On “The Bailout”, Part 8: Wisdom from John Cochrane (I like the way he thinks)

Here is the link. Highlights:

Let banks fail, in an orderly fashion. When a bank “fails,” we do not leave a huge crater in the ground. The people, knowledge, computers, buildings and so forth are sold to new owners – who provide new capital – and business goes on as usual. A new sign goes on the window, new capital comes in the back door, and new loans go out the front door. Current shareholders are wiped out, and some of the senior debt holders don’t get all their money back. They complain loudly to Congress and the Administration – nobody likes losing money – but their loss does not imperil the financial system. They earned great returns on the way up in return for bearing this risk. Now they get to bear the risk.
This process does need government intervention – “in an orderly fashion” is an important qualifier. Our bankruptcy system is not well set up to handle complex financial institutions with lots of short-term debt and with complex derivative and swap transactions overhanging. Until that gets fixed, we have to muddle through. An important long-run project will be to redesign bankruptcy, delineate which classes of creditors get protected (depositors, brokerage customers, some kinds of short term creditors), and how much regulation that protection implies, and to design a system in which shareholders and debt holders can lose the money they put at risk without creating “systemic risk.” But not now.
The second part of the solution is to maintain liquidity of short-term credit markets. The Fed is very good at this. Its whole purpose is to be “lender of last resort.” We are told that “banks won’t borrow and lend to each other.” But banks can borrow from the Fed. The Fed is practically begging them to do so. Even if interbank lending comes to a halt, there need not be a credit crunch. If banks are not making new loans, it is because they either do not have capital, or they don’t want to – not because they can’t borrow overnight from other banks. (And the “other banks” are still there with excess deposits.) If the Fed is worried about commercial paper rates, it can support those.
Banks can fail without imperiling the crucial ability of the banking system to make new loans. If a bank fails, wiping out its shareholders, and its operations are quickly married to the capital of new owners, the banking system is fine. Even if one bank shuts down, so long as there are other competing banks around who can make loans, the banking system is fine.

I think many observers, and quite a few policy-makers, do not recognize the robustness that our deregulated competitive banking system conveys. If one bank failed in the 1930s, a big out of state bank could not come in and take it over. Hedge funds, private equity funds, foreign banks, sovereign wealth funds didn’t even exist, and if they did there’s no way they would have been allowed to own a bank or even substantial amounts of bank stock. If a bank failed in the 1930s, a competitive bank could not move in and quickly offer loans, or deposit and other retail services, to the first bank’s customers. JP Morgan could not have taken over WaMu. But all those competitive mechanisms are in place now – at least until a new round of regulation wipes them out. This is, I think, the reason why we’ve had 9 months of historic financial chaos and only now are we starting to see real systemic problems.

There is a temptation for regulators and government officials to hear stories of woe from failing banks, their creditors, and their shareholders and mistakenly believe that these particular people and institutions need to be propped up.
Since the Treasury will not be able to raise overall market prices, it will end up buying from banks that are in trouble, at prices fantastically above market value. This is transparently the same as simply giving the banks free money. Make sure the taxpayers get a thank-you card.

There is other talk (reflected in the Senate bill) of abandoning mark-to-market accounting, i.e. to pretend assets are worth more than they really are. This will not fool lenders who are worried about the true value of the assets. If anything, they will be less likely to lend. Conversely, if prices are truly artificially low, then potential lenders to banks know this and would lend anyway. We might as well just ban all accounting if we don’t like then news accountants bring. No, we need more transparency, not less.

Many of the changes in new versions of the Bill make matters worse, at least for the central task of stabilizing financial markets. The Senate adds language to protect homeowners – “help families to keep their homes and to stabilize communities.” That’s natural; a political system cannot hope to bail out shareholders to the tune of $700 billion dollars without bailing out mortgage holders on the other end. But it makes the bank stabilization problem much worse. Mortgages are worth a lot less if people don’t have to pay them back. This will directly lower the market value of mortgages that we’re trying to raise.

Let the banks fail if need be. Let the new owners capitalize and run them. They is no reason to prop up the existing shareholder. That is not solving the real problem.


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