Joshua Rosner examines the House regulatory reform bill, which does not, in its current form, acknowledge that “Too Big to Fail” is too big to exist.

The House draft bill written by Rep. Barney Frank (D – MA) – along with several former Fed attorneys and Treasury staff and consultants — ignores fundamental reality: You don’t employ a bomb squad to sit around and wait for a bomb to explode, you engage them to dismantle it as soon as they find one.

Unfortunately, this bill is one more act of sleight of hand by a congress that, to the detriment of the public, fails to see that banks are there to serve the public good and can be regulated with such a goal. An honest bill would recognize that any institution that is “Too Big to Fail” should be given economic ‘incentives’ (through prohibitively high capital levels and insurance assessments) to shrink or sell off business units. The notion that we do not have the right to break up anti-competitive and oligo-polistic businesses flies in the face of antitrust laws and ignores the valuable lessons in growth demonstrated by Teddy Roosevelt’s trust-busting. Those legislators who are truly seeking to protect the public interest and to be worthy of re-election, should demand that legislation spell out, in plain English, that the entire capital structure of a TBTF institution be wiped out, and its holding company held responsible as a source of strength, before taxpayers are exposed to a single dollar of loss.

If leadership won’t add such language, call your elected official and ask how much they actually receive when they agree to put on the kneepads.

Rather than require the break-up or shrinkage of those institutions, this bill suggests we leave the institution intact until it becomes ‘troubled’ and instead subject it to greater oversight by the same Fed that mismanaged prudential oversight of precisely the large financial holding companies at the center of the crisis. Keep in mind that even on the 1-5 (best to worst) secret rating scale regulators use to define ‘troubled institutions’, BofA was only a 3 and it has been speculated that Citi was only a 2 even as they were begging the government for support. Should we wait to act until an institution is even worse off than they were in the height of the crisis?

This Trojan horse of a bill will recognize and codify the view that we must accept and agree to live in a world where there are institutions that are TBTF. We have chosen to head in the opposite direction from the responsible approach suggested by both Bank of England Governor Mervyn King, who wants to break up TBTF institutions, and other European regulators who are likely to oversee the breakup of TBTF institutions, ING and Lloyds.

Each of the elements of this historic and flawed approach was carefully negotiated in close coordination with the most interested parties – that is, the bankers and their friends. Mock hearings will be this week and the complete bill will be marked up mid-week next week. When the hearings begin, the public should demand to know how many of these “experts” have ever taken money as consultants or employees of the “Too Big To Fail” (TBTF) banks or the Federal Reserve System. You can play along with the game show at home by watching the testifying “experts” closely. Try to keep score of how many of  them identified the collapse of our credit markets in 2006 or 2007. You can go on to the bonus round and score which of these “experts” expressed a view or
highlighted the risk that the Fed’s “emergency powers” would create a moral hazard and be used to bail out our banks. Importantly, Senator Chris Dodd put these powers into legislation in the dark of night in 1991 at the request of Goldman Sachs and other large beneficiaries of government support in this crisis.

Perhaps I expect too much of these policy experts, after all, in May 2007 even Tim Geithner and the intelligent and thoughtful Fed Vice Chairman Don Kohn didn’t, in the face of over 100 mortgage lender failures and specific direct warnings, fully consider the risks that a crisis was already upon us.
As part of this Japanese-style kick-the-losses-down-the-road kabuki drama, Secretary Geithner desires that TBTF institutions write a “living will” so that when (not “if”) they end up in trouble, there will be a road map for investors and regulators to follow. This is honorable, but far from requiring banks or their managements to submit to the still more honorable tradition of Hara-kiri.

