How the Tricks That Crashed Wall Street Can Save the World

Suppose you are woken up in the middle of the night by a police officer telling you that your teenage son is at the hospital in an alcohol-induced coma. You are shocked and search for reasons. You blame his friends and their wild parties. You blame the bartender who broke the law and served alcohol to a minor. You blame the latest sweet cocktails. You blame your spouse. You even blame the media for making alcohol seem attractive.

Now, consider that the alcoholic son is the financial industry and Americans are the parent who received the wake-up call last fall, when banks collapsed, the credit markets seized, and the U.S. recession spread to the world. Since then, Americans have blamed the wild parties (the housing bubble), the bartender who broke the law (the mortgage brokers with their liar loans), the deceptive latest cocktails (the new derivatives), the permissive spouse (deregulation), greed (excessive executive compensation), and even transparency (the new accounting rules that require mark-to-market).

All of these factors have contributed to the problem. And Barack Obama’s administration is attempting to ameliorate some of them with Senate legislation designed to give regulators the ability to break up the biggest banks and create a new consumer-protection agency. But these measures, as well as others under consideration in Europe and Japan, do not address the fundamental cause of the crisis, nor will they help the world avoid more financial disasters down the road.

What really caused the 2008 meltdown — and is certain to create and burst bubbles in the future — are the financial industry’s distorted incentives. For the past three decades, the most fail-safe way to make money on Wall Street has been to take on risk, borrow, and bet; the crisis did not change that. Either you are lucky and you make a bundle, or you are unlucky and you walk away. In other situations, creditors dampen this opportunistic behavior by imposing covenants and monitoring borrowers. But why bother if the government will bail out ruined gamblers? Then, loans are valuable for borrowers and lenders alike, albeit disastrous from the taxpayer’s point of view.

The implicit policy of bailing out large financial institutions — those behemoths widely thought of as "too big to fail" — will become explicit if the administration’s regulatory reforms are approved. They do not stop the encouragement of bald risk-taking by removing the guarantee that the government will never let big, systemically important banks crater. But short of refusing to bail out banks, regulating them out of existence, or somehow miraculously eroding the profit motive, what should the Fed and Congress do?

There is a way forward, beyond new regulators, new requirements, and new rules, for the banks to figure out how to skirt. An intervention mechanism centered within banks and reliant on market signals will work much better than a Washington edict. And we believe such a system is possible to create and put in place.

The way to do it, contrary though it might seem, lies in the much-maligned credit-default swaps (CDSs), which are like insurance policies against a loan defaulting and whose value rises as the chance of failure increases. When these contracts are traded on an exchange that ensures that they are properly collateralized, they provide a daily assessment of the risk of a loan’s default. Our idea is to use this timely information to monitor banks.

Here lies an apparent contradiction. If banks are too big to fail, how can we use the market assessment of their probability of failure to monitor them? The answer is that large financial institutions are deemed too big to fail because they are highly interconnected through derivative contracts and repurchase agreements. If one big bank goes belly-up, others would lose money, producing further defaults and running the risk of bringing down the entire banking system. Although we can live without any single bank, no matter how big, we cannot live without the entire banking system. But not all bank debt has systemic implications. Long-term bank debt mostly resides in the portfolios of mutual funds and pension funds, which can absorb these losses in the same way as the losses from equity investments. Thus, even large banks can default on their long-term debt without bringing down the entire banking system, as long as there is a mechanism to make their other obligations whole.

Today’s bankruptcy procedure does not achieve this — hence the need for a special fix. We would require banks to hold two layers of capital to protect fragile, systemic obligations. First, as currently, a bank would be required to hold a layer of equity. Because equity holders are paid after creditors in a default, this equity cushion would absorb losses in daily activity without triggering any external intervention. The size of this cushion would be determined not by some arbitrary and fallible accounting number, but by a market assessment of the risk of the crucial — new — second layer.

This second layer would consist of long-term debt that is junior to the systemic obligations. The idea is not as complicated as it sounds: Junior debt is just debt that gets paid after senior debt, meaning that the parties that buy it take on more risk and demand higher payouts. For big banks, such debt would be frequently traded in a liquid market that determines its price. It would absorb the potential losses that might leach out the funds from the equity cushion, providing extra protection for the systemic obligations.

Our mechanism would work very similarly to something called a margin call. For that, an investor buys some stock, putting down only part of the cost. When the stock price drops, the broker who extended the loan asks the investor to post additional collateral. The investor can choose between posting new collateral (and in so doing re-establishing the safety of the position) or having his position liquidated (which allows the creditors to be paid in full). Our system works in a similar way. Big banks will post enough collateral (equity) to ensure that all the debt is paid in full. Then when the second cushion of junior long-term debt is in jeopardy, equity-holders can decide whether to inject new capital into the firm or to lose their stake.

