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David Brooks: Centralizer

At its base, the Dodd bill gives regulators more information to see when a financial firm is in trouble and more power to force them to get out of trouble. In practice, that will probably mean forcing them to raise capital so they have a bigger cushion against their risks.

Cue David Brooks, who grandly says that this represents "the great age of centralization" and goes on to say that "some Democrats regard federal commissions with the same sort of awe and wonder that I feel while watching LeBron James and Alex Ovechkin." Cute line. So what's Brooks's proposal? Glad you asked.

"It would be smart to decentralize authority in order to head off future bubbles," Brooks writes. "Both N. Gregory Mankiw of Harvard and Sebastian Mallaby of the Council on Foreign Relations have been promoting a way to do this: Force the big financial institutions to issue bonds that would be converted into equity when a regulator deems them to have insufficient capital. Thousands of traders would buy and sell these bonds as a way to measure and reinforce the stability of the firms."

You see the problem here, right? This proposal says that regulators -- who may even be organized into some sort of council or commission -- should watch financial firms and bring down the hammer when they get into trouble. Nothing about Brooks's proposal is less centralized than Dodd's proposal. In fact, they work in virtually the same way.

Now, there's some chance that Brooks is simply explaining his proposal poorly and he actually has in mind something like the Zingales/Hart proposal to use the market price for a special class of debt as a way to trigger automatic regulatory action, which would potentially protect against groupthink and inattentive bureaucrats.

If so, that's great. I'm a fan of this proposal, though no Democrats or Republicans have introduced it in Congress. But so far as what he's written goes, Brooks has created a centralized system that works at the behest of government regulators even as he's written a column criticizing Dodd for creating a centralized system that works at the behest of government regulators. It's a bit weird.


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By Ezra Klein  |  April 27, 2010; 11:22 AM ET
Categories:  Financial Regulation  | Tags: David Brooks, N. Gregory Mankiw  
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Comments

David Brooks' only talent is showcasing his absolute inanity in 1,000 words or less.

Posted by: cbaratta | April 27, 2010 11:44 AM | Report abuse

David Brooks doesn't understand the issue. He's a politics guy, not a policy guy.

Posted by: Quant | April 27, 2010 11:54 AM | Report abuse

What Quant said. Plus, Brooks fetishizes moderation in the grand Broder tradition, which in Washington always, always means that Democrats must cave in to GOP demands.

The other thing that must be noted about Brooks is that as a native New Yorker he knows diddly about the red-state social conservatives he constantly portrays as "real" Americans. Hence the idiocy of his now-famous op-ed about the Applebee's salad bar.

Posted by: scarlota | April 27, 2010 12:13 PM | Report abuse

I think what concerns David Brooks is the extent of government intervention. The proposal laid forth by Mankiw and Mallaby does depend on government as you correctly noted, but not nearly as much as the Dodd bill does.

Posted by: nathanpunwani | April 27, 2010 12:26 PM | Report abuse

Ezra,

I think the appeal of contingent debt is that it still works if the regulators are myopic/fall asleep at the switches on the fine details.

All the regulators really would be required to do would be to watch the capital levels and ensure that the bank had enough contingent debt. Just two easy to manage red flags. If capital ratios fall below a certain level, the debt converts to equity and recapitalizes the bank (which I think fits in well with your requirement for automatic regulatory action).

The regulators don't have to worry about whether or not there is too much exposure to subprime MBS or commerical real estate, or whether basel capital risk weights are encouraging gaming the system by loading up on high yield but low risk weight sovereign debt or whatever the financial boogeyman of the day is.

Since the contingent debt holders wouldn't want to be converted to equity under most scenarios, they would force banks to hold a decent buffer of capital against by requiring very high amounts of interest against companies who have small capital buffers. This is what Brooks means by decentralization - under most scenarios, fear of getting charged too much by the contingent bond holders keeps capital at safe levels.

Of course, if this decentralized process fails, you have the regulators step in and force the debt to convert, privately recapitalizing the bank. You don't completely eliminate the job of the centralized commission - but since you can't trust the regulators to manage the complex ins and outs of banking pefectly, you give them a relatively easy mission and try to tune market forces so that most of the time the regulators aren't needed.

The primary risks to the proposal would be raising all of this contingent debt, and making sure the requirement to have it isn't paired down/eliminated by future Congresses.

Posted by: justin84 | April 27, 2010 12:32 PM | Report abuse

the problem w automatically converting debt is that concievably you could have a short raid on an institution by a group of hedge funds and take it down. That's why Congress is loathe to leave it up to the markets. Well, that and they'd have to cede some oversight, whch is def part of it.

Posted by: Quant | April 27, 2010 12:58 PM | Report abuse

This analysis is letting Brooks off a little bit too much: http://variousprovocations.blogspot.com/2010/04/dream-worlds.html

Posted by: dariustahir | April 27, 2010 1:36 PM | Report abuse

The column's logic may be a bit weird, but it's vintage Brooks, who with every column makes less and less sense. He seems to be pining for an idealized past America that never existed.

Posted by: posterchild90 | April 27, 2010 1:59 PM | Report abuse

Quant,

How would a bear raid trigger a conversion? The calculation for capital uses the book value of equity, not market value.

A bear raid could create a liquidity problem, but a solvent bank should be able to overcome pure liquidity problems via the discount window.

A bear raid that's attempted against a positive fundamental backdrop is very dangerous, as there is a high risk of a short squeeze as value investors get long. If an institution is fundamentally weak, then a bear raid is providing valuable information about the true value of the institution.

Posted by: justin84 | April 27, 2010 2:57 PM | Report abuse

"It's a bit weird." No, it not. He's a "Serious Person," a status you have yet to achieve. David Broder, Washington's Most Serious Person, has anointed him a "Serious Person." You're still just a "person." (uncapitalized)

Posted by: golewso | April 27, 2010 6:50 PM | Report abuse

I think you are missing the point. (Maybe Brooks is too.) By requiring certain entities to only raise the money via convertible bonds, you eliminate the moral hazard of, say, lending money to Fannie Mae or one of the TBTFs, where it is essentially risk free because the taxpayer will bail you out. This actually protects the structure of companies fairly well, because much of their debt is eliminated in a conversion, although the existing shareholders (and employees with options) are massively diluted/wiped out.

These sort of automatic things are what we need to keep the system going through a crisis. We can't trust regulators to make all of the right moves.

Posted by: staticvars | April 27, 2010 10:14 PM | Report abuse

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