Too Big to Fail: The Real Choice

By James Kwak

Gillian Tett has an article criticizing the idea that CoCos — contingent convertible bonds — will solve the “too big to fail” problem. (And yes, she calls it “too big to fail,” even though Gillian Tett of all people understands what interconnectedness means.)

Contingent convertible bonds, a.k.a. contingent capital, are the latest fad to hit the optimistic technocracy in Washington and London. A contingent convertible bond is a bond that a bank sells during ordinary times, but that converts into equity when things turn bad, with “bad” defined by some trigger conditions, such as capital falling below a predetermined level. In theory, this means that banks can have the best of both worlds. They can go out and borrow more money today, increasing leverage and profits (which is what they want). But when the crisis hits, the debt will convert into equity; that will dilute existing shareholders, but more importantly it means the debt does not have to be paid back, providing an instant boost to the bank’s capital cushion. In other words, banks can have the additional safety margin as if they had raised more equity today, but without having to raise the equity.

Tett is skeptical for all sorts of reasons — defining the trigger point (remember, Bear and Lehman were well-capitalized on paper when they collapsed), finding people willing to buy these things, the impact on the market of triggering a conversion, etc.

I’m skeptical for a more basic reason. Contingent capital, like any other type of capital requirement, assumes that we can predict in advance how bad the crisis will be and therefore how much capital will be necessary to avert a bank-killing panic. That means we have to be able to predict (a) just how fat the fat tail is, based on virtually no data points, and (b) how panicked people can get and for how long. That seems to me technocratic hubris of the first order.

So why is contingent capital so popular? (It’s even mandated by section 107(b)(1)(D) of the Dodd bill.) Well, the people don’t matter don’t listen to me or to Gillian Tett. Here is Tett’s explanation:

“Even amid all those hurdles, the CoCo idea currently has many fans, not just among investment bankers touting for business, but some western regulators too. The reason stems from a big, dirty secret stalking the financial world: namely that while global policymakers have spent a year wailing about the ‘Too Big to Fail’ problem, they have hitherto done almost nothing tangible to remove that headache in a credible manner.”

Tett says what we need is a cross-border resolution system for bank failures. I’m a little skeptical of that too, for reasons I think I’ve outlined elsewhere. In case I haven’t, this is the problem: When push comes to shove, would the U.S. government use whatever “resolution” powers it has to take over JPMorgan Chase (JPM) or Goldman Sachs (GS) against its will (or let an international body do so)? Leaving aside the issue of political connections for the moment, the political hit it would take from the right (SOCIALISM!!!) would make the health care debate look like a friendly game of flag football. If we can’t even get meaningful derivatives regulation in 2009, what makes us think that any government would have the political capital to take over one of America’s biggest banks when it needed to? More technocratic hubris.

But I agree strongly with Tett on why contingent capital is suddenly so popular. Policymakers in Washington are looking for something, anything that will allow them to declare victory over the TBTF problem — without having to break up the banks. The idea that any clever regulatory scheme we come up with today, which by definition will be untested, can be counted on to come through in the next crisis seems hopelessly naive to me. I think it would be more honest to admit that there are really only two choices:

1. Break up any institution that is too big to fail.
2. Leave them in place (because “big companies need big banks,” or whatever other nonsense justification you want to use) and admit that we’ve done nothing to solve the TBTF problem.

That’s the real choice.

Comments

[Leftfield:]

Government is desperately, and only, looking for ways to cover up their TBTF friends like a cat covers up in a litter box. Not, properly disposing of the problem at all.
The word "conversion" is quite suitable, pertaining to "contingent convertible bonds." Legally, it means, theft.

Nov 13 12:52 PM

[fizzicyst:]

I've always liked regular convertible bonds; the reason is simple: Heads (stock price goes up) -- I win; Tails (it doesn't) -- I don't lose.

With contingent convertibles, this changes to: Heads (stock price goes down) -- I lose; Tails (it doesn't) -- I don't lose.

Why would any investor with even minimal intelligence buy them???

Nov 13 12:57 PM

[D. McHattie:]

Amen, James.

Too big to fail is too big to exist. All this other regulatory song-and-dance will get us nowhere.

Nov 13 01:26 PM

[apppro:]

<<Jamie Dimon penned an op-ed piece for The Washington Post, arguing that the "term 'too big to fail' must be excised from our vocabulary," and that the industry should pay its fair share.>>

Jamie should learn to keep his fat mouth shut, imo! JPM was just one step away from going the same way that Lehman's and even Bear did. Last March no bank was safe and if we hadn't put an end to the insanity by eliminating M2M, among other things - well the so-called suspect rally would never have occurred and we all would be lighting campfires next to our tents in Squatter City!

The shorts that took us all to the brink last year saw no qualms about driving even the mighty JPM down to $15.00 - it would have gone lower if things in macro hadn't changed.

Jamie would better serve his share holders (of which I am one) by getting our damn dividend back, keeping his mouth shut, buying back stock, and going after the shorts that still destroy this stock almost everyday at 10:40am.

Nov 13 02:09 PM

[Tower3chute:]

Much more useful would be to not allow the excessive leverage and amelioration of risk that led to these failures. If companies leverage 1:100 or even 1:40, then you have the possibility of making ALOT of money, however, you do not have that much skin in the game. Some other poor sucker (in this case american taxpayers) is on the hook for the failure of the strategy to which this leverage is applied. Even worse, there were idiots (known as AIG) who would insure you against the loss of even the 1:100 pittance you put down as leverage. You have now off loaded all your risk for a potentially huge return on investment, SIGN ME UP FOR THIS! I can make a bundle if the scheme works and foist off the mess on some other poor sucker if it fails? Who wouldn't do this?

The answer to this is simple.....make the company take a serious risk using their own capital by putting down 20% (1:5 leverage). I guarantee they will not do the moronic things that were done to create this crisis, IF they have to put their own money. The idea of risk mitigation is a bad one, I WANT you to have serious skin in the game if you going to make a financial deal. Otherwise we are just going to see this whole scenario again and soon. Hell....who wouldn't want this deal if they can do it? Minimal leverage must be mandated by law, otherwise this country is screwed and this legalized theft will continue...

T3

Nov 13 04:57 PM