Risk Transfer, Zombie Firms and the Credit Crunch

Edward Kane of Boston College managed a rare accomplishment last April; he wrote an essay on the economics of regulation and moral hazard that is both entertaining and informative.

The paper is Extracting Nontransparent Safety-Net Subsidies by Strategically Expanding and Contracting a Financial Institution’s Accounting Balance Sheet.

He argues that the complexity of (what the Bank of England calls) Large Complex Financial Institutions is not a natural consequence of size and success, but is achieved in a deliberate (if, perhaps unconcious) effort to maximize implicit government subsidies:

… value maximization leads them to trade off diseconomies from becoming inefficiently large or complex against the safety-net benefits that increments in scale or scope can offer them. Arguably, Citigroup has been the poster child for this kind of behavior.

Along with investments in political clout, an institution can obtain and hold TDFU [Too Difficult to Fail and Unwind] and TBDA [Too Big to Discipline Adequately] status by: (1) moving highly leveraged loss exposures formally off their accounting balance-sheet, and (2) maintaining an aggressive program of mergers and acquisitions. Over time, either strategy makes a large institution ever more gigantic, ever more complex, and ever more politically influential. The profitability of undertaking these dialectical responses to FDICIA [FDIC Improvement Act] tells us that the current wave of financial-institution consolidation and convergence is not just an efficiency-enhancing Schumpeterian long-cycle response either to past overbanking or to secularly improving technologies of communication, contracting, and record-keeping. Mergers that involve a TDFU or TBTDA organization have been shown to increase the capitalized value of the implicit government credit enhancements imbedded in their capital structure (Kane, 2000; Penas and Unal, 2004; Brewer and Jagtiani, 2007).

This thesis is then particularized:

It is a mistake to characterize the current turmoil as a liquidity crisis caused by fire-sale pricing and to try to cure the turmoil by auctioning off central-bank loans. In practice, multiple-tranche securitization (and resecuritization) of highly leveraged loans has revealed itself to be less about risk transfer than about risk shifting: i.e., undercompensating counterparties for the risks they assume. TBFU originators of leveraged loans and TBFU sponsors of securitization conduits transformed traditional default and interest-rate risks into hard-to-understand counterparty and funding risks that in distressed times pass back for reputational reasons from securitization vehicles. The critical point is that off-balance-sheet vehicles that booked complex swaps and structured securitizations created reputation-driven loss exposures for sponsors that managers and accountants knew lacked transparency for supervisors and creditors. The victims were investors who accepted inflated estimates of the credit quality of the instruments they purchased and the safety-net managers and taxpayers who now have to clean up the mess.

Besides confusing investors, complex forms of structured finance expand risk-shifting possibilities by making it easy for authorities to neglect the safety-net implications these positions generate and to exempt complex loss exposures from appropriate capital discipline.

I can certainly testify that the dealer community just loves to repackage risk and charge a high price for it. Back in the old days – by which I mean the late 1980’s – it was enormously profitable in Canada simply to strip the coupons from a government bond and and sell them individually – surely one of the simpler mechanisms of creating a synthetic. And I cannot count the number of times I’ve been offered some kind of hideously complex product that has left me puzzled for hours about the methodology of pricing it, let alone actually doing the pricing! These usually came with some kind of underhanded deal in which the purchasing portfolio manager could make a bet outside his mandate – currency speculation, say – while holding something that could plausibly be called a bond.

And, of course, they took their cut!

Dr. Kane concludes:

To minimize the costs of rehabilitating a damaged firm, a private rescuer begins by poring over its books to establish a solid knowledge of unrealized losses and continuing loss exposures. Armed with that knowledge, private rescuers (whose behavior can be typified by capital assistance provided by JP Morgan-Chase and sovereign investment funds during the current turmoil) force rescued stockholders to accept a deal that gives the rescuer a claim to the incremental future profits that the rescue might generate. This tells us that to control moral hazard, government rescuers must insist that the rights of shareholders in TDFU zombie firms undergo severe dilution. To see that taxpayers receive fair compensation for their preservation efforts, government rescuers must be made accountable for establishing for their agency (and ultimately for taxpayers) an appropriately large equity or warrant position on the upside of the rescued firm.

This is a big step up from Bagehot, but Dr. Kane is referring to zombie firms – those that are insolvent. Bagehot applies only to problems of illiquidity.

One Response to “Risk Transfer, Zombie Firms and the Credit Crunch”

  1. safety risk assessments…

    accident in the workplace…

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