All Things in Moderation

The conventional story line behind the passage of the new Dodd-Frank regulations, and in particular the Volcker rule, is that prior to 2008 banks were using federally guaranteed deposits to engage in highly risky “bets” using complex and esoteric derivative products which eventually blew up, necessitating a government bailout of the banks. In order to prevent taxpayers from yet again having to bear the cost of these risky bets going bad in the future banking activity needs to be much more heavily regulated and indeed much activity, such as these “bets” using derivatives, needs to be prevented entirely.

When it is pointed out, as I did yesterday, that in fact the “bailout” of the banks didn’t cost the taxpayers anything, and that the taxpayer has actually netted a profit on the assistance provided to banks during the 2008/09 crisis, the usual retort (although admittedly not in evidence yesterday) is that the bailout of AIG, while not officially a bank bailout, was in reality a backdoor bailout of the banks, and that particular bailout has not only not netted any profit for taxpayers, it is almost certainly going to result in a loss. While this is certainly a reasonable point to make, it also demonstrates the folly behind the conventional belief that it was “risky bets” on derivatives that resulted in bank losses.

The reason that the AIG bailout can be seen as an implicit bank bailout is that AIG owed the banks (or it owed some banks/institutions which in turn owed others) a lot of money on its derivative trades, and if AIG defaulted on its obligations, the banks would be out a lot of money. But if these were simple, outright bets of the sort routinely condemned by those in favor of Volcker or Glass-Steagall on the part of the banks, the bailout would have been totally unnecessary because the bank “losses” would have simply been paper losses of profit, not an actual drain on bank capital. The reason that AIG’s failure to pay would have been so devastating to the banks is because the gains from the “bets” with AIG were needed to offset losses that were being incurred elsewhere on other positions, for example corporate and real estate lending activities. In other words, the “risky bets” with AIG must in fact have been hedges, not outright bets. To draw an analogy, if you make a $1 million dollar bet with your neighbor on the outcome of the Super Bowl, but he fails to pay you when you win, you have, strictly speaking, “lost” $1 million dollars, but you aren’t going to have to sell your house and bankrupt yourself because of it. You haven’t actually “lost” any of your previously held capital at all.

The real problem, of course, was not that the banks lost on their “bets”, but that without the payouts from these “bets” that they had actually “won”, the banks stood to lose actual capital on the positions that the AIG “bets” were meant to hedge. Looked at another way, the losses the banks faced due to an AIG collapse were not due to “risky bets” on derivatives, but were instead due to a bad credit decision, ie the judgement that AIG would make good on its covering obligations. And as far as I know, no one is proposing that banks be disallowed from making credit decisions in order to protect taxpayers from such risk.

Now, the AIG situation does point to an area of the various derivatives markets that does deserve some attention. Would the banks’ judgement of AIG as a worthy credit have been the same had they known the extent of the risks that AIG was insuring against? Or, would AIG themselves have insured so much risk if they were required to post hard capital as margin/collateral against potential losses (over and above simple mark-to-market collateral) on the risks they were insuring? These are worthy questions, and areas where sensible regulation might prove beneficial. But the conventional portrayal of “risky bets” on derivatives as the cause of bank losses necessitating a bank bailout is both wrong and is spawning monstrous regulations that will do little more than make banks less profitable than they otherwise would be, and hence more likely to fail.

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