The story of an “unlevel playing field”

Those who argue against a more proactive reduction in risk and size of TBTF institutions will, as always, revert to an argument that strikes a natural chord in every American’s heart: ‘Doing so would create an unleveled international playing field for our institutions relative to their international competitors’. Level playing fields are a worthy goal, but this is not a relevant argument. Instead, this tired bromide must be resoundingly dismissed on several counts:

  • Those countries with the largest banks as a percentage of GDP (Iceland, Ireland, Switzerland) demonstrated that a concentration of banking power can cause significant sovereign risk and tilt global economic playing fields away from that country.
  • The likely breakups of ING, Lloyds and KBC suggest that it is we who seek to support an unlevel playing field where we subsidize our TBTF banks while other nations recognize the policy failures of moral hazard. If we continue down this path we will likely be at risk of violating international fair trade regimes.
  • When the “unlevel playing field” argument is cited, keep in mind this reasoning supports the disadvantaging of 8000+ community banks relative to our largest banks, all in the name of protecting big banks from governmentally- subsidized international competition.
  • There is no longer any evidence that, beyond a cost of capital advantage that comes with implied government support, there are sustainable and tangible economies of scale arising from being the largest. The financial supermarket concept has been proven a failure. The only ones who benefit are the high-level executives.
  • We must demand that our legislators no longer allow unelected officials at the independent Federal Reserve to sign international accords created by the TBTF banks through supra-national bodies like the Basel Committee.
  • Are we to believe that if we did not have such large and globally dominant firms, US borrowers might be paying more that the 29% interest that several of the TBTF firms are now charging on their card accounts? Perhaps we should think about what advantage our population has gained as a result of our financial institutions being such a large part of our economy or being globally dominant.
  • Since when did we accept a national strategy of following rather than leading? When we do what is right, others follow. As example, consider the bank secrecy havens – they made money for a bit. Now, even the Swiss and the Cayman authorities are coming around to our view.
  • We are already at a disadvantage given that the largest foreign banks operate in the US without any tier one capital requirement and yet mostlarge foreign banks have not built a bricks and mortar presence here. Nobody screams about their undercapitalization nor has that undercapitalization caused deposits to migrate to foreign banks.

Having provided preemptive arguments against their notion I would point out that by getting out of the TBTF game, we will have a more robust and economically competitive economy where no players have a governmentally-conferred advantage or subsidy. Such a leveled playing field will begin the process of regaining credible markets and attracting stable foreign capital. Let other nations pursue misguided policies of protecting uneconomic and anti-competitive businesses. Such an approach will allow our taxpayers to avoid having to be part of the next banking bailout crisis.

New GSEs for you and me

The Administration’s preferred approach, which is politically cynical, re-creates a class of special public companies that, because of their ties to the government, receive the benefit of a GSE-like “implied government guarantee”. For background, for the better part of the past 10-years market participants were increasingly convinced the GSEs (Fannie and Freddie) could become unstable. Even so bondholders viewed the companies as low credit risks. It was assumed that if they into trouble they would be bailed out with taxpayer dollars and without significant losses being forced upon bondholders. As a result of this belief, the GSEs had a significantly lower cost of capital than their non-“special” and fully private competitors. No matter how much Treasury, the
Fed, the White House or Congress said that the government did not stand behind the obligations of the GSEs the markets did not accept that view and, when push came to shove and the GSEs were taken over by the government last September it was the taxpayer that was place on the hook for up to $400 billion of GSE losses. GSE creditors walked away from the accident and even equity holders, who had always been paid to take the first loss, were not wiped out. So, are we expected to believe that these TBTF institutions will not be provided a lower cost of capital by the markets based on the understanding that the government will always stand ready to fund their losses? Moreover, from where in history can we draw comfort that when a macro crisis hits, regulators and policymakers will assess the cost of the losses on other TBTF institutions rather than arguing that that might lead to a contagion risk? As witnessed in this crisis, a withdrawal of liquidity from one systemically risky institution can lead to both a withdrawal of liquidity to its peers and also a contagious decline in asset values leaving all undercapitalized at the same time. If there is a positive to the GSE model and the “implied government guarantee” it is for the Washington political class. These companies will provide all legislators, regardless of their political affiliation, with a constant stream of lobbying dollars in return for help in stymieing regulators. The lobbying and campaign dollars the TBTF banks are spending to convince officials that their derivatives books were never at risk and their credit trends are stronger are welcome in Washington. In a testament to Washington’s love affair with
large financial firms Jamie Dimon has been repeatedly dubbed Obama’s “favorite banker”. Even so, there is still a massive lobbying dollar hole left by the withdrawal of the largess that disappeared with the predictable collapse of Fannie and Freddie.

