I am continually amazed at the quality of comments that Interfluidity attracts. But commenters to the previous post truly outdid themselves. I proposed a “novel” security intended to make debt-to-equity conversions gradual and automatic, in hopes of avoiding disruptive “discrete” bankruptcies. Commenters quickly pointed out earlier work along the same lines, and some serious problems that I hadn’t considered. All in all, I remain convinced that “continuous bankruptcy” is a goal worth pursuing. But I’m equally convinced that the specific security I suggested would probably not quite do it.

First, it turns out that better minds than mine have considered debt-like securities that would convert to equity as firms became undercapitalized. The excellent Economics of Contempt pointed out two antecedents, Mark Flannery’s “Reverse Convertible Debentures“, and a recent proposal by the “Squam Lake Working Group on Financial Regulation”. The Squam Lake piece is a diamond in the rough, but Flannery’s ideas are carefully developed. Flannery considers and tries to address most of the problems I would have missed without help from the comments. He also includes a detailed review of related work.

Flannery’s Reverse Convertible Debentures and my proposed “IACCPEs” are both fixed income securities convertible to common stock at a price not set in advanced, but determined by the market price of the stock at the time of conversion. Commenters Alex R and Independent Accountant were reminded of the infamous death-spiral convertibles from the late 1990s. bondinvestor pointed out that a form of catastrophe bond, “catastrophic equity puts” are similar, in that they allow the issuer to convert a fixed income obligation to equity in the event of a prespecified bad event. (Here the bad event that would trigger conversion is running short of capital.) Thomas Barker and jck of Alea pointed out that these securities resemble Islamic “sukuk convertibles”. jck suggests that these, like the death-spiral convertibles, have mostly not worked out so well. (I’d like to know more about Islamic convertibles, both the theory behind them and their history in practice — if you know of a good reference, please do drop a note in the comments.)

The trouble with my proposal is that it failed to adequately consider how both investors and firms would try to game them. Alex R pointed out that investors shorted the hell out of “death-spiral convertibles”. Those who owned them gained if prices could be pushed downward, as lower stock prices meant ownership of a larger fraction of the firm upon conversion. Other traders had incentives to short as well, since dilution caused share prices to drop post-conversion. If the conversion trigger is predictable to investors, and the same dynamic might hold for IACCPEs. (beezer thought this likely as well.)

Also, Alex R and Awake noticed that conversions are effectively at the option of the firm, since “IACCPEs” are only convertible “in arrears” — that is, when a firm hasn’t paid a dividend owed on the preferred shares. Since conversions (under my proposal) are made on terms favorable to IACCPE holders and disadvantageous to incumbent equity, managers might insist on paying dividends to the bitter end, even if overall firm value would be enhanced by preserving cash. Shareholders might prefer to “gamble for redemption” rather than transfer wealth up the capital structure and adopt a more conservative strategy. (In other words, the option value of an undercapitalized firm might be worth more to the original shareholders than the expected value of their fraction of a better capitalized firm.) Further, the fact that convertibility is at the option of firm management creates an incentive towards opacity and surprise non-payment of dividends. Firms would want to skip dividends when shares are overvalued (so that conversion would be on terms favorable to existing shareholders), and would want to hide any possibility of skipping dividends in distress (so that short-sellers don’t front-run à la death-spiral convertibles. Modifying capital structure in a way that creates incentives for managers to reduce transparency and promote mispricing doesn’t seem like a good thing.

Mark Flannery’s “Reverse Convertible Debentures” try to avoid gaming by managers and short sellers in three ways: First, RCDs convert automatically, at the option of neither issuers nor investors, based on a debt-to-market-equity trigger. Secondly, the securities are designed to avoid any transfer of net wealth from equityholders to creditors (or vice versa) upon conversion. Conversions would be based on the market value, not the par value, of the RCDs at the time of conversion, and the market price of the stock. In theory, this would make for a perfectly even exchange, so that no party would have strong incentives to game the trigger. Finally (as foreseen by commenter Bill) “triggered” RCDs wouldn’t all convert all at once. Only the minimal fraction required to bring a firm to a set level of capitalization would be affected, which again might make the threshold event less of an event worth manipulating.

