Mike’s Financial Pocket: The Race to Become Too Big To Fail

This Bloomberg article should be troubling to just about everybody:

Investment funds that manage more than $100 billion in assets may be labeled too big to fail, global regulators said, as they seek to expand financial safeguards beyond banks and insurers.

Hedge funds with trading activities exceeding a set value of $400 billion to $600 billion would also be assessed by national authorities to gauge whether they need extra rules because their collapse could spark a crisis, the Financial Stability Board said in a statement yesterday.

Since the financial crisis in 2008, there has been a lot of discussion regarding banks, insurance companies, and other financial institutions being deemed “too big to fail” (TBTF). Basically, this means that if a TBTF institution goes under, it is predicted that there will be major negative repercussions to the worldwide economy as a whole. Bear Stearns was deemed TBTF in March of 2008, as was AIG in September 2008. Lehman Brothers, for reasons I will get into later, was permitted to fail. When these institutions started toppling, what some predicted would be a mild housing decline and recession turned into the greatest economic downturn since the Great Depression.

To me, what’s most concerning about this report by the Financial Stability Board, the subject of the Bloomberg article, is how wide the TBTF label may be applied in the coming months and years:

Finance companies that provide business funding, personal loans, store credit and car loans may also be considered crucial for stability because of the “potential difficulty of substituting certain types of finance to the real economy that they provide,” the FSB said in the report, which was produced with the International Organization of Securities Commissions, a Madrid-based group of supervisors from more than 100 countries.

Congratulations! Ally Bank and your Dick’s Sporting Goods store card are now TBTF!

What in the world is going on here?

Finance companies mainly fund themselves using wholesale funding sources, such as bank loans, unsecured debt, CP (including asset-backed commercial paper (ABCP)) and securitisation. If a finance company is a subsidiary of a bank or industrial corporate, it may also receive funding or benefit from explicit or implicit guarantees from the parent. Finance companies’ reliance on wholesale funding could make them susceptible to funding problems in times of market stress, particularly if they are highly leveraged or if their funding is relatively short-dated compared to the maturity of their assets.

Basically, this report is trying to argue for more regulations for entities that are deemed to be TBTF. The problem with this is that getting labeled as TBTF is not a disincentive for these companies. Indeed, an implicit or explicit backstop permits these large institutions to take on excessive risk without any worry.

In case you’re not familiar with leverage in terms of finance, here’s a quick and dirty definition. Leverage amplifies the amount of your trading “bet.” In other words, if the institution is trading $1,000 of its own money at 2:1 leverage, it has the effect of a $2,000 trade without having to put up the $2,000. Smart traders can certainly make money using leverage. However, if the trade goes south, the institution is on the hook for the downside as well. This was part of the problem with MF Global and arch-criminal Jon Corzine (D-NJ). MF Global bet on the wrong side of European sovereign debt in 2011 to the tune of 80:1 leverage. That means that if the investment went down by 1.25%, it would be totally wiped out. The other problem with Corzine is that he stole his clients’ money to make these bets. You can read more about that here.

Imagine if you went to Las Vegas and were given a $10,000 credit line that you would never have to pay back. Would you go to the Hoover Dam tour, or would you bet it on the longest shot in the casino?

Who cares if your bank is leveraged 40:1? If you’re on the wrong side of a bet, and you’ve been deemed TBTF, the government (meaning the Federal Reserve, meaning the taxpayer) will bail you out!

The concept of TBTF should concern people on both sides of the aisle. For folks on the “right,” they should be concerned with government picking winners and losers, potential taxpayer exposure, and more regulation by government (which can lead to unforeseen consequences, as we know). For folks on the “left,” perhaps they should be concerned with the perceived cronyism and concentration of power within these TBTF institutions. Admittedly, I’m concerned with all of the above.

We may have seen some serious cronyism when Lehman was deemed OK to fail. While the official answer was that bailing out Lehman would not have stopped a run and would have created taxpayer loss, some speculate that Lehman was not saved because it refused to help bail out Long Term Capital Management in the late-1990s. If this is true, letting the government pick winners and losers in this manner is about as anti-capitalistic and anti-free market as one can get.

The other problem with deeming certain institutions as TBTF based on their size is that this provides incentive for institutions that might be outside of the TBTF threshold to make acquisitions to make themselves bigger so they can be deemed TBTF and get an implied backstop. Instead of a “race to the bottom,” we could have a “race to become TBTF.” That is the paradox of regulation which will deem certain institutions to be so critical that they cannot be permitted to fail.

Senators Sherrod Brown and David Vitter have introduced legislation which they think would end TBTF. I certainly think ending the implied taxpayer backstop is something that needs to be done and the bill is a good start of the conversation which, nearly six years after Bear, is long overdue.

Preferably, however, I would like to see a more natural breakup of financial institutions, rather than something done by fiat. Removing the implied federal backstop is one way to do achieve this.

As always, free markets are better markets.

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This week, earnings season begins to heat up, with one of the biggest names to report being Morgan Stanley (on Friday). We also will have reports on manufacturing, as well as consumer and producer price index. The Street is expecting slight increases in consumer prices (0.3%, or 0.1% when food and fuel are excluded). Various Federal Reserve officials will speak, and expect market movement when Bernanke speaks on Thursday. Initial claims will be reported Thursday morning, too (consensus of 327k).