NY Times: Why Creditors Should Suffer, Too

Editor’s Note: This article is on the right track. Using the guidelines of resolution trust, a fair and equitable distribution of risk and loss could be achieved while at the same time demonstrating to the world that the United States accepts the responsibility for what our “masters of the universe” on Wall Street and Main Street did to world commerce, government operating funds, pension funds and the rest. My faith in the Federal government coming up with a real solution to the financial crisis is diminishing daily. They talk to the talk about helping homeowners and states and the game still goes on. Impostors are stepping in to grab trillions in assets that don’t belong to them through the process of foreclosures. These proceedings are fraudulent in most cases, from one end to the other and dismissive of the offsets borrowers are entitled to for predatory lending, inflated appraisals and a complete abrogation of the underwriting duties.

The ultimate risk here is going to fall on the citizens of every state whether they have a mortgage or not. The inconvenient truth here is that title is becoming increasing cloudy on virtually all property in every state as these foreclosures proceed. There is a solution. It has been done many times and it is time to do it again — without concern to the repercussions on Wall Street. Since the Federal government seems to preoccupied with Wall Street Banks, leave that problem to them.

States need to look after their own affairs and one of those is property law and title to real property. A fair redistribution through agency authority under enabling legislation would give everyone a chance to prove up their title claims, and provide each state with the revenue they were cheated out of when this scheme of “off-record” assignments and hidden profits and fees were not reported because the entities were not even registered much less regulated by each state. Counties, cities and state treasuries could and should be filled back up as local banks take up the vacuum left behind by the monster mash left by Wall Street. Local banks (perhaps with state guarantee) could by state mandate be empowered to participate in the new loans under clear title providing the state with the revenue they lost and the homeowner with a fair transaction restoring some of the equity they thought they were getting but which was diverted to unknown players receiving undisclosed fees.

And certain states that have a potentially good tax base, along with underlying land or mineral assets could issue proprietary currency to avoid the repercussions of the wholesale printing of money going on in Washington. We’ve seen the result of that too. My opinion is that this is ONLY going to get solved at the state level. We can strengthen our state governments, strengthen the wealth of our citizens, strengthen the banks that did not play with the funny money derivatives and played fair, and regenerate the industries that drive each state economy. It doesn’t take money to do this. It takes commitment and resolve. If the Republicans want to take charge of this issue, let them do it where they can — in the state houses they still control. Success in this venture will change the trajectory of the GOP from being a marginalized party of NO to a party of fiscal responsibility that says YES and has the ideas to back it up.

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April 6, 2009, 7:00 am <!– — Updated: 8:30 am –>

Why Creditors Should Suffer, Too

The Obama administration’s proposals to reform financial regulation sound ambitious enough as they aim to bring companies like A.I.G. under a broader umbrella of government rule-making and scrutiny.

But there is a big hole in these proposals, as there has already been in the government’s approach to bailing out failing financial companies, Tyler Cowen writes in The New York Times’s latest Economic View column. Even as they focus on firms deemed too big to fail, the new proposals immunize the creditors and counterparties of such firms by protecting them from their own lending and trading mistakes.

This pattern has been evident for months, with the government aiding creditors and counterparties every step of the way. Yet this has not been explained openly to the American public.

In truth, it’s not the shareholders of the American International Group who benefited most from its bailout; they were mostly wiped out. The great beneficiaries have been the creditors and counterparties at the other end of A.I.G.’s derivatives deals — firms like Goldman Sachs, Merrill Lynch, Deutsche Bank, Société Générale, Barclays and UBS.

These firms engaged in deals that A.I.G. could not make good on. The bailout, and the regulatory regime outlined by Timothy F. Geithner, the Treasury secretary, would give firms like these every incentive to make similar deals down the road.

If we are going to prevent an A.I.G.-like debacle from happening again, institutions like these need incentives to be more wary of their trading partners. Any new regulatory plan needs to deal with them in a sophisticated way.

That’s because even smart and honest regulators can monitor a financial firm only so well. A firm’s balance sheet doesn’t always reflect its true health, and regulators do not have an inside perspective on the firms they are supposed to secure. We do need more effective regulation, but calls for regulators to “get tough” are likely to prove effective only as long as a crisis lasts.

What the banking system needs is creditors who monitor risk and cut their exposure when that risk is too high. Unlike regulators, creditors and counterparties know the details of a deal and have their own money on the line.

But in both the bailouts and in the new proposals, the government is effectively neutralizing creditors as a force for financial safety. This suggests a scary possibility — that the next regulatory regime could end up even worse than the last.

The more closely a financial institution is regulated, the more it will be assumed that its creditors enjoy federal protection. We may be creating a class of institutions whose borrowing is, in effect, guaranteed by the government.

It doesn’t need to be this way.

A simple but unworkable alternative is to let major creditors make their claims in the bankruptcy courts, as was done with Lehman Brothers. But that is costly for the economy and, after the fallout from the Lehman failure, politically impossible now. Instead, the key to effective regulatory reform is to find a credible means of imposing some pain on creditors.

Here is one possibility. The government has restricted executive pay at A.I.G. and banks receiving government funds, but this move fails to recognize that the richest bailout benefits go to creditors. Restricting compensation at these creditor firms would have more force — if it is done transparently, in advance and in accordance with the rule of law. A simple rule would be that some percentage of bailout funds should be extracted from the bonuses of executives on the credit or counterparty side of transactions.

Such a rule would make lenders more conservative, which would generally be a good thing. To make sure that this measure doesn’t choke off economic recovery, a workable plan would impose compensation restrictions only after the economy improves and banks are recapitalized.

Here is another option: Even in good times, when there is no threat of insolvency on the horizon, credit agreements should provide for the possibility of a future, prepackaged bankruptcy. Those agreements should require that the creditors themselves would suffer some of the damage — even if the government stepped in to bail out the afflicted firm.

There is a risk that these sacrifices will not be extracted when the time comes, but the prospect might still check the worst excesses of leverage.

Right now, people cannot understand why A.I.G. received bailout money, so they feel deceived. A single insurance company, even a very large one, just does not seem that essential to the American economy, which makes the company all the more a scapegoat. Much went awry at A.I.G., but in the context of a bailout, the company should be thought of as the conduit for helping an entire market that went bust.

This poses a very difficult public relations problem for the government, because the Federal Reserve and the Treasury do not want to discuss the importance of the creditors too publicly right now.

Why not? It would be bad precedent, and mind-bogglingly expensive, to promise to pick up all future obligations to major creditors. At the same time, any remarks that threaten to leave creditors hanging could panic the markets. So silence reigns, the Fed and Mr. Geithner receive bad publicity over the bailouts, and we are all laying the groundwork for a future financial crisis.

The challenge isn’t easy, and we can’t start on it today, but one way or another a new regulatory plan has to move some risk back to creditors.

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