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.