I don’t think that Flannery has solved all problems of strategic behavior — both the “automatic” trigger and the effective conversion ratio are susceptible to gaming, and I don’t think it would be either possible or desirable to define terms under which investors would be indifferent to conversion. Nevertheless, Flannery’s paper makes a serious attempt to address the problem of gaming the trigger, which really is the achilles heel of this genre of proposal.

But let’s pull back. There might not even be a need for an explicit conversion scheme. Plain vanilla cumulative preferred equity has a built-in duality. As long as an issuer is paying out dividends, cumulative preferred equity is very debt-like. Investors expect a fixed coupon, and firms have strong incentive to pay it (so that common shareholders can take dividends, and because nonpayment of preferred dividends is taken as a bad signal by the market). When preferred goes “in arrears”, it suddenly becomes very equity-like: Its value becomes dependent on the promise of dividend payments at some unspecified future date, and the probability that dividends will actually get paid is sensitive to the operating performance of the firm. Cumulative preferred equity has already been invented. So why do we still have a problem?

The first, easiest, and most important thing we could do to reduce the systemic risk and deadweight bankruptcy costs caused by brittle capital structure is change the %*$%&! tax code to eliminate the tax preference for debt over preferred equity. Long-term debt and cumulative preferred equity are basically identical, except for two things: 1) Taxpayers subsidize the issuance of debt while 2) debt contracts are enforceable via socially costly bankruptcy. Taxing preferred equity dividends but not interest on debt is like taxing people for the privilege wearing seatbelts, then wondering in gape astonishment at highway mortality rates. It is bass ackwards. We can either make dividends (at the very least cumulative preferred dividends) tax deductible, or we can make interest payments non-deductable (as Richard Serlin prefers). But we have got to stop tilting the capital structure scales towards bankruptcy-enforceable debt finance. The status quo is absurd, ridiculous, untenable.

(I have yet to encounter even an attempt to justify why interest payments should be deductible but CPE dividends not. There are arguments by definition — expenses are deductible, obligatory payments are expenses, obligatory means enforceable by bankruptcy, q.e.d. But the tax code needn’t be slave to an arguable and legally alterable set of definitions.)

If cumulative preferred equity were not tax disadvantaged, firms might find that it is not much more expensive than debt. But there are two other problems with vanilla CPE as “natural convertibles”. First, there is the question of control. When a firm runs into trouble and then deep goes into arrears on cumulative preferred equity, economically speaking, the preferred becomes equity-like, while the common stock becomes option like. Unfortunately, control usually in the hands of common equity, whose incentives may be to maximize the volatility rather than expected value of firm assets. Secondly, as a matter of convention, financial regulators and analysts often treat preferred equity like debt. When a financial firm is in jeopardy of skipping preferred dividends, regulators become inclined to intervene their “prompt corrective action” mandate. Markets may view skipping preferred dividends as tantamount to a default, and question firm viablity, potentially leading to self-fulfilling distress.

The second issue may or may not be easy to address. Economists pay too little attention to the role of convention in shaping corporate finance, and even less attention to the dynamics of convention. If preferred equity is going to serve as a means of strengthening firm capital structures, we need to move to an equilibrium where occasional periods of missed dividend payments are normalized, and not taken as a death knell for a firm. Sure, skipping preferred dividends is usually bad news, just as it is not a good sign when firms cut common stock dividends. But a skipped dividend needn’t signal a death spiral for a well-capitalized firm. Perceptions might change naturally if preferred equity managed to shed its tax disadvantage. Firms might then lever themselves to the hilt with preferred stock, and over a period of time, investors would observe viable companies go into brief arrears and then emerge. Regulators could help quite a lot by treating preferred equity as equity full stop rather than as a kind of pseudo debt. For financial firms, regulators should commit not to intervene if preferred payments are skipped or threatened, so long as the value (primarily the market value) of a firm’s total equity base remains high. Regulators should treat preferred equity as high risk capital. Regulated insurers, pension funds, etc. should be required to invest as if preferred shares are no less risky than common stock. Regulators should make it clear that during resolutions, preferred shares would go to zero as easily as common if any payout is made on guaranteed liabilities.