Contingent capital is neither contingent nor capital

While it is not yet clear if the absurd notion of “contingent capital” will be referenced in final legislation or left to the regulatory hacks to codify in rulemaking, it is gaining support in the Fed as witnessed by recent comments from Governor Tarullo and NY Fed President Dudley. Rather than
requiring banks to raise and hold significantly more (good, old’ fashioned) equity capital, they want banks to use “contingent capital” or debt that converts to equity in cases of precipitously falling equity values.

Contingent capital is a deeply flawed notion proposed by academic economists who should either be locked away in institutions or sent off to a vast wilderness where they can no longer threaten the broader population. Equity is equity, there is no substitute. As long as the Federal Reserve retains the “13.3″ emergency powers one must expect that when a TBTF institution is imperiled or required to convert their contingent debt to contingent equity the TBTF institution will lobby hold legislators and regulators hostage to the notion that such a conversion would cause a market panic and lead to counterparties pulling secured lines and withdrawing liquidity…hmmm, sound familiar?

Moreover, unless there are clear and specific prohibitions against banks investing in each other’s “contingent capital notes”, we will increase systemic risk by engendering precisely the entanglement and interconnectedness that defines systemic risk. We have witnessed the problem of interconnectedness in this crisis in at least two situations; banks and insurers investing in each other’s trust preferred securities (TRUPS) and becoming exposed to not only declines in the equity value of their TRUPS but also to losses on their investments in other banks’ TRUPS. We have also seen the damage caused by regional banks outsized exposure to GSE preferreds. Lastly, unless market participants saw through the contingent capital notion and considered it to carry an “implied government guarantee”, the cost of issuance of the notes would be at a prohibitively high rates.

Salvaging regulatory reform for the good of our public

There remains some hope for those who would like to see real regulatory reform. The first chance for the public to force a more real reform on Washington will come as taxpayers awaken to the realization that, absent the government largess, bank credit trends demonstrate the economy is hardly stable and that unsustainable improvements in banks’ results arise from their capital markets business, not traditional lending.

A second chance for meaningful reform might come if an unlikely bout of mass sanity takes over our legislators causing the government to abandon its reckless “a golden egg in every pot” approach to trying to pull forward future demand is stopped. A more destructive catalyst could ultimately come in the form of a U.S. variant of the “Soros v the Bank of England” incident if foreign investors abandon dollar assets until the government rejects the financial obligations of the private sector.

To be clear, passage of the House Financial Services Committee regulatory reform bills does not ensure that Senator Dodd (D – CT), who intends to introduce his bill in November, will have any luck moving it. In fact, sources suggest that Mitch McConnell (R – Kentucky) sees Senator Dodd as vulnerable in his re-election campaign and is encouraging Republicans not to support his bill. Senate Banking Committee Minority Leader Richard Shelby (R – ALA) continues to suggest he will not negotiate any regulatory reform legislation unless it meaningfully addresses GSE reform.

