Tuesday, June 2, 2009

Regulating and Resolving Institutions Considered “Too Big to Fail”

Regulating and Resolving Institutions Considered “Too Big to Fail”. By Martin Neil Baily & Robert E. Litan
Testimony, Senate Committee on Banking, Housing and Urban Affairs
May 06, 2009

Thank you Mr. Chairman and members of the Committee for asking us to discuss with you the appropriate policy response to what has come to be widely known as the “too big to fail” (TBTF) problem. We will first outline some threshold thoughts on this question and then answer the questions that you posed in requesting this testimony.

The Key Points

Too Big to Fail and the Current Financial Crisis
  • The US economy has been in free fall. Hopefully the pace of decline is now easing, but the transition to sustained growth will not be possible without a restoration of the financial sector to health.
  • The largest US financial institutions hold most of the financial assets and liabilities of the sector as a whole and, despite encouraging signs, many of them remain very fragile.
  • Many banks in the UK, Ireland, Switzerland, Austria, Germany, Spain and Greece are troubled and there is no European counterpart to the US Treasury to stand behind them. The global financial sector is in a very precarious state.
  • In this situation policymakers must deal with “too big to fail” institutions because we cannot afford to see the disorderly failure of another major financial institution, which would exacerbate systemic risk and threaten economic recovery.
  • The stress tests are being completed and some banks will be told to raise or take additional capital. There is a lot more to be done after this, however, as large volumes of troubled or toxic assets remain on the books and more such assets are being created as the recession continues.
  • It is possible that one or two of the very large banks will become irretrievably insolvent and must be taken over by the authorities and, if so, they will have to deal with that problem even though the cost to taxpayers will be high. But pre-emptive nationalization of the large banks is a terrible idea on policy grounds and is clouded by thicket of legal problems.
  • Getting the US financial sector up and running again is essential, but will be very expensive and is deeply unpopular. If Americans want a growing economy next year with an improving labor market, Congress will have to bite the bullet and provide more Treasury TARP funds, maybe on a large scale. The costs to taxpayers and the country will be lower than nationalizing the banks.
  • Congress recently removed from the President’s budget the funds to expand the TARP, a move that can only deepen the recession and delay the recovery.
Too Big to Fail: Answering the Four Key Questions (Plus One More)
  • Should regulation prevent financial institutions from becoming too big to fail? We need very large financial institutions given the scale of the global capital markets and, of necessity, some of these may be "too big to fail" (TBTF) because of systemic risks. For US institutions to operate in global capital markets, they will need to be large. Congress should not punish or prevent organic growth that may result in an institution having TBTF status.
  • At the same time, however, TBTF institutions can be regulated in a way that at least partially offsets the risks they pose to the rest of the financial system by virtue of their potential TBTF status. Capital standards for large banks should be raised progressively as they increase in size, for example. In addition, financial regulators should have the ability to prevent a financial merger on the grounds that it would unduly increase systemic risk (this judgment would be separate from the traditional competition analysis that is conducted by the Department of Justice’s Antitrust Division).
  • Should Existing Institutions be Broken Up? Organic growth should not be discouraged since it is a vital part of improving efficiency. If, however, the FDIC (or another resolution authority) assumes control of a weakened TBTF financial institution and later returns it to the private sector, the agency should operate under a presumption that it break the institution into pieces that are not considered TBTF. And it should also avoid selling any one of the pieces to an acquirer that will create a new TBTF institution. The presumption could be overcome, however, if the agency determines that the costs of breakup would be large or the immediate need to avoid systemic consequences requires an immediate sale to another large institution.
  • What Requirements Should be Imposed on Too Big to Fail Institutions? TBTF or systemically important financial institutions (SIFIs) can and should be specially regulated, ideally by a single systemic risk regulator. This is a challenging task, as we discuss further below, but we believe it is both one that can be met and is clearly necessary in light of recent events.
  • Too big to fail institutions have an advantage in that their cost of capital is lower than that of small institutions. At a recent Brookings meeting, Alan Greenspan estimated informally that TBTF banks can borrow at lower cost than other banks, a cost advantage of 50 basis points. This means that some degree of additional regulatory costs (in the form of higher capital requirements, for example) can be imposed on large financial institutions without rendering them uncompetitive.
  • Improved Resolution Procedures for Systemically Important Banks. This is an important issue that should be addressed soon. When large financial firms become distressed, it is difficult to restructure them as ongoing institutions and governments end up spending large amounts to support the financial sector, just as is happening now. The Squam Lake Working group has proposed one solution to this problem: that systemically important banks (and other financial institutions) be required to issue a long-term debt instrument that converts to equity under specific conditions. Institutions would issue these bonds before a crisis and, if triggered, the automatic conversion of debt into equity would transform an undercapitalized or insolvent institution, at least in principle, into a well capitalized one at no cost to taxpayers.
  • Where the losses are so severe that they deplete even the newly converted capital, there should be a bank-like process for orderly resolving the institution by placing it in receivership. Treasury Secretary Geithner has outlined a process for doing this, which we generally support. There are other important resolution-related issues that must be addressed and we discuss them below.
  • The Origin of the Crisis and the Structure of the Solution. The financial crisis was the result of market failure and regulatory failure. Market failure occurred because wealth-holders in many cases failed to take the most rudimentary precautions to protect their own interests. Compensation structures were established in companies that rewarded excessive risk taking. Banks bought mortgages knowing that lending standards had become lax.
  • At the same time, there were thousands of regulators who were supposed to be watching the store, literally rooms full of regulators policing the large institutions. Warnings were given to regulators of impending crisis but they chose to ignore them, believing instead that the market could regulate itself.
  • In the future we must seek a system that takes advantage of market incentives and makes use of well-paid highly-qualified regulators. Creating such a system will take time and commitment, but it is clearly necessary.
Read the full testimony »