Control issues may be more difficult to address, but not impossible. In one of several very helpful e-mails, Economics of Contempt pointed out that

[D]ebenture indentures have included a wide range of covenants over the years that were designed to serve as early warning systems (e.g., the negative pledge clause). No need to reinvent the wheel.

Debt covenants are the means by which divergence of interests within firm capital structures are usually addressed. Lenders do not explicitly exercise control over firms, but they can attach very stringent conditions to loans that limit the ability managers and stockholders to gamble with creditors’ money. Lenders hold a very big stick — if covenants are violated, they can demand immediate repayment of funds that will usually have already been spent. Debt covenants are violated quite frequently, but firms are not often forced to liquidate assets and cough up the cash. Instead, occasional violations allow lenders to renegotiate the terms of loans from a position of strength. So, even though lenders are not represented on a company’s board of directors, their interests are protected both passively (firm managers strive not to violate covenants) and actively (when a covenant is breached — and they are designed to be breached easily — lenders can intervene to actively shape firm decisions).

Preferred stock can include covenants as well, but how to enforce them is a tricky question. It would defeat the purpose of replacing debt with preferred equity if preferred shareholders could force repayment upon a covenant violation. I know very little nothing at all about how preferred stock covenants are written and work in practice. (Hint, hint, amazing commenters!) However, via Google books, I came upon the notion of “contingent proxy” in Raising Entrepreneurial Capital by John Vinturella and Susan Erickson. Apparently there is precedent for clauses that transfer voting rights as “a penalty for breach of covenant”. This idea could be very helpful. As preferred shares become more equity-like and common shares take on properties of options, control might be transferred quite directly to preferred shareholders without a formal debt-to-equity conversion. Transfers of voting rights could be architected so as to be gradual. They might be a function of the degree to which a firm is in-arrears, rather than the mere fact of in-arrear-edness, so that common shareholders would not much surrender control during occasional, brief lapses. Preferred shareholder control rights could depend upon the full mix of the solvency and health metrics typically included in debt covenants, so that there is little incentive by firm managers to game any one potential trigger. Formal options to convert to common equity could gradually be extended as well. Obviously, devils are in the details, and I don’t yet know enough to attempt an exorcism. But, as EoC reminds us, we don’t have to reinvent the wheel. Investors up and down firm capital structures have been eying one another warily for centuries. We have millions of paranoid legal documents to draw ideas from.

It seems to me that the right species of “trigger convertible”, in David Murphy’s coinage might well evolve from negotiation and experimentation, if fairly minimal changes in policy were made. First, we desperately need to level the tax playing field between debt and equity. At the very least, the differential treatment of debt and near-debt-but-safer cumulative preferred equity needs to be eliminated. Secondly, for financial firms, regulators should radically increase capital requirements for financial firms. Bankers will do what they do best, which is to seek the cheapest means possible of pretending to hold capital by inventing the most debt-like equity that they possibly can. Regulators should scrutinize these instruments carefully, but only to enforce two very simple requirements — that under no circumstances are dividend or principal repayments obligatory, and that no agreements made between the different classes of equity encumber firm assets or compel behavior that would compromise the interests of claimants higher in the capital structure. (Regulators, and creditors, would have to guard against “poison pill” arrangements, in which some form of “equity” is cheap because purchases have some means of sabotaging the firm if they are not paid. But this is not a new problem, see the negative pledge clause in EoC’s comment.)

