators, or "regulators" can't be trusted with complete discretion.'

Posted by: RichardHSerlin | April 16, 2010 2:46 PM | Report abuse

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