Libertarians: Stimulus Package Shrinks Economy, Destroys Private Sector Jobs

Stimulus Package Shrinks Economy, Destroys Private Sector Jobs, by Hans Bader
OpenMarket/CEI, May 31, 2009 @ 4:14 pm


Most of the $800 billion stimulus package has yet to be spent, but it’s already harming the economy, both by triggering trade wars [...], and by driving up interest rates for businesses that need to borrow money to expand or create jobs. (The government is keeping down interest rates on its own debt by printing vast sums of money to buy its own bonds, in order to finance the exploding national debt, which will result in massively higher taxes).

As economist Arnold Kling explains, “most of the stimulus spending does not take place until next year and beyond, so the short-run gains are puny. On the other hand, the big increase in the projected deficit creates the expectation of higher interest rates, which raises interest rates now. These higher interest rates serve to weaken the economy. According to this standard analysis, the stimulus is going to hurt GDP now, when we could use the most help. Much of the spending will kick in a year or more from now,” when the economy will already be in recovery, and “when the economy will need little, if any, stimulus. This is the flaw with using spending rather than tax cuts as a stimulus. The lags are longer when you use spending. Of course, if the real goal is to promote government at the expense of civil society” through “political favoritism, then the stimulus is working exactly as intended.”

1.2 million Americans have lost their jobs since Obama signed the stimulus package into law. The Congressional Budget Office predicted it would shrink the economy “in the long run” (contrary to Obama’s claim that it would prevent “irreversible decline“), but create jobs in the short run.

But the stimulus package turned out to be harmful even in the short run, because it was so badly designed. It poured money into sectors of the economy where no help is needed because unemployment is low, while siphoning money out of sectors where unemployment is high. Moreover, “states hit hardest by the recession are getting the least amount of stimulus spending.

The stimulus package is just one example of the Obama Administration running up the national debt to bail out the more fortunate while sticking less fortunate people with the bill. The auto bailouts are another. They run up the national debt to keep unskilled auto workers enjoying wages and benefits that are much better than those enjoyed by the average American (while ripping off pension funds and bondholders). As Mickey Kaus notes, “Why should the government tax unskilled workers making $18 an hour, who haven’t bankrupted their employers, in order to protect unskilled workers making $28 an hour, and who have bankrupted their employers, from having to take a pay cut?”

The stimulus package has directly destroyed tens of thousands of jobs. A provision in the stimulus package that blocked a mere 97 Mexican truckers from U.S. roads “caused Mexico to retaliate with tariffs on 90 goods affecting $2.4 billion in U.S. trade,” destroying 40,000 American jobs. And its vague “buy American” provisions, despite doing little to promote purchases of U.S. products, managed to ignite a trade war with Canada.

[...]. One of Obama’s own advisers admits that “the barrage of tax increases proposed in President Barack Obama’s budget could, if enacted by Congress, kill any chance of an early and sustained recovery.” Even the Washington Post, which endorsed Obama and once supported his auto bailouts, now has soured on them and their waste of taxpayer money.

