If an activity is important enough to justify a government nationalization to prevent a default, it is important enough to be regulated. The regulators need to know what risks are being taken, and by which institutions, in time to act before a crisis develops.
Had the government bothered to do that in years past, it might not have faced the decisions it faced this week. First, it let one big firm go down, and then it became scared enough to nationalize another one to keep it afloat.
Now, showing no sign of embarrassment over how badly they failed before, the current crop of regulators seem to be unified in their determination not to let the markets force them to make a similar choice on some other big financial institution.
The result is a campaign against those who bet that the financial system was crumbling.
If the government is forced to decide whether to save another firm, it will face the same question it faced with A.I.G. and Lehman Brothers. Would this failure cause systemic damage to the financial system?
Lehman did not measure up because its chief executive, Richard S. Fuld Jr., simply was not reckless enough as he ran Lehman into the ground.
Had he had the foresight to make a lot more bad bets in the derivatives market, the government would have feared financial chaos and might have nationalized Lehman, just as it nationalized A.I.G., Fannie Mae and Freddie Mac. Or it would have subsidized a takeover, as it did for Bear Stearns.
The Paulson-Bernanke Doctrine is not “too big to fail.” It is “too reckless to fail.” If you get your company into enough trouble to threaten the financial system, Ben Bernanke, the Federal Reserve chairman, and Henry Paulson, the Treasury secretary, won’t let you collapse.
It may be that they miscalculated. Lehman’s default caused a money market fund to suffer losses, and scared investors into pulling their money from similar funds. If those funds cannot find buyers for their assets, there could be more defaults, and perhaps more failures.
The Paulson-Bernanke Doctrine was born not of theory or ideology, but instead from improvising as each new crisis erupted. The Fed’s briefing on the nationalization of A.I.G. did not start until 9:15 p.m. on Tuesday night, which is not a sign of carefully thought-out decisions. When they met with Congressional leaders Thursday night to seek a plan to get cash to banks before they fail, it was almost as late.
If these nationalizations smack of socialism, it is closer to the Marxism of Groucho than of Karl.
The Cox Proviso to the Paulson-Bernanke Doctrine is that the rules will change, and change again, if that is needed to avoid another failure.
On Wednesday morning, Christopher Cox, the chairman of the Securities and Exchange Commission, announced new rules on short-selling. The market plunged anyway, and that night he was back with a news release saying he would ask the commission to force short sellers to publicly disclose their positions.
“The enforcement division will obtain disclosure from significant hedge funds and other institutional traders of their past trading positions in specific securities,” he added.
By Thursday night, after Senator John McCain denounced him for not doing enough about short selling, he was talking of banning the practice.
Had the S.E.C. gone over the records of Lehman and Bear Stearns with the vigilance it now promises for the shorts, we might not be in this mess. But that was then, and it is clear that anyone betting against the big banks now is fighting not just the Fed, but the S.E.C. and Treasury as well.
It is a sad commentary that the authorities are most worried about a market that they were unwilling to do anything about when it was growing and growing. That market is credit-default swaps. The people who developed that market hired good lobbyists, who got the law written to keep regulators away. Alan Greenspan, then the chairman of the Federal Reserve, thought it would be wrong for regulators to try to, as he frequently said, “outguess the market.” Now the country dares not risk letting the market work its magic.
Credit-default swaps are a way of transferring the risk of owning a bond. If I own a bond issued by General Motors, and have also purchased a credit default swap on G.M., then I am covered if G.M. defaults. I can recover my losses on the bond from the institution that sold the swap to me.
There are now many more credit-default swaps outstanding than there are bonds for them to cover. They became a way to gamble with almost no money down. For a small fee, my hedge fund can bet that a company will go under. And your hedge fund can collect that fee, and produce instant profits. Years down the road, you may have to pay, but big companies rarely default anyway, so the risk is minimal. Or so people thought.
One way to think of the swaps market is as insurance that is issued by companies that do not have to keep reserves and may be totally unregulated. I can’t legally buy fire insurance on your house, since I have no stake in it, and letting me have insurance would give me an incentive to burn it down. But I can buy a credit-default swap on G.M. even if a G.M. default would not cost me a penny.
That brings up “counterparty risk.” If my hedge fund bought a G.M. swap from A.I.G., and sold one to your hedge fund, then my fund has laid off the risk. If G.M. defaults, I will have the money to pay you as soon as A.I.G. pays me.
But if A.I.G. has taken lots of those positions — and it did — then who knows which banks and funds and investors will be in trouble if A.I.G. cannot honor its obligations? My fund may have a perfectly matched book, but it is suddenly in deep trouble if a counterparty is defaulting. Since no one keeps track of all the moving parts, no one knows just who may get into trouble if one participant fails.
The theory that beguiled legislators and regulators was that the market could regulate itself. Each bank would be careful to deal only with counterparties it could trust, and so the whole system would be trustworthy. But even if you believe that, remember that most swaps are good for five years. Not long ago, A.I.G. was a Triple A company, whose credit was viewed as sterling by everybody.
It is worth remembering that A.I.G.’s credit standing did not fall even after it was caught helping other companies rig their financial statements. Nor was it hurt by evidence it had fudged its own numbers. Discovering that a company is run by people with what we might call flexible integrity should have been a red flag.
But who would have looked? The insurance subsidiaries were regulated by state insurance departments, and activities of the parent were not their focus. Had anyone suggested an aggressive audit to see what other games A.I.G. was playing, I am sure that neither the Fed nor the Treasury would have thought they had jurisdiction.
Now they say the national interest required them to step in. “A disorderly failure of A.I.G.,” the Fed said, “could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth and materially weaker economic performance.”
That may sound outrageous, but it is probably true. By the time A.I.G. was on the verge of failure, the government’s options were limited.
In letting Lehman default, the authorities wanted to send the message that they were not going to bail out somebody every weekend, and that the damage from a big brokerage failure could be contained. They may have been wrong on both counts
I doubt anyone in government thought to wonder if a money market fund would have to “break the buck” because it owned Lehman debt. But that did happen.
It is not easy to forecast the reverberations of one big failure, and the Fed may not have done it well. But the biggest errors in Washington were made long before A.I.G. arrived at the Fed with its hat in hand, and long before short sellers began to think the banks were in trouble.