While it is unclear if this is a hard line or an opening position, he has also made it clear he will not entertain the Fed in the role of either “il capo di tutti capo” of prudential financial regulators nor will he accept Ben Bernanke wearing a pinky ring and playing systemic risk regulator. On the latter Dodd is seemingly in agreement. Democrat leadership appears to believe Shelby is merely posturing and that, even though the reform language on OTC derivatives, consumer protection, TBTF, and systemic risk are laughably weak, it will be impossible for Republicans to convince the public that they are holding up reform legislation for honest and political reasons, rather than merely political ones. Democrats expect that they will be able to shift the debate from a debate on what would constitute good public policy to one of “the Republicans are a party of ‘No’”. I will predict that passage of this legislation on a partisan vote would have more negative implications for Democrat re-elections than the passage of a healthcare reform bill on a party-line vote. Americans hate their healthcare insurers but like their pharmacists and doctors. Americans hate their banks and have grown to hate bankers and their bailouts far more.

Even so, populist acrimony should not be directed at “the” bankers, rather it should be focused on the “Too Big to Fail” bankers. Perhaps we will ultimately force them to wear scarlet letters. Maybe we will tie them to rocks and throw them in water to determine if they are witches. It is urgent for taxpayers to see that their greatest allies in pursuit of good public policy on most of these issues are institutional investors, who bet that market forces ultimately prevail and rebalance to equilibrium, and also those small community bankers who largely stuck to their knitting, made plain vanilla loans, didn’t arbitrage regulatory capital rules, remained sufficiently well capitalized relative to their exposures. It is those two groups that suffer because the implied government backstop of the TBTF crowd is resulting in small banks being forced to compete for business at an economic disadvantage. It is institutional investors that now have to chase assets bid up by to those TBTF institutions that speculate and take on more risk as a result of their “implied government guarantee”.

Make no mistake, the TBTF crowd is still controlling both Congress and most regulators as witnessed by all the focus on secondary reform items rather than resolution authority and an end to TBTF. If you are TBTF you are too big and must shrink or be broken up. If we achieve this these bankers will be better and more focused on risk management and we wouldn’t have to even care as much about other secondary issues.

Over the next few days I will offer a section analysis and critique of the discussion draft.

Joshua Rosner is managing director of an independent financial services research firm.

Category: Bailouts, Credit, Regulation

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

20 Responses to “Congress and TBTF – Bring in the Bomb Squad”

  1. Captain Ned says:

    I’m a state-level bank regulator in a very small state. Our banks have followed the old-fashioned norms and as a result enjoy Tier 1 ratios well in excess of well-capitalized levels. Hell, our last failure came in 1992 as a result of the New England condo glut. I was a banker back then and the lessons of that debacle are hard-welded into my brain. Unfortunately, not all of my former banking colleagues from that era took away the same lesson. I’ve had some pointed (and disjointed) discussions recently with people that should know better based upon shared history.

    TBTF means too big to be allowed to survive. Each and every banking firm must run the risk of failure that wipes out all stockholders (which explains why the few remaining mutually-owned banks ’round here have double-digit leverage ratios and even higher Tier 1 ratios). In various fora I advocated back in 06-07 that we’d be better served by letting the dead entities fail and endure the 2 years of pain rather than babysit them for the 10+ years of pain. Somedays it sucks to be Cassandra.

    As part of my duties I’ve attended several training events put on by the Federal Reserve Bank of Chicago. The first time I went to one of these classes I was walking south on LaSalle to the bank building with the Board of Trade building looming over all. As I got to tbe Fed, I noticed that the substantial building on the other side of the street had a somewhat anachronistic corporate name still chiseled into the facade:

    Continental Illinois Bank

    Yes, the progenitor of TBTF still exists in the facade of the building directly across from Fed Chicago. My hysterical laughter at that discovery some 5 years ago certainly freaked out many on the sidewalk with me.

  2. Moss says:

    This is a very clear analysis of what is happening regarding the TBTF institutions and reform in general.

    The statement ‘the TBTF crowd is still controlling both Congress and most regulators as witnessed by all the focus on secondary reform items rather than resolution authority and an end to TBTF’ is all one really needs to understand.

    We are now being held hostage by the failed institutions and the political apparatus of the Corporate Communists. The so called socialists of Europe are more free market proponents than any of the hypocrites that got us into this mess.

