Monday, June 18, 2012

Are the US authorities prepared for eurozone collapse?

During the financial crisis, the US government rescued the financial system from full-blown liquidation following Lehman’s collapse. The government rescued banks, bank holding companies, mortgage banks, securities firms, nonbank financial institutions, insurance companies, GSEs, and money market funds. All of this was done more or less on the fly, some of it within existing law, some on the edges, and some with new legislation such as TARP.

It is worth noting two things: (1) the government prevented a financial collapse; and (2) the total cost of the “Wall Street bailout” was zero. All of the Fed’s loans and most of the Treasury’s capital investments were repaid with interest, plus gains on warrants.

Following the successful resolution of the crisis, there was bipartisan criticism of the fact that the government “bailed out the reckless bankers”. You can still read in responsible publications that the Fed, the Treasury and the taxpayers spent “trillions” bailing out the banks. (If I lend you one thousand dollars overnight for one thousand days, I have supposedly lent you one million dollars.)

The legislative result of this populist outcry was the Dodd-Frank “Wall Street Reform and Consumer Protection Act of 2010”. The big debate over the bill was whether to end Too Big To Fail or allow it under special circumstances. The result was a fudge that sort of allows limited TBTF under certain circumstances for instiutions deemed to be systemically important (Sifis). It reads to me as if creditors of failed institutions, such as bondholders of bank holding companies, are at risk.

I expect that the looming collapse of the European financial system will put this new machinery to the test. The principal vectors of European contagion will be (1) market and credit losses on government and bank bonds; (2) losses on European loans; (3) losses on credit protection written on European obligors; (4) capital impairment resulting from credit and market losses; and (5) loss of confidence-sensitive funding due to the unknown scale of the above losses in relation to banks’ capital resources.

When the hurricane of fear hits this side of the Atlantic, it will focus upon financial institutions with the most European exposure. In the maelstrom, we may find ourselves facing another Lehman moment. What will be crucial then will be coherent signalling from the authorities that there is no repeat no risk to creditors of large US financial institutions. Any ambiguity on this subject will fuel the tidal wave of contagion. Geithner knows this, but can persuade the rest of the administration?

The authorities will be handicapped during this crisis by politics. Since the Obama administration will be in power until at least next January, the crisis will most likely happen on their watch. While the Obama/Geithner/Bernanke team will want to do everything they can to stem the crisis, they may not have the full support of the Congress or the Romney campaign. Rescue efforts could (will) be demagogued, as they were in 2008. It is unlikely that Congress can derail the rescue, but it can certainly add confusion and uncertainty.

I reiterate that two things must occur to stem the contagion: (1) no Sifi can be allowed to default upon anything; and (2) this fact must be clearly understood and credible. In fact,  during a financial crisis, the list of Sifis can be very long, since one run will lead to another.

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