Bankruptcy

Too Big to Fail? Is Obama Proposing an Implicit Government Guarantee of Goldman Sachs' Liabilities?

By Adam Levitin

Secretary Geithner was quoted by the Times as saying that from now on, ?no one should assume that the government will step in to bail them out if their firm fails.?

Sorry, but that's just not credible.  The Obama financial reorganization blueprint basically says that there are Tier 1 FHCs financial institutions that get special regulation) that are too-big-to-fail (TBTF).  For these (today 19?) companies that the administration has decided are guaranteed a bailout.  The blueprint refers to a guarantee of liabilities only passingly in its section on special resolution powers for Tier 1 FHCs, but given how we've handled the GSEs, AIG, Bear Stearns, etc., its hard to believe that we wouldn't guarantee the debts of a failed Tier 1 FHC--the whole nature of being a Tier 1 FHC is that there is systemic risk from its failure to honor debt obligations. 

This means that for Tier 1 FHCs, their debt is as good as guaranteed by the U.S. government.  The implications of this are far-ranging and serious; I haven't worked through all of them, but here's what jumps out at me:

(1)  This implicit (or almost explicit) guarantee will give these financial institutions a huge advantage in the market--they will enjoy a cheaper cost of capital  than any of their rivals (the same that the GSEs enjoyed).  That means all smaller banks, broker-dealers, and insurance companies will get crushed.  It also means that foreign financial institutions will be competing against the US government in essence.  I hate to think of the trade law implications. 

(2) This funding advantage for Tier 1 institutions will come at taxpayer expense--the result of guaranteeing the debt of large financial institutions is to balloon the federal balance sheet and raise the cost of Treasuries, which means raising the cost of borrowing for everybody (except maybe its offset by the cheaper cost of funds for borrowers from the TBTF institutions).

My intital thought is that this implicit guarantee would be very disruptive to the economy--possibly more so than the failure of any of these Tier 1 FHCs.  If that's the case, it's a bad trade-off. 

The blueprint's goal seems to be to regulate these TBTF institutions so carefully that they won't need a bailout (and maybe the regulation will be so onerous that companies will voluntarily shrink to avoid Tier 1 status or the regulatory costs will offset the funding advantage).  Methinks there's a bit of Master-of-the-Universe-as-regulator hubris there.  I don't trust the smartest guys in the room to get it 100% right, whether they're on Wall Street or Treasury.  We should know better now.  No regulatory scheme is failsafe, just as no investment scheme is guaranteed.  Even if it works now, what works today will be dated in 5, 10 or 20 years.  We shouldn't kid ourselves that a bailout will never be necessary with a revamped regulatory system and that we aren't therefore guarnateeing anything. 

The Obama plan is an implicit guarantee of JPMorgan, Bank of America, Citi, Goldman, Amex, Morgan Stanley, CapOne, and the rest of the Stress Test 19 institutions.  Do we really want the US government implicitly guaranteeing Goldman Sachs or CapOne's debt?  Is that what this world has come to?  Did we really cross the Rubicon in September 2008 without realizing it?  I recognize that the alternative is trust-busting, and shrinking financial institutions until they are no longer systemic risks, and that isn't very palatable, but it strikes me as possibly the less bitter gall.  

Full post as published by Credit Slips on June 18, 2009 (boomark / email).