Hank Paulson on Bailout in Lieu of Bankruptcy
In an interview for the March/April 2010 issue of the Dartmouth Alumni Magazine, Jake Tapper of ABC News asks Hank Paulson about his role as Treasury Secretary during the financial meltdown. Here is one question that caught my attention (page 37):
Should there not be any organizations that are too big to fail?
Well they are as big as they are, so the key question is how do you regulate them and how do you have the proper authorities and tools in place so you can let them fail without taking down the rest of the system? This is something that Ben and I had talked with Congress about before Lehman went down. We saw we needed these powers. There’s no way we could get them, and the president and current Treasury secretary still haven’t gotten them. But I believe that with the right tools no institution needs to be too big to fail. You just need the power to unwind them outside of bankruptcy.
It is true that if you have these powers, then you can shovel taxpayer funding into them so that they don't fail and thus there is no risk of them "taking down the rest of the system." But you don't get the taxpayer's money back -- look at AIG. It is also true that you can "unwind" them in a way that violates the priority that would typically be assigned in bankruptcy -- look at the auto bailout/bankruptcy.
But the taxpayer is entitled to ask, "Couldn't you have gotten me a better deal than that?" and "Couldn't you have done that without institutionalizing moral hazard?" And the debt holder is entitled to ask, "Couldn't you have done that without running roughshod over my property rights?"
There is a difference between saving the financial system and saving the most reprehensible actors in the financial system. I have maintained that the malactors had to be forced to file for bankruptcy as a condition of any special taxpayer assistance being offered. It greatly diminishes the moral hazard, and it allows direct recourse to the malactors' creditors, who have in some cases -- like Paulson's former employer, Goldman Sachs -- made out like bandits as a result of the bailouts.
Unwinding TBTF
Stan - one of the things I generally like about this blog is that y'all try to be evidence-based. Which is a blessing and a burden because it creates an expectation as well as a requirement to dig into those areas where your expertise might not quite match the complexities of the problem.
In this case you have more than a bit of that problem. If we pursue organic metaphors letting a large "real" company go BK is like removing a large organ, or part of it. Serious damage and risks but perhaps necessary for long-term health. Removing a major financial institution that is wired both to other major financial institutions and to many real businesses who then cascade their own complex inter-connections out is rather like trying to remove a subset of the circulatory/respiratory system. An analogy that's close to being a model since credit flows are the respiratory lifeblood of the economy
Because of the complex counter-party links going into normal BK risks ripple effects all across the entire set of inter-connections. That's why, just as one example, bringing derivatives-especially CDS's- into a exchange and clearing house regime is so important. It makes the unwinding more transparent, visible and feasible.
For your kill them all, God will know his own to work, you need to show how those interconnections will not in fact have systemic risk problems. Contrawise what Paulson says is exactly true. We need to gradually unwind all the associated obligations and need new mechanisms and authorities to do it.
What's your counter-proposal?
Stan?
Stan?
Sorry..
...Andrew. It was early and I was typing fast. But feel free to respond to the central question in lieu of Andrew or make a joint reply :)