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The Paulson-Bernanke Doctrine, improvised in crisis

Thursday, September 18, 2008

NEW YORK: Now we know what Richard Fuld Jr. did wrong at Lehman Brothers, thereby forcing it into bankruptcy.

He didn't take enough risks.

Had he had the foresight to write a lot more credit default swaps - so that the government feared chaos if Lehman defaulted - then perhaps the U.S. government would have nationalized Lehman, just as it nationalized AIG, Fannie Mae and Freddie Mac. Or it would have subsidized a takeover, as it did for Bear Stearns.

The emerging Paulson-Bernanke Doctrine is not "too-big-to-fail." It is "too-reckless-to-fail." If you get your company into enough trouble to threaten the financial system, Ben Bernanke, the Federal Reserve chairman, and Henry Paulson Jr., the Treasury secretary, won't let you collapse.

It may be that the Fed miscalculated on Lehman and that it had been reckless enough to threaten the system. Fear that that was true spread this week after the Lehman default led to the inability of a money market fund to meet its obligations, causing investors to pull their money from similar funds. If those funds cannot find buyers for their assets, there could be more defaults.

The Paulson-Bernanke Doctrine was born not of theory or ideology, but instead came from improvising as each new crisis erupted. The Fed's briefing on the nationalization of AIG did not start until 9:15 p.m. Tuesday night, which is not a sign of carefully thought-out decisions. If this wave of nationalizations smacks of socialism, it is closer to the Marxism of Groucho than of Karl.

It is a sad commentary that the authorities are most worried about a market that they were unwilling to do anything about when it was growing and growing. That is credit default swaps.

Before explaining what those swaps are, let me propose a simple principle that the next president and Congress could follow as they devise a new regulatory regime to replace the one that failed so badly:

If an activity is important enough to justify a government nationalization to prevent a default, it is important enough to be regulated and closely monitored. The regulators need to know what risks are being taken, and by which institutions, long before a default happens.

None of that happened with credit default swaps. The industry had very good lobbyists to get the law written to keep regulators away, and Alan Greenspan, then the chairman of the Federal Reserve, thought it would be wrong for regulators to try to, as he frequently said, "outguess the market."

Somehow, when the market turns down, it becomes essential for the government to decide that the market cannot be allowed to function.

Credit default swaps are a way of transferring the risk of owning a bond. If I own a bond issued by General Motors, and have also purchased a credit default swap on GM, then I am covered if GM defaults. I can recover my losses on the bond from the institution that sold the swap to me. That obligation lasts for five years.

There are now many more credit default swaps outstanding than there are bonds for them to cover. They became a way to gamble with almost no money down. For a small fee, my hedge fund can bet that a company will go under. And your hedge fund can collect that fee, and produce instant profits. Years down the road, you may have to pay, but big companies rarely default anyway, so the risk is minimal. Or at least that is what a lot of people thought.

One way to think of the swaps market is as insurance that is issued by companies that do not have to keep reserves and may be totally unregulated. I can't legally buy fire insurance on your house, since I have no stake in it, and letting me have insurance would give me an incentive to burn it down. But I can buy a credit default swap on GM even if a GM default would not cost me a penny.

That brings up "counterparty risk." If my hedge fund bought a GM swap from AIG, and sold one to your hedge fund, then my fund has laid off the risk. If GM defaults, I will have the money to pay you as soon as AIG pays me.

But if AIG has taken lots of those positions - and it did - then who knows which banks and funds and investors will be in trouble if AIG cannot honor its obligations? My fund might have a perfectly matched book, but it is suddenly in deep trouble if a counterparty is defaulting. Since no one keeps track of all the moving parts, no one knows just who could get into trouble if one participant fails.

The theory that beguiled legislators and regulators was that the market could regulate itself. Each bank would be careful to deal only with counterparties it could trust, and so the whole system would be trustworthy. But even if you believe that, it is not easy to make such calls five years out. Five years ago, AIG was a triple-A company, whose credit was viewed as sterling by everybody.

It is worth remembering that AIG's credit standing did not fall even after it was caught helping other companies to rig their financial statements. Nor was it hurt by evidence that it had fudged its own numbers. Discovering that a company is run by people with what we might call flexible integrity should have been a red flag.

But who would have looked? The insurance subsidiaries were regulated by state insurance departments, and activities of the parent were not their focus. Had anyone suggested an aggressive audit to see what other games AIG was playing, I am sure that neither the Fed nor the Treasury would have thought they had jurisdiction.

The government wants us to know that in nationalizing AIG it was not just bailing out AIG's lenders and counterparties. It was protecting the rest of us, too. As the Fed explained, "In current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth and materially weaker economic performance."

That may sound outrageous, but it is probably true. By the time AIG was on the verge of failure, the government's options were very limited.

In letting Lehman default, the authorities wanted to send messages that they were not going to bail out somebody every weekend, and that the damage from a big brokerage failure could be contained. They may have been wrong on both counts.

I doubt that anyone in government thought to wonder if a money-market fund would have to "break the buck" because it owned Lehman debt. But that did happen.

It is not easy to forecast the reverberations of one big failure, and the Fed may not have done it well. But the biggest errors in Washington were made long before AIG arrived at the Fed with its hat in hand.