Finally, regulators would have to severely curtail the ability of regulated entities from holding preferred equity. All equity securities should be treated like common stock for risk-weighting purposes. No matter how the contract is writtem, when a security acquires a sufficiently high weighting in the portfolios of insurance companies, pension funds, and banks, it acquires an implicit state guarantee that issuers will aggressively exploit. One lesson of the current crisis is that the distinction between debt and equity has less to do with the legal characteristics of securities than with the political connectedness, financial interconnectedness, and risk-bearing capacity of the entities who hold them. Equity securities, preferred or common, must be restricted to parties whose losses the state would tolerate.

I’d like to propose a financial innovation that I think would actually be good (besides the ATM). It would be a new security that firms could market to investors, just like CDOs and all of that good stuff. But rather than being a means of expanding the supply of credit (the questionable purpose of most “financial innovation”), this investment product would change the character of credit provided by investors to firms. It would provide an alternative to the customary form of corporate debt.

True believers might argue that if what I suggest were a good idea, a free capital market already would have discovered it. I’m not a true believer, but I’ll make common cause in part, and point out that securities like those I propose are presently tax disadvantaged, so capital markets have not been free to discover them. In particular, if dividends on preferred equity were tax-deductible to firms like interest, perhaps these securities would already be commonplace. But I’ll reveal my cruel, statist heart by hinting that since firm managers may be myopic in their preference for cheap financing, and since distress costs are in part external to firms, an active policy tilt in favor of more robust capital structures might be worth considering. [1]

I’m suggesting a new financial instrument. Here’s its catchy name: “In-arrears convertible cumulative preferred equity”, or “IACCPE”. (“Yak-pee” for short?) Let’s chop that aromatic mouthful into tasty, digestible chunks:

Preferred equity is a form of investment that is like debt, in that the issuing firm promises to pay an agreed dividend level (like an interest rate), rather than a share of a firm’s variable profits. However, preferred equity is unlike debt, and like stock, because if a firm for whatever reason does not pay the promised dividend, aggrieved investors cannot sue for bankruptcy. Preferred shareholders’ only means of enforcing payment is priority: common equityholders cannot receive dividends if preferred shareholders’ dividends have not been paid.

Cumulative means that if the issuing firm has skipped some dividend payments, the firm is said to be “in arrears”, and must pay preferred investors all past skipped dividends before it can make any payout to common shareholders. “Cumulativity” ensures that, unless a firm goes bust before ever paying another dividend, preferred investors will eventually get all the payments they were promised, although they may suffer from delay. Cumulative preferred equity is more “debt-like” than noncumulative preferred equity, in that noncumulative investors permanently lose claim to some dividends if a company falls on hard times and suspends payments, while debtors always have claim to interest owed.

In-arrears convertible means that while payments on the preferred shares are “in arrears”, when the firm had failed to pay some of the dividends that it had promised and not yet cured the failure, investors would have the option of converting the shares to common stock on favorable terms.

It’s the in-arrears contingency that makes this security novel and interesting (I hope). But the feature requires some explanation. Usually, a convertible security has a par value and a conversion price that fix the number of shares of common stock an investor would get for converting a share of the security. This means that investors normally convert only when a firm is doing well. Suppose you have a share of preferred stock that (without the conversion feature) would be worth $100, but that can be converted to 10 shares of common stock. You would never exercise that right when the common stock price is less than $10, since the preferred share is more valuable than the stock you’d get. You would only convert when the common stock is doing well enough so that the value of the stock you would get on conversion exceeds the value of your preferred share. [2]

An “in-arrears convertible” would be pretty useless unless the conversion price were very low, since firms stop paying their preferred stock dividends in difficult times, when their stock price is depressed. So rather than fixing the conversion price in advance, these securities would be convertible at a discount to the market price of the stock at the time the preferred dividend was not paid. [3] That is, by going into arrears on the preferred shares, firms would open themselves up to dilutative preferred-to-common-equity conversions, at the option of the preferred shareholders. If a firm does have long-term, going-concern value, but is simply unable to meet the cash flow requirements of its capital structure, preferred shareholders could convert at a bargain rate during the limited in-arrears period. If a firm is not likely to be viable as a going concern, preferred shareholders could choose to hold tight. They’d be paid out in preference to common stock holders at the eventual liqudation.

