Bailouts Through the Back Door

By James Kwak

Tyler Cowen quotes from Robert Pozen’s yet-to-be-released book:

“In my view, the adverse repercussions of Lehman’ failure could have been substantially reduced if the federal regulators had made clear that they would protect all holders of Lehman’s commercial paper with a maturity of less than 60 days and guaranteed the completion of all trades with Lehman for that period.”

Back when people cared about these things, I wrote a couple of posts on the issue of selective protection of creditors.

The point I was trying to make at the time was that it should be at least conceptually possible for a regulator to determine what the ripple effect of default would be and impose haircuts in such a way that systemic failure would not result. This would provide a middle way between bankruptcy (complete uncertainty and panic) and blank-check bailout (100% taxpayer guarantee, no losses by creditors). I was envisioning this in the context of government receivership, but I also had this tentative idea:

“I think that the government could let AIG (AIG) fail, if – and this is a big if – it can first identify which creditors and counterparties would be hurt, determine which of those cannot be allowed to fail (which should not be all of them), design a program to provide them enough capital directly, and announce everything on the same day. The net cost to the taxpayer cannot be higher than under the Too Big To Fail strategy, which implies a 100% guarantee for all counterparties and creditors.”

But if I am interpreting Pozen correctly, he is suggesting a more elegant way to achieve the same objective. Once the government has determined which liabilities and exposures will have systemic ripple effects (he says short-term CP and outstanding trades), it could just announce a guarantee on those liabilities and exposures and let everything else go into bankruptcy. Now maybe they didn’t have time to make such a determination the weekend before Lehman failed (although arguably they had since March to figure it out), but by the time Citi (C) and Bank of America (BAC) and the last AIG bailout rolled around arguably they did. I’m not enough of a markets person to be sure this would work, but it seems like a viable proposal.

Comments

[MattZN:]

I was under the impression that Lehman was financing tens of billions of dollars with short term debt. Frankly, that debt would have had to go into bankruptcy because if it didn't it would signal to large companies that "hey, it's ok to finance huge bets with short-term loans that you can't cover". In otherwords, that sort of debt-use is precisely what we do NOT want to see people use ever again. It would be stupid for the government to bail it out and not bail out the more traditional debt instruments.

-Matt

Sep 30 02:59 PM

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Oct 01 01:02 AM

[John Lounsbury:]

My cynical view is that Lehman failed and AIG was covered because of counter party interests. For example, Goldman Sachs had a much larger loss if AIG failed than it experienced because of Lehman's failure.

If true, the moral of the story is that if you want to assure bail-out when under duress, sell large numbers of CDS contracts that you can't cover to all the banks that are too big to fail.

Oct 01 12:51 PM

[Clive Corcoran:]

The quote cited from the book by Robert Pozen makes the sterilization of the Lehman debacle sound deceivingly simple.

PWC has about 250 people working full time on disentangling the Lehman mess and many hundreds of others (including ex Lehman staff) will be gainfully employed for a considerable period - with very considerable fees -sorting out the complex labyrinth of counter-parties to their trades. AIG's labyrinth went right to the "heart" of the financial system.

As John L suggests at the end of the day it came down to a "gut" level decision by Mr Paulson about who most needed to be protected.

Oct 01 01:46 PM