  3. bsneath says:

    This sounds like it will not restore competition or safety in the banking system.

    Once the TBTF banks screw up, isn’t it a bit too late? I seem to recall that after the investment banks leveraged 40 to 1, set up SIVs, created toxic assets and over extended the economy, saving the TBTF institution was the least of our worries. By the time Lehman failed, much of the permanent damage was already done.

    The banks control our politicians. Nothing will really change until that is no longer the case.

  4. philipat says:

    IMHO the real crisis in The US is a moral crisis not a financial crisis. The whole sytem of Governance (Which includes both Public and Private sectors) is rotten from top to bottom.

    When did it all go wrong and what does this promise for the future? Fascism or Socialism or perhaps just a plain vanilla banana Republic, whcich is already how the Government is behaving. Maybe all those corrupt dictators in the Third world were just a little ahead of their time?

    When do we get some integrity and true leadership?

  5. scharfy says:

    There are enough laws right now on the books to jail about 10,000 people involved in this collapse for fraud. A federal prosecutor with some teeth could subpoena and indict for the next decade. Until the people pull there dollars from mega-banks, and call for the heads of Dodd, Frank, Bernanke, Geithner et al., this problem should continue and amplify.

    I applaud Senator Frank for attempting cosmetic legislation to fix a problem he had a major hand in creating (Fannie, Freddie), but this is tiresome political theather.

    Great article… but The American people gotta get vicious.

    Quoting the previous caller :

    “The banks control our politicians. Nothing will really change until that is no longer the case.”


  6. clawback says:

    “If leadership won’t add such language, call your elected official and ask how much they actually receive when they agree to put on the kneepads.”

    I nearly fell out of my chair when I read this. Having read Rosner’s stuff before, I was more than a little surprised to see such colorful language pop up out of the blue like that. (Then I noticed the italics.)

  7. Greg0658 says:

    all of that … and breaking up a TBTFight means 1 more big empty building gets occupied and at least 1 more janitor, 1 more indian, and 1 more chief gets a job TOO
    … I know capitalism is striving for Highlander “There can be only One”

  8. clawback says:

    Wow, this is a fantastic piece. Also, check out Rosner’s 2007 presentation on MBS, CDO’s and the risks they pose by clicking on the “direct warnings” link. It’s truly a shame that people like Josh Rosner and Chris Whalen are on the outside looking in, rather than directly involved in helping to solve these problems. Turbo has to go.

  9. Graveltongue says:

    This is nothing short of a coup.
    My only hope is that after the dust has settled after ‘The Gathering’ the one corp left standing is Disney, then life might be bearable!

  10. torrie-amos says:

    Well, many discussions on bonuses and how it totally disgusted most of us to the core, Why, one might say expereince………when you see blatant stupidity/corruptness, take you’re pick, he trend is easy to see………imho-40-1 leverage was insane I always wondered how it could have happened, who in there right mind would have allowed it………i chalked it up too a “one off” chit happens………this, well it is Insanity II, one must ask why, are people really really really this stupid and gullible, can they not add up 1 + 1, do freshman algebra perhaps……..imho, there are three choices:

    A. they really are that stupid
    B. the banks control congress uni-lateral, with ex GS men in high places
    C. they are good men, who in the back room while smoking stinky cegars see no way out and know a greater great depression is under the surfice and they just do not know when, and this is there best solution
    D. I am clueless and have been my whole life and should pledge allegiance too ignorance for peace of mind

    there may be more, yet, the statistical probable outcome based on any of those answers is not good

    I hated TARP to the utmost, yet, understood the issue of social unrest and it’s consequences, one can only wonder what they wonder about because well they seem to get more and more clueless each day.

    We need a million man march on Goldman Sachs on Valentines Day, lol, that would be some nice symbolism.

  11. PithyDog says:

    philipat Says:
    When do we get some integrity and true leadership?

    Why don’t you run for office?