Firms could issue multiple classes of “IACCPE”, like they now offer multiple debt issues, each with a distinct priority in the capital structure of the firm. Ordinarily, these securities would be indistinguishable from debt, both to the firm and to investors. Investors would fork over a set amount of cash, and then expect to be repaid with interest (formally dividends) on a predetermined schedule. But in bad times, firms that fail to meet their obligations would be forced to offer equity, including control rights, to creditors on very favorable terms. (Non-payment of a dividend could also provoke a special shareholders meeting, and holders of the unpaid preferred could be given the right to propose replacement directors, thereby maximizing the value of converters’ control rights.)

Substituting this kind of security for debt in firms’ capital structure would enable a kind of bankruptcy in increments, an automatic and self-enforcing reorganization. I think this would improve value for all stakeholders compared to our present system. Chapter 11 bankruptcy was itself a great innovation, but it exposes even viable firms to large, indirect distress costs when capital structure and cash flows become misaligned. To the degree that a firm has widespread or important stakeholders outside its capital structure (customers, employees, financial counterparties, local governments, etc), Chapter 11 even at its best produces costly externalities, as stakeholders must provision for abrupt and unpredictable changes even when a firm is likely to survive and even thrive once arguments over who gets what are resolved. Because Chapter 11 bankruptcies (and receiverships for financial firms) are disruptive, governments sometimes intervene to prevent them or to the process with subsidies. The expectation of intervention causes investors in “systemically important” firms to over-lend and under-monitor. For large firms, the threat that contractually prescribed, preferred-to-common conversions might be triggered would be more credible than the threat of an uncontrolled bankruptcy without government subsidy. Investors would be forced to actually price the “lower tail”, rather than hoping it will be truncated by the state. Common stockholders would face a steep penalty for missing “debt” payments, but the extent of their dilution would be predictably related to the scale of the obligations they fail to meet.

IACCPEs wouldn’t replace or eliminate traditional bankruptcy, of course. Regardless of capital structure, firms that are not viable businesses will need to be liquidated. Sometimes firms have contractual arrangements other than straight debt that need to be modified if a firm is to become viable. Moreover, even if all “financial” debt were eliminated from firm capital structures (I think that would be a good thing), firms would still have transactional business creditors, for whom traditional “hard” debt makes sense. [4] This proposal does not directly address off-balance-sheet contingent liabilities or pension and health obligations, which are increasingly sources of firm distress. I think pension and health issues will have to be addressed on a national basis, that our employer-centric system of managing health and retirement issues will ultimately have to be, um, retired. But some contingent liabilities (uncollateralized derivative exposures) could and probably should be replaced by contracts that can be paid off in some form of equity (at punitive valuations) when they cannot be paid in cash.

Highly leveraged capital structures make individual firms, and networks of interdependent firms and communities, brittle. Replacing debt in firm capital structures with some form of preferred equity would serve as a shock absorber, allowing viable firms to survive transient cash flow shocks without affecting outside parties. It might be enough to simply level the playing field between debt and preferred equity by making preferred stock dividends tax-deductible for firms. But debt investors take some comfort in the fact that they have power, via the bankruptcy process, to enforce payment. That threat may reduce the cost to firms of debt finance. The sense of the present proposal is to define an instrument that gives fixed-income investors as much of the power they would have in a bankruptcy as is possible while reducing the likelihood of a “singularity” that creates far-reaching costs and uncertainties.

