Is This the End of 'Too Big to Fail'?

Includes: AIG, C
by: Karl Denninger

The WSJ reports:

WASHINGTON -- A deal between the Treasury Department and a key House Democrat would give the government sweeping new powers to police the country's largest financial companies, including the ability to seize and break up failing companies and order large firms to shrink.

Uh huh.

The proposal would require financial firms with more than $10 billion of assets to pay for the unwinding of a collapsed competitor. The measure would also give the Federal Reserve the power to direct any large financial holding company to sell or transfer assets or stop certain activities if the central bank determined there could be a "threat to the safety and soundness of such company or to the financial stability of the United States." This suggests the Fed would win new authority to order companies to shrink.

The Fed.

The same Fed that ignored the subprime lending fiasco? The same Fed that gave a rubber stamp to a black-letter unlawful merger between Citi (NYSE:C) and Travelers, then lobbied for retroactive passage of Gramm-Leach-Bliley to legitimate it? The same Fed that permitted primary dealers and other large financial institutions under its supervision to transact credit default swaps with AIG (NYSE:AIG) despite the fact that AIG's financial products group was inadequately capitalized (by a factor of 50 or more) to cover those transactions?

The Hill of course sees it differently:

The Financial Services Committee and the Obama Administration are committed to ensuring that the taxpayers are never again called upon to take responsibility for Wall Street’s business decisions. The bill creates a strong, inter-agency council to monitor and oversee stability of the financial system and address threats to that stability. The bill provides strengthened supervision for large, interconnected financial firms to prevent failure. A new resolution regime will ensure that firms that fail despite these measures will do so in a way that minimizes impacts on taxpayers, the health of the financial system and the overall economy.

Let's not mince words - there is good in here. Among the good parts of this bill are that "too big to fail" will become formally invalid as public policy.

It requires the failed firm's creditors and shareholders to bear "first loss", and, if the brief is to be believed, only if they are entirely wiped out and there remains a shortfall will assessments be laid - on other large financial institutions, not the taxpayer. This should result in large amounts of "social pressure" to stop stupid actions, since the risk of them can fall on other large market participants.

It requires that securitized products retain 10% of the risk (which can be reduced to 5% but not lower by regulators) of any product so securitized, stopping the "pass it all on and watch the bomb go off on the back of the fool who you sold it to" game.

And finally, it requires approval of the Treasury Secretary for The Fed's employment of 13(3) authority - the blanket "we can lend to anyone" authority that The Fed has cited (and in my opinion both abused and exceeds the limits of) during this crisis. In addition, it prohibits "special facilities" entirely - that's a real improvement.

Left unanswered is whether there are criminal penalties imposed for violations. My expectation is that like the rest of the "toothless tiger that roared" games out of Washington DC, the critical "or else" is missing, but we'll see once the markup is complete.

I cannot endorse this as written, but I can say that it is a vast improvement over what we have now, and what has happened to date. For The Fed to have that primary seat at the table and the "final backup authority" they must be subject to regular and comprehensive audit, so as to insure that the people can see they are complying with the strictures of law - otherwise any so-called "restrictions" are nothing other than a joke.

In addition it is critical that this law include criminal penalties for violations as any failure to follow the constraints laid down will of necessity expose the taxpayer to enormous loss (as has occurred in this instance), and as there is no reasonable civil penalty available in such a circumstance, severe federal criminal penalties are appropriate.

We must not only end "too big to fail" we must also end "too bribed to give a damn", which has permeated the entirety of Washington DC over the last three decades.

The bill being debated in committee hearing today (and presumably being marked up soon) is a good start, but without the addition of full "sunshine" and criminal penalties for violations to the mix it will remain merely a set of suggestions that can and will be ignored when it suits the "rich and powerful", just as has been "Prompt Corrective Action" and the existing bevy of alleged "laws" that supposedly prohibit and should have prevented the outrageous practices that led us into this mess.

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