'Ownership But Not Control' Is More Like Control Without Accountability

I've been unimpressed with this oft-quoted bit from Phillip Swagel's insider account of the Paulson Treasury.

Legal constraints were omnipresent throughout the crisis, since Treasury and other government agencies such as the Federal Reserve must operate within existing legal authorities. Some steps that are attractive in principle turn out to be impractical in reality—with two key examples being the notion of forcing debt-for-equity swaps to address debt overhangs and forcing banks to accept government capital. These both run hard afoul of the constraint that there is no legal mechanism to make them happen. A lesson for academics is that any time the word "force" is used as a verb ("the policy should be to force banks to do X or Y"), the next sentence should set forth the section of the U.S. legal code that allows such a course of action—otherwise, the policy suggestion is of theoretical but not practical interest. Legal constraints bound in other ways as well, including with respect to modifications of loans.

Thursday's news (Clusterstock + source docs, WSJ Deal Journal, McArdle, Naked Capitalism, Calculated Risk, Marketwatch), that Henry Paulson, um, forced Bank of America's (BAC) near suicidal merger with Merrill Lynch kind of clinches the case. Pre-Merrill, BOA was viewed as relatively healthy among large banks. What's the statute under which a Treasury secretary unilaterally fires and replaces the board of a healthy bank? The Paulson Treasury talked up legal constraints whenever they were faced with something Paulson didn't want to do.

When Paulson, or Bernanke, really did want to do something, they were very creative about bending the law to their will. The Fed's "special purpose vehicles" are clearly not lending in the sense that the architects of the Federal Reserve Act's "unusual and exigent circumstances" clause foresaw. The FDIC has no statutory authority to issue ad hoc guarantees of bank debt, but flexibility was read into the laws.

With respect to the banks, the Paulson Treasury could have forced any big bank into a bailout or receivership scenario just by looking at it funny, or by having the Fed take a conservative view of bank asset collateral values under the special liquidity programs. It's worth noting that Treasury very ostentatiously forced banks to accept TARP capital, and Geithner's Treasury was able to persuade holders of Citi (C) preferred to convert to common equity.

It's not exactly right to say that our don't-ask-don't-tell quasinationalization policy has given us "ownership but not control". An assertive Treasury secretary has tremendous leverage over zombie bank managers. Instead, what we have is control without accountability. An informal, unauditable, hydra-headed set of private managers and public officials controls how quasinationalized banks behave. Neither taxpayers nor shareholders have reason to believe that decisions are being taken in their interest. The informality and disunity of control impedes the kind of hands-on, detail-oriented supervision and risk management that ought to be the core preoccupation of bank managers. Exactly as opponents of nationalization feared, America's large banks are poorly run behemoths that routinely make idiotic commercial decisions to satisfy tacit political mandates. No one really knows who is responsible for what.

Ironically, there might be less scope for political control if banks were in formal, least-cost-resolution receivership. A bank that has already failed cannot fail. If independent boards are appointed to oversee the receiverships, politicians might have very little leverage. Incumbent private managers face collapse, sacking, disgrace, and potential civil and criminal liability for improprieties that come to light during the post-mortem. New moderately paid, high reputation board members would bear no responsibility for what came before, and could very publicly resign in protest if pushed to act in a manner inconsistent with their charter. (Resignation in protest by long-affiliated board members of a zombie bank would have different reputational consequences, and it would be difficult to recruit high-reputation outsiders to serve on zombie bank boards.) Promoting insiders or recalling retired executives to run zombie firms leaves the leadership weak and compromised. A much higher caliber of outside talent could be recruited to oversee banks in receivership that would accept responsibility for banks that are insolvent but on government life support.

This is not to say that formal public control would be a panacea. The list of public and quasipublic organizations currently being gutted by politically motivated credit expansion includes Fannie Mae (FNM), Freddie Mac (FRE), FHA, FHLB, FDIC, and the Federal Reserve system. A bank in receivership managed by a weak board or not institutionally segregated from political bodies could easily join the list. But if received banks were put under strong boards, and given clear mandates to divide and sell their assets (maximizing taxpayer value subject to a scale constraint) while running off their lending books, there would be little hazard of politically directed credit or other shenanigans. That would imply that large insolvent banks would reduce their lending, contradicting the Administration's endless exhortations that banks should lend, lend, lend. My view is that public encouragement of expanding indebtedness is very bad policy (read Finem Respice). But if you misguidedly believe that "credit is the lifeblood of a modern economy", the thousands of well-run smaller banks in America are fully capable of taking advantage of today's deeply subsidized lending spreads to serve creditworthy borrowers. Whether in private or in public hands, the big, broken banks are simply too compromised to lend.

