The Bair Facts

July 10th, 2011 at 11:07 pm

I found Joe Nocera’s exit interview with outgoing FDIC chairwomen Sheila Bair to be a good read.

Like Nocera, I always thought Bair was the best kind of regulator: driven by common sense, on-the-ground experience, and not laden with the ideology that markets, left alone, will tend towards equilibrium.  That, and her experience spotting trouble on banks’ balance sheets, led her to sound early warnings of the subprime mess and its consequences for undercapitalized banks.

The fact that her warnings went unheeded is, of course, another problem.

To me, these ‘grafs get to the heart of the thing:

“As she thinks back on it, Bair views her disagreements with her fellow regulators as a kind of high-stakes philosophical debate about the role of bondholders. Her perspective is that bondholders should take losses when an institution fails. When the F.D.I.C. shuts down a failing bank, the unsecured bondholders always absorb some of the losses. That is the essence of market discipline: if shareholders and bondholders know they are on the hook, they are far more likely to keep a close watch on management’s risk-taking.

During the crisis, however, Treasury and the Fed were adamant about protecting debt holders, fearing that if they had to absorb losses, the markets would be destabilized and a bad situation would get even worse.”

I agree with Ms. Bair.  As I’ve written before, debt is not equity and the latter is much more of a bet—anyone who buys a stock knows it can go to zero.  You loan money to a big bank, even an investment bank, you expect to get it back with interest.

But bankruptcies and restructurings happen.  In Bair’s world, in fact, they’re not that uncommon.  And when they happen, creditors get whacked.

It’s not a slamdunk, and Nocera perhaps pays too short shrift to the damage that extensive creditor haircuts could have caused.  I mean Lehman wasn’t even that big a player, yet its collapse was integral to the meltdown.  In a similar vein, the piece would have benefited from a bit more analysis/acknowledgment that the path the US Treasury did follow under Geithner’s direction did successfully revive the financial system and at a much lower cost than many, including myself, expected.

But if the world knows that a government is not willing to let a certain class of debt holders take a hit, you inevitably underprice risk, and if you want a two-word explanation of the monster that caused the Great Depression, my choice would be precisely that: underpriced risk.


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5 comments in reply to "The Bair Facts"

  1. Taryn H. says:

    Why were Treasury and the Fed adamant about protecting debt holders? You were there Dr. Bernstein – maybe you can shed some light. And while you’re at it, explain to me why everything I hear coming out of the White House sounds like a Republican talking point.

  2. foosion says:

    JB, Nocera’s article should be read together with Frank Rich’s article in NY Mag, Rich’s article argues that the original sin of the Obama adminstration was coddling the bankers who caused the financial crisis:

    “What haunts the Obama administration is what still haunts the country: the stunning lack of accountability for the greed and misdeeds that brought America to its gravest financial crisis since the Great Depression. There has been no legal, moral, or financial reckoning for the most powerful wrongdoers. Nor have there been meaningful reforms that might prevent a repeat catastrophe. Time may heal most wounds, but not these. Chronic unemployment remains a constant, painful reminder of the havoc inflicted on the bust’s innocent victims.”

    @Taryn, they wanted to protect debtholders because the financial system is heavily interconnected and heavily leveraged and the fear was a cascading wave of defaults that would cause the entire system to stop functioning. A issues debt held by B. If A can’t pay, then B has a major problem paying its own debt. Therefore so does C, who holds debt in B, etc., etc. Others answer that they could have protected the financial system without protecting those who made these bad investments.

  3. Bob Wyman says:

    If bondholders are protected from risk, then how can bond purchasers justify anything other than a “risk-free” interest rate? If bank debt presents no risk, then why wouldn’t all bank debt sell for exactly the same interest rate?

    The mere fact that bank debt sells for a premium above risk-free and that yields differ between issuers offering similar terms indicates that bond holders are aware that there is risk and, most importantly, that they have received what they consider to be fair compensation for that risk.

    To “protect” bank’s bondholders is to give them a return at a price below what they freely negotiated and considered fair when they purchased the debt.
    This is socialization of private profit.

  4. Joseph Patrick Bulko MBA says:

    As the tepid “recovery” fizzles to a stall, the U.S. economy seems to be working reasonably well for about 75 percent of the available workforce. The “other” 25 percent consists of the unemployed (e.g., those who are collecting unemployment benefits), the underemployed (e.g., those forced to work part-time when they need full-time employment), the non-employed (those who have dropped out of the employment market and are no longer counted as unemployed), and the working poor (e.g., the vast underclass of all those people working full-time dead-end very low-paying jobs while trying to support families). For some of us, this 75 percent “success” rate is simply not good enough! We need a better jobs solution!

    I’ve written a proposal that describes a mechanism through which we can fund a massive number of new business ventures by tapping the financial power of Wall Street to create jobs on Main Street. This approach ramps up employment quickly and puts money directly into the hands of the people who need it now: the consumers (whose spending represents 70 percent of GDP). This enormous financial turbo-boost to the economy will reinvigorate economic activity and quickly return the eight million jobs lost during the Great Recession. The purpose of this mechanism is to take a private sector proactive approach to address the expected long-term high unemployment problem.

    You can read the proposal (“A Modest Proposal to Save the American Economy: Entrepreneurial Blitzkrieg as Job Creation Vehicle”) and its companion piece (“The 75 Percent Solution? A Moral and Economic Imperative to Create Good Jobs NOW!”) here:

    Joseph Patrick Bulko, MBA

  5. Michael says:

    Wait, what? Why are random bondholders suddenly protected by the Full Faith and Credit of the United States?