Scare-Mongering Over Fed Oversight Bill

Full disclosure: I love Andrew Ross Sorkin’s Too Big To Fail and think everyone should read it. But having said that, Sorkin has spent a bit too much time running with the big dogs.

In today’s piece in the New York Times, he hones in on an amendment added to the Paul/Grayson bill passed last week that is admittedly problematic (I was asked by a Congressional staffer about it, I said I thought it was badly thought out and gave the reasons why). But Sorkin comes off as if he has become a mouthpiece for the aggrieved officialdom (in this case, the Fed) when there is more to the story than meets they eye.

First, let’s start with the eyesore. From Sorkin:

Representative Brad Miller, Democrat of North Carolina, and Representative Dennis Moore, Democrat of Kansas, added their own bell-ringer for voters still outraged over bailouts: the next time the government has to step in and rescue a company, secured creditors will take a hit, too.

That would be a huge shift in the way bondholders are treated. Up to now, they’ve been kept whole, even as others have been asked to share the pain. Otherwise, some feared, creditors might get spooked, and lending might seize up.

Yves here. On this level of abstraction, Sorkin is dead wrong. As we saw with the SIGTARP analysis of the the AIG non-negotiations with the banks who had credit default swaps exposures to the failed insurers, the banks should have taken haircuts on their CDS. If AIG had gone into bankruptcy, who knows how little they would have gotten (even assuming their companies survived the fallout, a very big if) and how long it would have taken. But given the need to move fast, the Fed just went ahead and did the rescue, and didn’t bother with costly details like getting the best deal (and frankly, the Fed is not in the negotiation business, so the idea that they lost ground in the “shape of the table” stage never occurred to them).

But the point here is more general. Creditors take hits in bankruptcy. If a bankruptcy is untenable (as in it might pose a systemic risk), why should the taxpayer get a worse deal? There should have been an explicit reference to the notion that the objective was to create an outcome that was comparable to what might result via a bankruptcy process to help guide action.

So the problem is NOT with creditors taking a hit. Creditors ARE risk capital, if they made bad decisions, they should take their lumps before innocent bystanders like taxpayers. That is a perfectly sensible idea.

What is wrong is this PARTICULAR amendment was just lame. But before we get to that, we have what amounts to ad homimem attacks on those who want to rein in the Fed. Revisit his language:

…. the next time the government has to step in and rescue a company, secured creditors will take a hit, too.

Yves here. Again, Sorkin is wrong-headed. He needs to bone up on bankruptcy law. In commercial bankruptcies (and that is what we are talking about here), secured loans are written down to the value of the collateral. Again, secured creditors are not as sacred as he thinks they are. In fact, one can argue that the bill is too liberal. It allows loans to secured creditors to be cut only by 20%. What if the collateral is worth only 50% of its face value? Even a 20% reduction would be too low. Back to the article:

That would be a huge shift in the way bondholders are treated. Up to now, they’ve been kept whole, even as others have been asked to share the pain. Otherwise, some feared, creditors might get spooked, and lending might seize up.

Yves again. Um, per above, no, this is NOT a huge change, the idea that bondholders could not be messed with is a very new phenomenon that took hold in the bailouts made in this crisis. And now is the time to undo that. Back again to the story:

One other amendment was added, as well. Representative Paul E. Kanjorski of Pennsylvania proposed giving regulators power to undo firms deemed to be too big to fail.

All of these amendments, which are part of a 300-page bill to reform the financial industry that is making its way around the House of Representatives, are intended to help quiet some of the outrage over the bailout.

Yves here. As we noted last week and as further discussed in a post by Ed Harrison, the Kanjorski moves are charades at best and actually in important respects make it harder to corral banksters.

But the key bit is in the next sentence: the accusation that the reforms measures are merely efforts to appease voters. First, that implies that the only reason for reform measures is to appease the angry public. Gee, the banking industry just drove the economy off the cliff, and the Fed and Treasury just stood by and watched. I’d say that is prima facie evidence of a need for a change.

Second, it suggests that everyone in Congress is just out to play to the lowest common denominator. While I would say that that is very often true, it is quite another thing to say that that is universally true. One of the big problems now is the artificial time pressure. The perception is that if reform measures are not passed now, they will not be passed after the Christmas recess (as in they will drag on into March-April, lose momentum, and never get done, because the longer they drag out, the closer they get to mid-term elections). So in the interest of trying to seize what may be the only window until the next train wreck, a lot of stuff is being pushed through. Some of the bad drafting may reflect sheer cynicism, but it may also be the result of the nutty timetable.

So the process is defective. But we also have a Fed that has performed very badly. Yet the scaremongering is decidedly one-sided:

But consider these words of caution from Senator Judd Gregg, Republican of New Hampshire: “Congress has demonstrated time and again its inability to manage the nation’s fiscal policy, illustrated by our staggering national debt in excess of $12 trillion. So how can anyone think that its involvement in monetary policy would be good for the country?”

So any unintended consequences of the amendment — what Senator Gregg calls “a dangerous move by this Congress to pander to the populist anger” — could indeed lead to less independence for the Federal Reserve, and the result ultimately may not be good for the economy.

That has been Fed Chairman Ben Bernanke’s line all along. He does not want the Fed to be a puppet of Congress. And on that score, he is probably right. Could Paul Volcker have raised interest rates in the early 1980s to nosebleed levels if Congress were pulling strings? What would happen in an election year? Interest rates would invariably go down, only to go up again later.

Yves here. Ahem. Who proposes budgets? It’s the executive branch. The deficits can hardly be pinned solely on Congress (as I dimly recall, it was Bush who gave us the combo plate of tax cuts and very costly Middle Eastern misadventure. And we’ve had 40 years of imperial Presidents, with Congressional power slowly eroded. Lyndon Johnson would be spinning in his grave if he could see what goes on now.

And look at the rhetorical tricks. Some checks on the Fed suddenly becomes the Fed turning into a puppet of Congress. Huh? The Fed has abused its role and the pushback is long overdue. The Fed lost its vaunted independence in the Greenspan era, when he started throwing his weight behind various Administration initiatives. That was a huge break from the past. And it got vastly worse under Bernanke, with the Fed operating as an off-balance sheet entity of the Treasury to evade normal Constitutional budgetary processes. This is simply heinous, but you’d think the Fed was completely innocent and undeserving of such rough treatment if you read only this article.

This article is badly one-sided and reads like a PR plant from friends of the Fed. I’m the first to admit the proposed legislation has problems, but it is quite another thing to depicts its objectives as illegitimate, and to create the impression that any measures along these lines would be damaging.

Update 11/25/09, 1:30 AM: Apologies for not updating this sooner. I have been on mission this week, and not spending much time on the blog.

Brad Miller weighed in in comments, and clarified a key issue that I had wrong in the post. While his amendment does provide for fully secured creditors to take an up to 20% haircut, there is already a provision in the bill for collateralized loans to be written down to the value of the collateral. Thus the up to 20% haircut is in addition to that.

This is the rationale for this measure:

The creditors to whom the amendment would most likely apply would be existing creditors who see the collapse coming and are in a position to demand more and more collateral. Only a desperate management agrees to tie up all of the firm’s liquid assets as collateral for short term debt. In those cases, the FDIC should probably not wait until Friday night to knock on the door. The resolution would certainly be easier, and cheaper, if the firm still has some assets that aren’t pledged as collateral.

If the amendment deters short term lending to collapsing companies that allows some creditors to grab enough collateral to cut in line ahead of taxpayers on resolution, that’s okay. That’s an intended consequence.

I’m not certain I like this idea either, and I need to ponder it further. I’ll be elaborating in another post.