[1] The proposed “IACCPEs” would not necessarily be a more expensive form of financing than traditional debt: On the one hand, they take a weapon away from creditors, so creditors would want to be compensated for the additional vulnerability. On the other hand, by reducing the likelihood that a transient shock provokes an unnecessary bankruptcy, replacing debt with IACCPEs might reduce expected distress costs, and thereby increase overall firm value relative to a firm financed with traditional debt, which would be reflected in a lower cost of financing across the capital structure. Which of the two offsetting factors dominates would have to be an empirical question.

[2] Usually you would wait quite a bit longer than that, because the option of converting at any time makes the convertible security as valuable as the shares, but the agreed-in-advance payments of the unconverted security provides protection should the stock price tank. Exactly when it’s worthwhile to exercise the conversion option on convertible shares is complicated, and in real life depends on the level of dividends paid by common shares and the relative liquidity of the market for common and preferred shares. In frictionless markets for a firm that issues no common dividend, it would only be worthwhile to convert an instant prior to maturity of the convertible security (if it is not perpetual). For our purposes, however, all that matters is that investors usually convert preferred stock only when the common shares are doing well.

[3] Getting the conversion option trigger right would be an important technical issue in defining these securities. Managers might try to manipulate their stock price around the time of the triggering nonpayment, in order to minimize the cost of dilution to existing shareholders (and themselves). The conversion price might be based on an average stock price over 30 days prior. Managers would not have very much scope to time the nonpayments, because they would be required to skip dividends on the most junior class of preferred shares, whose dividend schedule would have been set in advance.

[4] Broadly, “financial” investors should be expected to research and take some responsibility for the firms in which they invest, while customers and suppliers should be able to do business with a firm without worrying very much about its balance sheet. There is no bright line between transactional credit and financial debt, but it is nevertheless a distinction worth making, and even policing, in firms’ capital structure. The “cash efficiency” movement, which encourages firms to maximize their use of transactional credit as a source of cheap financing, is in my view pernicious. But that’s a rant for another day.

You just never know who you’ll run into here in blogland.

Joe Peek is a professor of finance at the University of Kentucky (where I am a very poor excuse for a graduate student). He has a guest post over at The Hearing.

Dr. Peek’s professional obsession is the Japanese banking system. He takes an unreconstructed view of the parallels between our response to the banking crisis and Japan’s, and is particularly unhappy with the recent softening of mark-to-market rules. Here’s a snippet:

Much like in Japan, U.S. policy makers have made efforts to avoid distinguishing among banks, for example, forcing all of the largest banks to accept billions of dollars of Troubled Assets Relief Program funds. The stress tests for the 19 largest banks provide policy makers with an opportunity for a “do over.” The results of the stress tests must be based on market values and whether the banks are truly economically viable. Government capital should not be injected into banks indiscriminately; only the strong should survive. We need disclosure, as well as closure, if a bank either is not viable or cannot raise sufficient private-sector capital to become viable.

The time has come for transparency to replace the “parency” of government support of non-viable firms, financial or non-financial. The “convoy system” did not work in Japan during their “Lost Decade,” and should not be expected to work here.

Do read the whole thing.

Would it have been better if Timothy Geithner had had the power to guarantee all bank debt early on? As James Surowiecki reminds us, that was part of the Swedish solution. Justin Fox plausibly suggests that we might have avoided a lot of pain with a fast, full guarantee.

But that’s not the point. The question isn’t whether we could have avoided this crisis, if only we had cut a big check. We could have, and that was not lost to any of us debating these issues more than a year ago. (See e.g. me or Mark Thoma.) Had we done so, the near-to-medium term fiscal costs might have been less than they probably will be now. So, with 20/20 hindight, would it have been a good idea?

How you answer that question depends upon how you view the crisis. Is it an aberration, a shock to a basically sound financial system, or is it a painful symptom of an even more dangerous condition? Under what circumstances would our political system be likely to impose reforms that would prevent large scale misallocations of capital and shifting of losses to taxpayers in the future?

