Bailouts, Wall Street, and the Bad Motivator

Bailout. To any believer in real honest-to-goodness capitalism, bailouts are an anathema. The way our system of economics is supposed to work, those that take risks and are successful are supposed to be rewarded, and those that fail are supposed to suffer the consequences. The system only works if there is both that upside and downside.

But in recent months, we've seen Bear Stearns bailed out. We've seen a "Hope for Homeowners Act" proposed in congress which will bailout certain borrowers. We've seen the Fed accept all sorts of collateral for loans. And if it comes to it, we will see the government bail out the GSEs as well.

So what happened to capitalism? Why couldn't we have just let Bear Stearns die? Or at least force them to seek a private transaction with no backing from the Fed?

The answer is that our financial system has become too intertwined. It has become too reliant on the continued solvency of all its players. Had Bear Stearns been allowed to fail, banks world wide would have lost their counter-party on various derivative transactions. A bank that assumed it had hedged some of its credit risk on a particular borrower would suddenly have all that credit risk back in its lap. I don't need to paint the picture as to the level of contagion that would ensue. I'm not even talking about fear here, merely that many financial institutions were relying on hedges in so many ways, that to suddenly lose a counter-party would be disastrous.

Let's say you allow Bear Stearns to fail and that caused XYZ bank to fail. Is that capitalism? Forcing XYZ to suffer for the sins of Bear Stearns? I posit that the ideal of pure capitalism becomes functionally impossible once financial institutions start relying on each other for survival. Capitalism is supposed to reward those that take good risks and punish those who take bad risks. What do we call it when our system might reward good risks, assuming all your counter-parties also take prudent risks?

Maybe capitalism is a religion where we've all fallen from the true faith. Maybe the Fed will always have to be there as a lender of last resort. But maybe we could make that last resort a little less common.

The first step is obvious. Credit-default swaps need to be exchanged-traded. Perhaps there needs to be some significant modifications to how CDS are structured in order to make this work. Fine. But given the myriad of derivatives and futures contracts that currently trade on exchanges, I can see no reason why the same cannot be done for CDS.

I imagine a system where the 20 or so largest banks and brokerages contribute cash to create the exchange. Or there could be seats on the exchange which were auctioned off. The exchange would then stand in the middle of all CDS contracts. Thus the failure of any one player in the CDS market wouldn't threaten the whole system.

Of course, if there is a single exchange there is also a single counter-party. But I argue this still is a reduction of risk to the system. Look, right now, the number of true market makers in CDS are very limited, probably around 10 or so. That means that for every CDS contract, there is a very limited number of firms standing on the other side. So as things stand, 1/10 of the $50 trillion CDS market could disappear if one of the current market makers goes down. Doesn't seem too wise does it? If you think about it that way, under the current system, tax payers are somewhat exposed to the demise of any of 10 different financial institutions. Would it really be so hard to capitalize an exchange such that it could withstand the failure of a small number of its members? And wouldn't the somewhat joint-and-several nature of an exchange improve confidence? Was anyone worried about the CBOE going under when BSC was in trouble?

There would be some relatively simple ways to bring such a thing about. What if banks were required to recognize the credit risk of their counter-parties directly? I.e., the capital needed to execute a private derivatives contract would be prohibitively large. I think back to banks needing to reserve for losses dealt to them by XLCA/FGIC/Ambac/MBIA's potential failure to perform on CDS contracts. Why not just make them reserve a larger amount for this possibility up front? Efforts to start an exchange would begin the next day.

I'd like to live in a world where Bear Stearns could have failed without it impacting better-managed institutions. Unfortunately I don't live in this world right now. But that shouldn't stop us from trying to move in that direction.