How to Stop Another GM: Abolish Pensions

How to Stop Another GM: Abolish Pensions, by Eli Lehrer
OpenMarket/CEI, June 01, 2009 @ 4:27 pm

GM, of course, declared bankruptcy today. A number of things—bad management, poor products and screwy labor relations—hurt the company. But in the end, the biggest problem GM couldn’t solve related to the company’s liabilities to retirees. The company, which currently employs about 150,000 hourly workers, was responsible for the health care of over 1 million people and pension obligations for over 650,000 people. These pension obligations were probably the largest factor in GM’s demise and public policy should, at minimum, stop encouraging companies to take on anything like them.

The lure of pensions is obvious. A pension is another benefit that a company can provide to its workforce and, although quite attractive (“We’ll support you for life!”) it imposes few up front costs. A company that offers pensions has more money to invest in new products, pay dividends, and meet payroll while simultaneously being able to do well by its existing work force. The problem, however, is that all companies go through a lifecycle: they start small, become big, decline, and eventually go out of business. Of the 100 largest companies in 1900, only 7 existed in the same form by 2000. And this cycle of creative destruction is accelerating, of the 100 largest companies in 2000, by my count, at least 19 have either merged with a similarly-sized company, been bought out, gone bankrupt, or needed a government bailout to stay afloat.

To make matters worse, life expectancy continues to increase meaning that the number of retired people will also increases.Quite simply, pensions are almost always a bad idea for any private company. It’s likely that a company will offer the most generous pensions when it is at the height of its power, influence, and payroll. As things change in the company’s market, it will end up—as GM did—with enormous obligations to people who don’t work for it and no resources or market share to pay for them. As a result, it would make sense, from a public policy perspective, to change the tax code to create disincentives for any promise that a corporation wants to make to its employees down the road. Quite simply, it’s bad for corporations, bad for the economy, and bad for employees. Corporations should not receive any preferential tax treatment, writeoffs, or anything else for any obligations to employees beyond a year or two in the future. A typical corporation just isn’t going to be around to make good on any promises it makes in for the distant future.

Companies that want to offer pensions or retiree health care, of course, would remain free to do so but the tax code should, at minimum, look at this with extreme skepticism. It might well even exact a penalty on companies that chose to compensate their employees this way. As a corollary to this, the federal government should also stop accepting new participants in the Pension Benefit Guaranty Corporation (the federal agency that provides partial backing for private pensions) and look for ways to wind down its operations over time. (Since it has promised to manage certain pension funds and creates a certain reliance interest, it wouldn’t be fair to abolish it right away.)

At the margins, ending tax incentives for pensions and retiree health care would almost certainly increase Medicare costs and might well result in somewhat more people relying on Medicaid for nursing home care. But the alternative—endless bailout of pension funds and the companies that provide them—seems a lot worse.

Ignatius on Kerry's visit to Syria and Midde East policy

Kerry's Unusual Role in Mediating U.S.-Syria Relations. By David Ignatius
WaPo, June 1, 2009; 5:30 PM ET

The long-stalled U.S. diplomatic engagement with Syria is moving forward -- thanks to an unusual bit of mediation by Sen. John Kerry.

A mini-breakthrough in U.S.-Syria relations came Sunday in a telephone conversation between Secretary of State Hillary Clinton and Syrian Foreign Minister Walid Moallem, according to U.S. and Syrian sources. Moallem said that Syria would welcome a visit by U.S. Central Command officers to Damascus this month to discuss joint efforts to stabilize Iraq. In return, Clinton promised to develop a joint “road map” for improving bilateral relations between the two countries.

Kerry reportedly played a key role in breaking the logjam between the two countries, which had worsened after the Obama administration announced last month that it was renewing sanctions against Damascus under the Syria Accountability Act. The Syrians had been expecting that move, but they were upset by a presidential statement accompanying the renewal, which repeated harsh Bush administration language that said Syria posed an “unusual and extraordinary threat to the national security, foreign policy, and economy of the United States.” The Syrians said that unless this sharp language was withdrawn and the bilateral relationship improved, they wouldn’t provide the security assistance that Centcom wanted.

Enter the chairman of the Senate Foreign Relations Committee.

According to Syrian diplomatic sources, Kerry and Syrian President Bashar Assad have been developing a relationship of “respect and friendship,” including a long private dinner between the two men and their wives at the Narenj restaurant in the old city of Damascus when Kerry was there in March.

Kerry is said to have called Assad twice over the past two weeks to explore ways to improve relations; at the same time, he was talking to the Obama White House and State Department. In these and other conversations, apparently, the gap between the two countries was narrowed. Kerry’s office had no comment today.