Comments

[morph366:]

There are several reasons why "quasi-nationalization" has been chosen as the preferred route and the fact that Administration officials can intimidate current management, even making token replacements, without having to take on full control and responsibility is certainly one of them.

Another is that it avoids having to deal with the debt-holders and the third is that it prevents triggering lots of CDS contracts.
Seen in this light it is not surprising that the government is doing all it can to avoid putting those troubled banks into receivership. Only in the fullness of time will the error of this approach be confirmed.

Apr 24 04:49 AM

[CautiousInv...:]

You raise a number of interesting points.

As to nationalization, the Swedish and Japanese experience would strongly suggest that this model be invoked where required and appropriate. It would be fast, efficient and provide resolution.

We have not done so because the FDIC does not have the authority to take over a bank holding company but, as you suggest, this has not prevented from other questionable undertakings. I have no idea as to what authority Paulson would draw upon to for BAC to acquire Merrill.

Other arguments against nationalization include international turmoil, a full collapse of equity value, bonholder haircuts and broader doubts about the global financial system. The point made by Morph about CDS, could morph (sorry I could not resist) into something that would make AIG look small.

So we have taken the path of least resisitance all the while praying that by buying time the markets will recover along with the banks themselves. With growing estimates of exposure to real esate losses, I think we will be forced to pursue other strategies.

Apr 24 08:05 AM

[Leftfield:]

All steps taken until now look like the sorts of ill thought-out half-measures that have characterized Detroit for a long time. With halfway non-solutions to problems, they kick the can down the road only, to an even worse outcome later.

Naturally, I see this as failed Wall St. and DC leadership primarily protecting each other. The 83% rise in Caribbean holdings of US bonds shows where lots of taxpayer money is fleeing from these people. Since these people are the architects of failure, their likelihood of admitting it and changing course to a successful strategy is about nil. Especially as they are among the most arrogant on the planet.

The idea that we have to pay up to keep the same "talent" in place doesn't seem valid in light of this article or common sense. After watching unprecedented wealth transfer to the top these last 30 years supposedly for merit, I wonder, is anyone home?

Apr 24 09:19 AM

[John Lounsbury:]

Steve Waldman and all three preceeding commenters - - -

You are all presenting the very strong arguments why the fly by the seat of your pants approach of the past eight months must be stopped.

Simon Johnson presents some related arguments today:
seekingalpha.com/artic...

It is not too late to end the emergency room treatment of the banking system and get into more productive reconstructive treatment. But the clock is ticking.

Apr 24 01:34 PM

[Between The...:]

So, let's jump between the numbers: the Treasury via Paulson forced Merril upon BofA, taking a weak bank and bolting on a nearly failed bank, with all of the inefficiencies that a merger initially entails. This huge mega bank is now even more "too big to fail", and was created at the behest of the federal government. With the 2.2B in assets and 2.1B in debt, it is on a razor's edge for losses with that sort of leverage. Clearly, this would demand the common equity and junior debt of BofA should be greatly stressed, but in practice, it now has an implicit government guarantee. With the Fed's hand in the cookie jar as well (thanks for spreading some blame where deserved, Mr. Paulson!) there are basically two all-powerful institutions that dare not let BofA fail. BofA can't possibly go BK now, because the shareholders/bondholders of BofA would have legit cause to come after the Treasury and Fed arguing that the failure is a direct cause of the shotgun wedding. Just like AIG's bailout was a tunnel of money to banks, Treas/Fed basically made ML bondholders whole on their assets by getting BofA to take them and then issue bailout number 3.

Apr 24 06:30 PM

[bricki:]

John's comment is very insightful. What we have now is an ad-hoc crazy quilt of poorly coordinated and incompletely thought out programs that could easily come apart at the seams.

If this seat of the pants governing of history's largest, most dynamic and at least up to now most productive economy does not get some careful reassessment and unwinding the quilt will turn into a multi-trillion dollar pile of lint. The affects of this may devastate the US for a generation or more.

The amount of money and radical changes that are in play right now is frightening. And do we have the correct people making the decisions needed? Hard to say who exactly has the seat of power right now. I hope it is Volker as he is probably one of the few people capable of sorting this out. I certainly don't like the idea of Bernanke and Geithner making policy here.

Apr 24 10:08 PM

[altaman:]

The failure to repair the financial system in a timely and transparent manner is truly disturbing and disheartening to anyone that loves America. Failure of one or more of the "two big to fail" banks, a prolonged depression and/or hyperinflation are becoming real possibilities in the coming years. Only a complicit press and pundit class, massive market manipulutions with derivatives and taxpayer money, an ignorant retail investor class and Obama "don't worry be happy" euphoria is keeping the market from falling by 50% from here.

Apr 25 12:48 AM