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Nocera on Bair and bailouts

by Robert Teitelman | Published July 12, 2011 at 1:32 PM

Bailouts are back on the table, which is where they undoubtedly belong. Two recent pieces by Allan Sloan in Fortune, who does the math on what he defines as "bailouts" and declares on purely quantitative terms a success, and Joe Nocera, who offers up an exit interview with outgoing Federal Deposit Insurance Corp. head Sheila Bair in The New York Times magazine, bring all the nightmarishly tangled issues of 2008 back again: the rescue and fire sale of Bear Stearns Cos. to J.P. Morgan Chase & Co.; the failure to step in to save Lehman Brothers; the intertwined dangers of moral hazard and too-big-to-fail; and the notion of special interests, like bondholders, shareholders, taxpayers, homeowners. Sloan's piece makes the implicit argument that aggressive government action can make a big difference. It speaks to those who argue, from left and right, that we would have been better off without bailouts, and that somehow Main Street is magically insulated from Wall Street. You detect echoes in this argument in the Republican position on the debt ceiling. The more extreme Republicans will insist that federal default does not matter all that much, as if there's no relation between the financial and real economies. In short, and remarkable for the traditionally business-friendly Republicans, they will insist that bondholders don't matter. Bair, as depicted by Nocera, presents a far more nuanced and sophisticated perspective. Nocera is eager to distinguish Bair not only from her regulatory colleagues, all men, many of them Democrats, but from current Republican orthodoxy; she is, he says, that nearly extinct breed, the moderate Republican. Bair now says she believes Bear should have been allowed to fail, with both shareholders and bondholders taking the hit. Her argument is reasonable: The investment banks did not have consumer deposits and FDIC insurance, and thus they could take on more risk and investors in Bear stock and paper should have borne the consequences. She also suggests that Bear was a "second-tier" firm, which introduces a level of realpolitik to the equation. Bear Stearns could have failed without blowing a hole in the system. What she doesn't elaborate on is whether Bear's failure, which would preserve some semblance of moral hazard, might not have set off a further panic. Clearly, the Fed and Treasury moved to help Bear and Wall Street because they had very little idea of the depth and breadth of the mortgage crisis, which Bair had been warning about. They (Bernanke and Paulson mostly; Bair seems to have been excluded from the inner circle at the height of the crisis, setting off a frisson of male chauvinism) clearly hoped that they could stop the panic with this one step. They were wrong. The mortgage crisis was much more serious than they envisioned. Still, had Bear gone down, the rest of Wall Street may have begun to collapse even earlier.

But Bear's implosion clearly set the policy table, and that's what the real sin of the episode was. Bear's rescue left the impression that the Federal Reserve would help out Wall Street and firms would not be allowed to fail. This clearly worked into Dick Fuld's dithering over selling Lehman in the summer of 2008; he expected Paulson to bail him out. What's not clear in Nocera's profile on Bair, however, is what exactly would have been different if Bear had gone down. Bair admits to Nocera that "there was no way, under the prevailing law, to wind down the systemically important bank-holding companies that were at the risk of failing. The same was true of a nonbank like AIG. ... An AIG bankruptcy would have been disastrous, damaging money-market funds, rendering giant banks insolvent and wreaking panic and chaos." Bair argues, however, that the AIG counterparties, like Goldman, Sachs & Co., could have taken a "10 percent" haircut. That seems reasonable, although the political fallout of even that would have been ugly.

Still, neither Nocera nor Bair go into the really tough calls that preceded AIG: the seizure of Fannie Mae and Freddie Mac and the Lehman failure. It is one thing to declare that the investment banks should be allowed to fail; it's another thing entirely when you see the possibility that all of them might topple. That looked like the situation immediately after Lehman collapsed. The systemic consequences in that case would have been far more consequential. In short, even if Bear had been allowed to die, the situation was unlikely to have looked any better. Moral hazard is a serious long-term problem, but it was clearly trumped by the mortgage collapse and its various amplifiers, everything from old-fashioned leverage to credit default swaps.

By far Bair's most fascinating interplay with Nocera takes place when she talks about the role of bondholders. "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," writes Nocera. Bair was, to say the least, far less sensitive to bondholders than her colleagues, who viewed the creditor class as essential to systemic safety and soundness. This puts quite a lot about the last few decades in finance in perspective. Bondholders emerged (talked up by Robert Rubin) as the ultimate economic power bloc in the Clinton administration -- even above shareholders, which as a class had been ascendant since the late '60s -- and many of the bailouts like the government sponsored enterprises and AIG, not to say the euro-zone rescues, were designed to avoid what's often characterized as "messy" bondholder restructurings, which, to this day, are viewed by regulators as systemically destructive. From this perspective, creditors as a body resemble the true too-big-to-fail interest. The big banks are only systemically important and TBTF because they could create huge losses among bondholders, which must be protected, whether they're large pension funds, hedge funds, investment banks or sovereign wealth funds. How did we arrive at the point where this was the case? Have we always been here? Or as the populist argument has it, is this simply a sop to the bond-holding plutocrat?

Bair urges greater discipline be applied to bondholders and wants to be seen as a defender of taxpayers, depositors, homeowners and "the little guy." She has a track record to point to: her early recognition of real estate problems, her activism on mortgage modifications and her willingness to suddenly shift gears, as she did by scotching Citigroup's pricey (for the government) deal for Wachovia with Wells Fargo's less-expensive deal. But Nocera and Bair do play a political game here by suggesting that these "interests" are clear and distinct. In fact, they're profoundly tangled, just like interrelated financial firms and instruments. Again, it comes down to looking at Main Street as somehow separate from Wall Street. In reality, there is considerable overlap among these interests and the system is a nightmare of feedback loops, on the upside and downside. Taxpayers and homeowners have their retirement in stocks and bonds. Taxpayers and homeowners work in companies that buy and sell massive amounts of bonds and that depend on the financial sector for their daily lifelines. Stocks may get hit and eventually recover; bonds in a default register a loss. In fact, the entire economy -- consumers, corporates, Wall Street, the government itself -- was clearly overleveraged, which begins to explain how bondholders and bond holdings became TBTF in the first place.

How do you begin to untangle all of that? Well, you can reduce leverage across the board, which would reduce the power of the creditor class. But that is a very long and painful slow-growth process -- and one it appears we lack the political patience to endure. You can reduce the size of the banks, which threaten those bondholders. You can try to reduce the exposure of ordinary Americans to the markets; but then, particularly given pressures on Social Security and Medicare, how would they build retirement savings? You could force accountability and enhance moral hazard across the board by removing various safety nets, like deposit insurance, but at the risk of creating larger and more frequent economic tsunamis and an even more fractured, state-of-nature political climate.

None of this is easy. Bair is very careful about her pronouncements, for all her aggressiveness in defending her agency and her point of view. Her departure does raise a further question: Why does there seem to be fewer and fewer small "c" conservatives and moderates, particularly in regulatory ranks? Bair is something of a throwback, to the likes of Paul Volcker, who also seems to have retired once again, and a tradition of regulators who did not identify their own success with the prosperity of their institutions. That is a tradition we should revive. - Robert Teitelman

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