On quasi-bailing out Too Big To Fail, and doing it contra Bagehot

The main idea: bailouts that make creditors whole but wipe shareholders and the firm itself are a great improvement over the current practice.     

0. Posts on this blog are ranked in decreasing order of likeability to myself. This entry was originally posted on 03.01.2022, and the current version may have been updated several times from its original form.

 

1.1 When it comes to entities alleged to be “too big to fail” which are nevertheless teetering on the edge of failure, you usually get two options: let them go, or bail them out. But there is a third beyond the two that have been known since Lombard Street.

1.2 OK, say you buy that these are too big to fail. What does the treasury or central bank do whilst still limiting moral hazard and not completely breaking market discipline?

1.3 Step one. Order a stop to all sales or any other activity except as required to service liabilities already incurred. This involves letting go of all staff not required to service these. All execs go.

1.4 Step two. Invest in the entity, as much as needed (but no more) to ensure the continued ability to discharge already incurred liabilities. Invest not as a shareholder, but as creditor, by issuing open-ended, zero-interest loans. In another departure from Bagehot, issue these in an unsecured format, no need for collateral.

1.5 Step three. Now that the immediate emergency has passed, use the skeleton staff and the CEO appointed by yourself to discharge liabilities in an orderly fashion. Transfer as many as you can to third parties for a fee, or buy them back from the owners, such as to limit the time you have to keep running this zombie.

1.6 Step four. As soon as all liabilities are either discharged or transferred leaving only yours, call your loans and close the thing down. Liquidate, let all owners take what is left. If you have been diligent, there will be zero equity by the end of this process, and all owners will have lost everything. Ideally you would have made back what you put in, but some losses are acceptable. Profits are not the point.

1.7 To ensure that you end up with zero equity, make sure to invest as per point 1.4 in a staggered fashion, only as liabilities that are uncovered come due, and not in one lump sum on day one. Very hard to calculate with certainty how much the shortfall is for some of these orgs which may have liability streams going on for decades, so just invest as you go. Done, no more steps.

1.8 Now, maybe some of these firms can be salvaged. It is alleged that the US made a profit on its GFC bailouts, so why aim for a sure loss? Why purposefully tank a firm that could have been saved, maybe at a profit? To ensure market discipline, of course.

1.9 A major firm went belly up, so someone messed up bigtime and caused a massive inconvenience at least, or a potential meltdown at worst. They have to pay and lose their shirt, and they cannot do so if the firm is saved and continues to linger on. Further, the firm itself, its very name, is tainted by failure. It must go, but it can be allowed to do so in an orderly fashion.

1.10 Of course, the market discipline this approach allows for is only relevant to shareholders, whilst creditors are made whole. Is this fair? Well, shareholders are willingly taking on default risk, whilst creditors agree to lower returns in exchange for a lower risk profile, so not a fair comparison between the two.

1.11 Still, moral hazard with regards to lending remains, and this is not a true substitute to just letting the thing fail. Some of these bankruptcies though are matters of a forced fire sale of assets decimating your ability to service liabilities there and then, and once the worst passes and immediate cash is made available, assets usually suffice to make whole all creditors. These are usually not Ponzi schemes.

1.111 Neurotoxin notes that the FDIC operates in a similar fashion, where they will usually facilitate the acquisition of a nearly insolvent bank by another bank, and add some money into the deal. Which seems great but leaves one question: are the shareholders of the original bank wiped? Big problem if not. If yes, seems like I have just reinvented the wheel, but am still annoyed that plenty of firms get bailed out and are allowed back afterward.

1.12 Now, all of this is especially relevant to banks, as viewed from the lenses of a central bank. The current paradigm requires the central bank to bail out banks in trouble by extending ample credit at allegedly higher-than-market rates, and against good collateral, which has now evolved into the practice of REPOs.

1.13 REPOs have in their stead evolved from tools to prevent allegedly systemic bank failures into the daily bread and butter of monetary policy, the principal tool by which monetary policy is enacted. This state of affairs is unsatisfactory for a myriad of reasons, not the least of which is that it makes the credit market of the entire economy a function of monetary policy, in effect quasi nationalising it (the way the proper gold standard worked has something to do with this too, but this is no longer a relevant consideration). 

1.14 Away with this all. Having an alternative to the current bail-out paradigm allows monetary policy to adopt an altogether different transmission mechanism, if the central bank so wishes. You can keep using REPOs, but you don't have to.