Growing Expectations Of TBTF Bank Creditor Bailouts Tighten Their Tentacles Around Taxpayers

One of the few rebellious Fed heads, Richmond Fed President Jeffrey Lacker, fired another salvo when he was testifying at the House Judiciary Committee’s hearing. And he hit Wall Street risks that are wrapping their growing tentacles ever more tightly around the economy and taxpayers.

The hearing, according to Chairman Bob Goodlatte, would examine whether the Bankruptcy Code is “best equipped” to deal with the insolvency of large banks, such as the “unusual level of speed” needed for their “efficient and orderly resolution,” and the “unique threats” their collapse would pose to the “broader stability of the economy.”

Lacker was on his turf. For years, he has spoken out against QE. Earlier this year, he committed heresy by admitting that “labor market conditions are affected by a wide variety of factors outside a central bank’s control“; he’d yanked away the Fed’s fig leaf for its QE and zero-interest-rate policies. And in June 2012, before QE3 had appeared on the horizon, he’d stunned his listeners when he said, “Monetary policy doesn’t have a lot of capability right now for enhancing growth.” He dissented at the FOMC meetings in 2012 when he last was a voting member. His concerns were confirmed by QE3’s subsequent failure to budge the economy, though it inflated glorious assets bubbles all around.

Now, in his prepared remarks, he told the Committee that the Bankruptcy Code should be tweaked to make it “feasible to resolve failing financial firms in bankruptcy.” The financial crises showed “glaring deficiencies” in the way “distress and insolvency” of big banks are handled, he said. Meaning, they were all bailed out by the Fed and to a much smaller extent by TARP, when there should have been a system in place to wind the failing ones down in bankruptcy. The bailout of investors has created, he said, “two mutually reinforcing expectations”:

First, many financial institution creditors feel protected by an implicit government commitment of support should the institution face financial distress. This belief dampens creditors’ attention to risk and makes debt financing artificially cheap for borrowing firms, leading to excessive leverage.

This belief also encourages the riskiest types of borrowing, “such as short-term wholesale funding,” that could evaporate at a moment’s notice and leave banks and other companies high and dry, which is what had happened during the financial crisis. And these types of funding then “prompt the need” for an implicit government or Fed “protection,” he said.

Second, policymakers may well worry that if a large financial firm with a high reliance on short-term funding were to file for bankruptcy under the U.S. bankruptcy code, it would result in undesirable effects on counterparties, financial markets, and economic activity. This expectation induces policymakers to intervene in ways that allow short-term creditors to escape losses, such as through central bank lending or public sector capital injections. This reinforces creditors’ expectations of support and firms’ incentives to grow large and rely on short-term funding, resulting in more financial fragility and more rescues.

He cited the Richmond Fed’s research into how expectations of creditor bailouts – the implicit guarantees – have grown over time.

In its 2013 estimate, using 2011 data, the Richmond Fed found that there were $44.5 trillion in total liabilities in the financial system, such as bank deposits and bonds. Of them, $10.6 trillion (23.8%) carried explicit guarantees, such as FDIC deposit insurance. And a stunning $14.83 trillion (33.4%) carried implicit guarantees. Unlike FDIC insurance, these guarantees are issued for free to the beneficiary, and when they come due during a bailout, all Americans are forced to pay, through either government or Fed action, to protect the wealth of the creditors. These implicit guarantees in 2011 amounted to 97% of GDP!

They have done nothing but balloon. The Richmond Fed’s first estimate, using 1999 data, found that implicit guarantees amounted to $3.4 trillion (18% of the liabilities in the financial system). A mere 27.6% of GDP. Another screaming data point – as if we needed anymore – in how Wall Street’s risks have been wrapping their ever larger tentacles around the US economy and the taxpayer.

How could this happen? How could these expectations of creditor bailouts balloon so fast so much? Who encouraged it? Well, the Fed and the government. “Through gradual accretion of precedents,” Lacker explained. One bailout followed by a bigger one, followed by an even bigger one, etc., followed by the massive bailouts during the financial crisis. It has been going on for four decades, he said.

While these implicit guarantees have altered risk-taking on Wall Street, banks have become fewer and bigger. In the mid-1980s, there were over 18,000 federally insured banks. Now there are 6,891. Of the goners, 17% collapsed; the rest were mergers and consolidations, based on FDIC data cited by the Wall Street Journal.

Of the survivors, 98.6% are banks with $10 billion or less in assets that control 12% of all assets in the banking industry. Then there are 70 regional banks with up to $250 billion in assets. They make up 1.2% of all banks but control 19% of all bank assets. Should any of them fail, it would entail private-sector losses and ownership changes with minimal governmental intervention. And then there are 12 megabanks – 0.17% of all banks that control 69% of the banking assets!

Their “owners, managers, and customers believe themselves to be exempt from the processes of bankruptcy and creative destruction,” Dallas Fed President Richard Fisher pointed out when he once again vituperated against TBTF banks that, as “everyone and their sister knows,” were “at the epicenter” of the financial crisis. They “capture the financial upside” of their bets but are bailed out when things go wrong, “in violation of one of the basic tenets of market capitalism.”

While Chairman Bob Goodlatte bent over backwards to address ostensibly the collapse “of large and small financial institutions,” everyone knew he was talking about just 12 banks, the only banks in the country exempt from the Bankruptcy Code. Their bondholders are benefiting, free of charge, from implicit guarantees in the size of America’s GDP. These guarantees have encouraged banks, aided and abetted by the Fed, to pile on mountains of risk as if the financial crisis had never happened.

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