Wednesday, July 15, 2009

The Moral Hazard of Bailing Out Banks...

When reading a WSJ story with the headline "A Tale of Two Bailouts," my mind began thinking of Dickens and his rather famous opening paragraph for A Tale of Two Cities, the Dickensian tale of the French Revolution, when the unwashed masses rose up in violence against the privileged ruling class.

"It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair...."

Interesting, how apt that quote remains today....

For Goldman, the Crash has truly been the cause of some very good times.

However, for CIT, another TARP recipient, the worst of times are possibly approaching. It is a financial institution that still teeters on the verge of bankruptcy.

And it is not yet clear if the feds will bail CIT out.

So what does CIT's possible failure mean? The WSJ explains:

"What the Goldmans of the world have in addition to profits is the widespread belief that they are too big to fail. Both Goldman and CIT converted into bank holding companies at the height of the financial panic last fall, which made them eligible for TARP injections. Goldman also benefited at a crucial moment from the Federal Reserve takeover of AIG, and it received the additional filip of FDIC-guaranteed debt issuance through the Temporary Liquidity Guarantee Program. CIT was excluded from the latter program on grounds that it didn't pose a systemic risk, even as larger competitors like General Electric were allowed in.

CIT's asset quality has since fallen further, and it now faces $2.7 billion in maturing debt this year that investors fear it will not be able to roll over. So it is seeking another taxpayer rescue, and officials at Treasury and Fed are sympathetic.

But if CIT -- a company one-tenth the size of Lehman Brothers -- can be bailed out long after the panic has passed, the word "systemic" has lost all meaning. CIT has long been a lender to subprime corporate borrowers, and this decade it took on even greater risks at precisely the wrong time. It has lost money for eight straight quarters. Its lending supports less than 1% of the total U.S. retail and manufacturing, and plenty of competitors could pick up its market share."

Should the feds bail them out? I am eager for the day when the financial community will have the strength to absorb its own losses. (Perhaps I yearn for a day that will never come.)

However, do I want to know today that only the small banks get pushed off the edge of the cliff without a bailout? Do I really want proof that we've institutionalized "too-big-to-fail" into our bailout/recovery programs?

I do not have an answer for this dilemma. So I'll leave the last word to the WSJ:

"If there is a lesson in this week's tale of two banks, it's that it won't be enough to give the Federal Reserve a mandate to "monitor" systemic risk. Last fall's bailouts are reverberating through the financial system in a way that is already distorting the competition for capital and financial market share. Banks that want to be successful will also want to be more like Goldman Sachs, creating an incentive for both larger size and more risk-taking on the taxpayer's dime.

One policy response to the incentives created by last fall's bailout is simply to restrict the proprietary trading done by the subsidiaries of bank holding companies that enjoy both FDIC deposit insurance and an implicit government subsidy on their cost of capital. This is what Paul Volcker proposed, only to be overruled by Tim Geithner and Larry Summers. Another answer would be an FDIC-style bailout tax, perhaps tied to leverage ratios, for those in the too-big-to-fail camp. Developing a template to facilitate the seizure and orderly winding down of failing financial giants is also an essential element of whatever reform Congress cooks up.

* * *

No one welcomes the pain and dislocation if CIT files for bankruptcy. But U.S. policy toward financial companies cannot avoid all hardship, or the result will be a de facto cartelization of finance, with a resulting loss of competition and dynamism that have long been an American strength. The divergent fortunes of CIT and Goldman Sachs show how much we changed when we stepped in to save certain banks in the name of saving the system."

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