The result of this mediation was Sunday’s carefully scripted conversation between Clinton and Moallem. Clinton told her Syrian counterpart, “We will be prepared to discuss with you all issues related to Syrian-American relations,” according to one transcript of the conversation. The U.S. pledged to “focus our efforts on forming a new sort of relationship,” according to this transcript. There was no pledge about when the U.S. will send an ambassador back to Damascus; the ambassador was withdrawn after the assassination of Lebanese Prime Minister Rafik Hariri in 2005, an attack for which many Lebanese blamed Syria.

The road map toward better relations will be discussed when Sen. George Mitchell, the U.S. special envoy for the Middle East, visits Damascus, probably this week. He will be the most senior U.S. official to visit Syria since relations went into the deep freeze three four years ago.

The Syria opening is part of a larger effort toward engagement by the Obama administration in the Middle East. President Obama will take that message to the heart of the Arab world Thursday in a Cairo speech that will discuss America’s desire for better relations, including contact with longtime adversaries, such as Syria and Iran.

Kerry’s role in all this is intriguing for two reasons: First, it shows that the former Democratic presidential candidate is carving out a role for himself as a foreign-policy player -- courageously taking on issues that are sensitive in political and policy terms. Second, it shows a fluid and creative foreign-policy process in the Obama administration, in which people outside the White House inner circle are able to get the president’s attention and push the envelope.

Ethanol's Grocery Bill - Two federal studies add up the corn fuel's exorbitant cost

Ethanol's Grocery Bill. WSJ Editorial
Two federal studies add up the corn fuel's exorbitant cost.
WSJ, Jun 02, 2009

The Obama Administration is pushing a big expansion in ethanol, including a mandate to increase the share of the corn-based fuel required in gasoline to 15% from 10%. Apparently no one in the Administration has read a pair of new studies, one from its own EPA, that expose ethanol as a bad deal for consumers with little environmental benefit.

The biofuels industry already receives a 45 cent tax credit for every gallon of ethanol produced, or about $3 billion a year. Meanwhile, import tariffs of 54 cents a gallon and an ad valorem tariff of four to seven cents a gallon keep out sugar-based ethanol from Brazil and the Caribbean. The federal 10% blending requirement insures a market for ethanol whether consumers want it or not -- a market Congress has mandated will double to 20.5 billion gallons in 2015.

The Congressional Budget Office reported last month that Americans pay another surcharge for ethanol in higher food prices. CBO estimates that from April 2007 to April 2008 "the increased use of ethanol accounted for about 10 percent to 15 percent of the rise in food prices." Ethanol raises food prices because millions of acres of farmland and three billion bushels of corn were diverted to ethanol from food production. Americans spend about $1.1 trillion a year on food, so in 2007 the ethanol subsidy cost families between $5.5 billion and $8.8 billion in higher grocery bills.

A second study -- by the Environmental Protection Agency's Office of Transportation and Air Quality -- explains that the reduction in CO2 emissions from burning ethanol are minimal and maybe negative. Making ethanol requires new land from clearing forest and grasslands that would otherwise sequester carbon emissions. "As with petroleum based fuels," the report concludes: "GHG [greenhouse gas] emissions are associated with the conversion and combustion of bio-fuels and every year they are produced GHG emissions could be released through time if new acres are needed to produce corn or other crops for biofuels."

The EPA study also explores a series of alternative scenarios over 30 to 100 years. In some cases ethanol leads to a net reduction in carbon relative to using gasoline. But many other long-term scenarios observe a net increase in CO2 relative to burning fossil fuels. Ethanol produced in a "basic natural gas fired dry mill" will over a 30-year horizon produce "a 5% increase in GHG emissions compared to petroleum gasoline." When ethanol is produced with coal burning mills, the process "significantly worsens the lifecycle GHG impact of ethanol" creating 34% more greenhouse gases than gasoline does over 30 years.

Both CBO and EPA find that in theory cellulosic ethanol -- from wood chips, grasses and biowaste -- would reduce carbon emissions. However, as CBO emphasizes, "current technologies for producing cellulosic ethanol are not commercially viable." The ethanol lobby is attempting a giant bait-and-switch: Keep claiming that cellulosic ethanol is just around the corner, even as it knows the only current technology to meet federal mandates is corn ethanol (or sugar, if it didn't face an import tariff).

As public policy, ethanol is like the joke about the baseball prospect who is a poor hitter but a bad fielder. It doesn't reduce CO2 but it does cost more. Imagine how many subsidies the Beltway would throw at ethanol if the fuel actually had any benefits.