It’s Official: Too Big to Fail Is Alive and Well

Thank heaven for Tom Hoenig, the only proven-honest central banker we’ve got. Yes, I know he’s moved on from the KC Fed to serve as Vice Chairman of the FDIC. He actually might do a lot more good over there, anyway.

In recent months, we’ve heard how Wall Street’s Blood-sucking Vampire Squids have reformed themselves. They no longer pose any danger to our economy. They’ve written “living wills” that describe how they’ll safely bury themselves without Uncle Sam’s help next time they implode.

You see, it doesn’t matter that they remain big—indeed, the biggest behemoths are much bigger than they were before they caused the last Global Financial Crisis. They are no longer “too big to fail” because they’ve all got plans to unwind their dangerous positions when stuff hits the fan.

This is very important to Wall Street and Washington because Dodd-Frank requires downsizing and simplification of the Vampire Squids if they remain a threat.

Big financial institutions that are highly interconnected can cause a relatively small problem with one bank’s assets to snowball into a national and international crisis that forces Uncle Sam to intervene to bail-out the miscreants.

We know that the biggest half-dozen US banks are huge and have highly interconnected balance sheets. We know they have legacy garbage on their balance sheets, and they are creating massive quantities of new trashy assets every day they remain open.

That’s their business model. They love that model because it enriches a handful of top management at each institution. As Bill Black says, these are run as control frauds—their motto is “Frauds R Us.” Nearly every day one of them gets caught red-handed in yet another fraud. They pay peanuts in fines and go about their fraudulent business. Nice work if you can get it.

So it is critical that each of these demonstrate it has a way to disconnect its balance sheet from the others as it oversees its own demise. Otherwise, these institutions would have to be downsized and their frauds curtailed.

As expected, most government officials have been congratulating themselves and Wall Street’s “finest” for the “heckuva job, Brownie” they’ve been doing in writing those living wills.

As she left office, Mary Miller, Treasury’s undersecretary for domestic finance, claimed that we no longer have any TBTF institutions. Like magic, with a tip of her wand, she made them all disappear.

A common use of the too-big-to-fail shorthand is the notion that the government will bail a company out if it is in danger of collapse because its failure would otherwise have too great a negative impact. With respect to this understanding of too-big-to-fail, let me be very clear: It is wrong. No financial institution, regardless of its size, will be bailed out by taxpayers again. Shareholders of failed companies will be wiped out; creditors will absorb losses; culpable management will not be retained and may have their compensation clawed back.

I heard her say pretty much the same thing at a Levy conference. It is not believable. When huge financial institutions are closely interconnected, problems in one impact another. The other “creditors” that she claims will absorb the losses are largely other financial institutions. It is a huge daisy chain of lending to each other, so if one goes down they all go down. That wipes out shareholders of all of them, plus all the unsecured creditors of all of them.

A full-blown run to safety occurs, which means asset prices collapse. The Fed and the Treasury will bail-out. You can bet on it. Indeed, markets are betting on it every day. Otherwise no one would be a creditor of any of these TBTF frauds.

Miller’s boss, Treasury Sectretary Jack Lew, who is on loan from Citigroup to oversee Wall Street’s interests, made claims similar to hers.

Dodd-Frank ended “too big to fail” as a matter of law; tough rules are now in place to make sure banks have the capital to absorb their own losses; monitoring through stress tests is underway; and resolution authorities and plans are in place.  There is a growing recognition of these changes, and market analysts are now factoring them into their assumptions. Put simply, the reforms we are putting in place raise the cost for a bank to be large, requiring firms to internalize their risks, and together, with resolution authority and living wills, make clear that shareholders, creditors, and executives—not taxpayers—will be responsible if a large financial institution fails.  Earlier this year, I said if we could not with a straight face say we ended “too big to fail,” we would have to look at other options.  Based on the totality of reforms we are putting in place, I believe we will meet that test, but to be clear, there is no precise point at which you can prove with certainty that we have done enough.  If, in the future, we need to take further action, we will not hesitate.

He went on to celebrate the weak stress tests that the big banks are subjected to. (I note with some irony his own bank failed the tests.) He concluded with an upbeat assessment of his job so far:

We have made tough choices, and very significant progress toward reforming our financial system.  Every day more change comes, not just on paper, but in the way banks, private funds, exchanges, and clearing houses do business.  As we move forward, and as new, higher standards are phased in, the changes will be even more apparent.  And our financial system will be even more secure.  Because our financial system is always evolving, this is work that, by its basic nature, is never finished and it is our ongoing obligation to remain vigilant and responsive to a dynamic and changing financial system.

To be fair, he’s right that you cannot know the “precise point” at which you can be certain you’ve done enough to protect the nation from Vampire Squids. Let’s get the opinion of a regulator who’s not in a bank’s back pocket. Do the living wills pass the smell test, or are do they smell as fishy as three-day-old squid?

Here’s Tom Hoenig, who cannot be bought off:

Each plan being discussed today is deficient and fails to convincingly demonstrate how, in failure, any one of these firms could overcome obstacles to entering bankruptcy without precipitating a financial crisis. Despite the thousands of pages of material these firms submitted, the plans provide no credible or clear path through bankruptcy that doesn’t require unrealistic assumptions and direct or indirect public support.

Doesn’t sound like he drank the Kool-Aide. He goes on:

These firms are generally larger, more complicated, and more interconnected than they were prior to the crisis of 2008. They have only marginally strengthened their balance sheet to facilitate their resolvability, should it be necessary. They remain excessively leveraged.

Remarkably, the Fed’s Board of Governors joined the FDIC in issuing a milder, but still damning, joint statement on the TBTF institutions’ living wills:

While the shortcomings of the plans varied across the first-wave firms, the agencies have identified several common features of the plans’ shortcomings. These common features include: (i) assumptions that the agencies regard as unrealistic or inadequately supported, such as assumptions about the likely behavior of customers, counterparties, investors, central clearing facilities, and regulators, and (ii) the failure to make, or even to identify, the kinds of changes in firm structure and practices that would be necessary to enhance the prospects for orderly resolution. The agencies will require that the annual plans submitted by the first-wave filers on or before July 1, 2015, demonstrate that the firms are making significant progress to address all the shortcomings identified in the letters, and are taking actions to improve their resolvability under the U.S. Bankruptcy Code. These actions include:

*establishing a rational and less complex legal structure that would take into account the best alignment of legal entities and business lines to improve the firm’s resolvability; 

*developing a holding company structure that supports resolvability; 

*amending, on an industry-wide and firm-specific basis, financial contracts to provide for a stay of certain early termination rights of external counterparties triggered by insolvency proceedings;

*ensuring the continuity of shared services that support critical operations and core business lines throughout the resolution process; and

*demonstrating operational capabilities for resolution preparedness, such as the ability to produce reliable information in a timely manner.

I do not believe these conditions can be met, but in any case they will prove to be inadequate.

Size does matter. Interconnectedness matters. Put them together and you’ve got the recipe for another Global Financial Crisis that will force the Treasury and the Fed to bail out the Squid again.

(cross-posted from EconoMonitor)