Give Bankruptcy a Chance
Let's not institutionalize the bailout approach. There's a better way to deal with financial failure.
Jun 29, 2009, Vol. 14, No. 39 • By DAVID SKEEL
By all accounts, Paulson, Geithner, and Bernanke--the three musketeers of the financial crisis--never seriously considered stepping to the side and allowing Bear Stearns to file for bankruptcy. Why is this? One reason is that the mere whisper of systemic risk strikes fear into the hearts of financial regulators. If regulators agree to a misguided bailout, there are few immediate consequences. But if they forgo the bailout and the default infects other institutions, they could face a marketwide collapse and eternal condemnation. Given the stakes, regulators routinely overestimate the likelihood of systemic risk.
These particular regulators--Geithner, especially--were even more wired for bailouts than most. Paulson, the former head of Goldman Sachs--one of the healthiest investment banks--is a problem solver and deal maker. His instinct is to make a deal and move on--which is what regulators did with Bear and JPMorgan. Bernanke, as is well known, was a scholar of the Depression at Princeton prior to his appointment to the Federal Reserve. The mistake he vowed never to repeat was being too tightfisted with government money in a time of crisis, as the Depression-era Fed certainly was.
With Bear Stearns and AIG especially, Geithner seems to have been the point man. Geithner cut his teeth in the international affairs division of the Treasury, and as a key underling to Larry Summers, when Summers was secretary of the Treasury in the Clinton administration. The 1990s saw two key crises that seem to have permanently shaped Geithner's instincts: Mexico's currency crisis in 1994, and the collapse in 1998 of Long Term Capital Management, the giant hedge fund run by superstar economists and mathematicians. Both times, regulators opted for a bailout (funded by private banks in LTCM's case), and both bailouts are widely viewed as successful interventions. Mexico's crisis passed, and Long Term's collapse had little evident lasting effect on the market.
What is often forgotten is that these bailouts, successful as they were, did have a cost: They protected investors against the downside risk of lending to developing countries. Investors kept pouring money into these markets after the Mexican bailout, which contributed to crises in Asia and elsewhere at the end of the decade.
But the bailouts are remembered as successes. The lesson Geithner learned is that bailouts are always the best response when a large institution or country is in trouble. This lesson lies at the heart of the Treasury's proposals for reforming U.S. financial regulation. In addition to requiring hedge fund advisers to register with the SEC, imposing disclosure requirements for derivatives, and expanding the Fed's systemic risk authority, the proposals authorize bank regulators to step in and take over "systemically important" nonbank financial institutions, as the FDIC already does with commercial banks (that is, banks that take deposits). By taking resolution authority away from the bankruptcy courts and giving it to bank regulators, this proposal extends and institutionalizes the bailout policy of the past year. If the proposals pass, large financial institutions will have the same incentives that Bear Stearns, Lehman, and AIG had: to make sure a default would be as messy as possible, and count on negotiating a bailout with banking regulators if things go sour.
A more sensible approach would be to give the bankruptcy laws a chance. The prospect of bankruptcy at the end of the line would discourage excessive risktaking in the first instance, encourage creditors to monitor the institutions they have invested in, and if dark clouds do develop, encourage managers to make plans for an orderly bankruptcy. Bailouts will be even less necessary, and bankruptcy more sensible, when the administration's other reforms are put in place. As one of their principal justifications for bailing out Bear Stearns, regulators claimed that Bear's books were so unclear that they had no idea what its exposure was. The new disclosure and capital requirements will significantly reduce this opacity.