But how will we know when the second cushion is in trouble? The answer is a market-based trigger. One can exercise political pressures on a credit-rating agency. But one cannot influence thousands of traders who have their money on the line. Thus, we look to the junior long-term debt — more specifically, the CDS on it. Because the CDS is a "bet" on the institution’s strength, its price reflects the probability that the debt will not be repaid in full. In essence, the CDS indicates the risk that the equity cushion is being exhausted by losses. In our mechanism, when the CDS price rises above a critical threshold, the regulator forces the bank to issue equity until the CDS price moves back below the threshold. If this does not happen within a predetermined period of time, the regulator intervenes.

One potential danger of a market-based trigger is the risk of self-fulfilling "bear raids." A few hedge funds lose confidence in a bank and start to buy protection in the form of CDSs. This drives up their price and eventually triggers regulatory intervention. If this intervention automatically translates into a default on the debt, the hedge funds will win big. For this reason, we introduce an important filter.

When the mechanism is triggered, the regulator is forced to carry out a stress test to determine whether the bank’s debt is at risk. Then, the regulator decides if the company is adequately capitalized. If it is not, the regulator would replace the chief executive with a receiver (or trustee) to recapitalize or sell the company. In this case, the shareholders would lose their money, and the creditors would be paid back in part (not in full). In fact, we want the receiver to impose a haircut — a loss — on creditors so that the CDS price is informative about the risk of default.

What prevents the regulator, under strong lobbying by the bank under investigation, from always declaring that the company is adequately capitalized? To constrain the regulator we would require her endorsement of an institution to be combined with an investment of some of the regulator’s own budget in junior debt of the bank. If the mechanism was triggered by a "bear raid" driven by a temporary illiquidity of the bank, this injection of liquidity will reassure the market and bring down the CDS price. But if the regulator mistakenly endorsed the bank, the extra loan will not make it safer: The CDS price will go back up and the regulator will be forced to stress test the institution again. The regulator’s political cost of forgiveness will go up hugely if she has to intervene in the same bank a second or even a third time, and so will the regulator’s potential losses. In other words, our mechanism is a delicate balance between forcing the regulator to intervene and not tying her hands too much.

Our mechanism has several advantages. First, despite the jargon, it is really very simple and not that different from the two-tier system of capital requirements that exists. But it is more refined in several ways, introducing a market-based trigger for intervention and requiring the long-term debt to be explicitly junior. It also implements an intervention different from bankruptcy to deal with restructuring, thus avoiding bankruptcy’s destabilizing effects. Second, this mechanism would be easily applicable to financial institutions from hedge funds to insurance companies. Many mechanisms explicitly designed for banks could not easily be applied to other financial institutions. Third, our system would overcome the natural hesitancy of regulators to intervene by introducing a market trigger and reducing the cost of action. Last but not least, our mechanism does not rely on taxpayers’ money.

This feature is particularly appealing in Europe, where regulators face the problem of dealing with pan-European institutions without a pan-European fiscal authority. Our mechanism could be applied even in the absence of such an authority because it is self supporting: The haircut imposed on the creditors of failed institutions will support its budget. The more financially sound countries, like Germany, should like that because it would free them from being the lender of last resort to profligate European financial institutions.

Would this mechanism prevent the next crisis? The evidence suggests so. If we look at the prices of the CDSs of large financial institutions in the last three years, we see that they provided an amazingly accurate prediction of the troubles to come. At the beginning of the crisis in August 2007, the highest CDSs were in order: Bear Stearns, Washington Mutual, Lehman Brothers, and AIG. A simple rule that required action when the monthly average price of the one-year CDS was above 100 basis points would have forced all the troubled institutions to recapitalize or be taken over at least six months before the time they failed or were rescued.

The most dangerous legacy of the financial crisis is the perception that some institutions are too big to fail. This perception distorts competition and the allocation of capital, favoring risk-taking and incubating the conditions for the next crisis. Ignoring the problem will only make it bigger. Intelligent regulation is essential. We have proposed a new market-based capital requirement system that we believe is superior to current regulatory proposals.

To protect the public, several states require people convicted of driving under the influence of alcohol to install an in-vehicle breathalyzer that prevents their car from starting if they have drunk too much. The crisis showed that all our major financial institutions have been "driving under the influence" of too much risk. Doesn’t it make sense to force them to install a device that stops them in their tracks next time they embark on a dangerous journey? Our mechanism does just that.