    It looks like the first head that is going to roll is Dodd. The joke around just now is he’s raised perhaps $500 from his constituants for his re-election BUT millions from zombies from other states.

    I think Washington has Hollywood beat for discraceful storylines. Except for perhaps “The Twilight Zone”

  12. Lugnut says:

    “The House draft bill written by Rep. Barney Frank (D – MA) – along with several former Fed attorneys and Treasury staff and consultants”

    As a hardcore cynic, my BS meter went off the scale at the beginning of the article, unless by ‘consultants’ we define them as banking industry lobbyists and grognards who are paying for the priveledge of carefully crafting the legislation they are willing to live with. Congress doesn’t write any legislation that hasn’t been handed to them in draft form already by their industry Johns.

  13. “This is a very clear analysis of what is happening regarding the TBTF institutions and reform in general.”
    –Moss, above

    No doubt, yon’ Rosner is one of the sharpest knives in the Drawer.

    as bsneath pointed out: “The banks control our politicians. Nothing will really change until that is no longer the case.”

    this: “I will predict that passage of this legislation on a partisan vote would have more negative implications for Democrat re-elections than the passage of a healthcare reform bill on a party-line vote.” from JR, above, is a Lock..

    that idea may need to be checked through:
    Disney’s Neuroscience/Advertising Lab
    October 24th, 2009
    Via: New York Times:

    A technician in a black lab coat gazed at the short, middle-aged man seated inside the Walt Disney Company’s secretive new research facility here last week, his face shrouded with eye-tracking goggles. Read on that BlackBerry, she told him soothingly, like a nurse about to draw blood. “And have fun,” she added, leaving the room…

  14. Michel Caldwell says:

    Please indulge me in an attempt at tongue in cheek humor.
    Whereas Secretary Henry Paulson made it clear to America and the congress that — like it or not — the
    american taxpayer was on the hook for the sins of the TBTF financial institutions. That we are going to
    have to pay big time to fix their problems.

    Whereas pre-revolutionary political slogans advocated that there should never be Taxation without

    I hereby humbly suggest that we pass a law all0wing antibusiness congressmen to appoint people to the
    boards of directors of TBTF banks.

    Supporting argument: The merest thought of having Michael Moore and Carl Ichan on their board should be sufficient to drive those institutions into instant draconian financial diets.

  15. ForkMeetsRoad says:

    Looks like Barry has two choices:

    1. Continue toeing the line of liberal political correctness so he can grow his business while still claiming to be a man of the people (let’s call this “fake rocking the boat”)
    2. Draw a line in the sand and take a stand for the betterment of his country

    Pick a team Barry. Stop having people like Josh do your dirty work so you can still keep those important relationships with the mega bankers while at the same time still maintaining your “man of the people” persona with the little guy. You’ve got one of the loudest voices around… Use it.


    BR: Pick a Team? Political Correctness? WTF are you talking about?

    You have obviously never read anything here before . . .

  16. DouglasT says:

    Rosner nails it: the banksters are nailing the legislators.

    “If leadership won’t add such language, call your elected official and ask how much they actually receive when they agree to put on the kneepads.”

    There is the problem. Naked public bribery has rendered “our” selected officials utterly deaf to sheep bleating in the slaughterhouse. Thus the die is cast, and unless or until a sufficient number of people with influence (wealth) act in enlightened self-interest to contravene, then the status quo, velvet-glove fascism so far, will inexorably destroy capitalism itself, potentially giving rise to revolution. When law and morality is so blatantly discarded by the aristocracy, trickle down is inevitable.

    Where is the change we voted for? Where is FDR to save US from the butchers and the butchers from themselves?

  17. [...] (managing director of an independent financial services research firm), has written an important essay debunking this argument: Those who argue against a more proactive reduction in risk and size of [...]

  18. [...] (managing director of an independent financial services research firm), has written an important essay debunking this argument: Those who argue against a more proactive reduction in risk and size of [...]