If you think that our financial system just needs some tweaks, some consolidation of regulators’ organizational charts and sterner supervision, then you should prefer that we had just cut a check, passed Sarbanes/Oxley Book II, and moved on. But that is not what I, or most proponents of nationalization temporary receivership for insolvent banks, believe.

If you believe, as I do, that we need a root-and-branch reorganization of the financial system, which must necessarily involve the dismemberment and intrusive restraint of deeply entrenched institutions, does that mean pain is the only way forward, “the worse the better” in the old revolutionary cliché? It need not mean that. But it does mean that palliative measures, like giving the banks money, would have to be attached to curative measures, like enacting capital requirements and imposing regulatory burdens that would force financial behemoths to break themselves up or become boring narrow banks. For almost two years, policymakers at the Fed and the Treasury, including Secretary Geithner, have offered bail-out after bail-out and asked for nothing serious in return.

Do I regret that Henry Paulson was not empowered to issue a blanket guarantee of bank assets early on, as the Swedes did? No, I don’t regret that at all. Why not? Because I think that “Hank the Tank” was a crappy negotiator, not only for taxpayers in a fiscal sense, but also for the economy and the polity more deeply. He would have offered the financial system sugar without requiring it to make the medicine go down. He may believe, quite sincerely, that a cure would be worse than the disease. He may believe that, but he is wrong. If we “get past this crisis” by restarting a consumer-credit-based, indiscriminate-investor-financed, current-account-deficit-making, income-inequality-expanding economy, we will have increased, not diminished, the likelihood of a major collapse.

You may believe that we have learned our lesson, that if we can just get some stability and comfort for a while we are prepared to do what must be done. That’s a respectable position. But I don’t share it, and neither do the majority of Americans who are unwilling to allow their representatives to sign off on any more expensive aspirin. We want value for value, an ironclad commitment of root and branch reform in exchange for the unimaginable sums of money we are being asked to hand over.

Surowiecki has in the past suggested that those of us who favor nationalization would criticize any alternative simply because it is not precisely the policy we advocate. But it is not we who have refused to compromise. We’ve seen variations on the same basic proposal over and over again. Geithner’s PPIP really does resemble Paulson’s TARP, besides the part about actually asking taxpayers for the money. Each latest plan from our incestuous cadre of economic Mandarins demands only symbolic concessions from the dysfunctional organizations we are asked to support. The “moderate” political class goes on and on about how Geithner and Bernanke have to go all Enron, funding the banks via off-balance-sheet guarantees and special purpose vehicles, because “populist, childish” Congress won’t put up the money. Setting aside how audaciously corrosive that sentiment is to Constitutional democracy, it is simply wrong. Congress would, because the public would, support large, explicit transfers, if they were attached to reforms sufficiently radical to prevent a recurrence, and suitably punitive towards the people who managed the system that brought us here. Value for value.

I am a true believer in American-style capitalism. So I would like to see people who earned profits lending to banks in good times bear the high costs of failing to monitor the organizations they funded. Investor fear is what is supposed to prevent the indiscriminate misuse of capital. To the degree that creditors have leaned upon “implicit” government guarantees, I think it would both be just and set a useful precedent if they were reminded that investors have to take responsibility for where they place the precious capital they steward.

That said, like Paul Krugman, I would be willing to hold my nose and tolerate a Swedish-style guarantee of bank creditors. I’d acquiesce to that even without formal nationalization. Nationalization is no one’s idée fixée. It is a means to an end, and the desired end is a world in which too big to fail is too big to exist for any financial institution that originates or holds credit risk in any form. Secretary Geithner could send a bill to Congress today that would put all banks with a balance sheet of over $50B into run-off mode, while clearing away legal obstacles so that larger organizations could arrange their own breakups over time. I’d fax my Congressman and support a $2T on-budget buyout of bank creditors as part of that bill, as long as it had teeth. (“Teeth” would include making sure that off-balance-sheet and derivative exposures were included in the size cap, etc.)

It’s not that us pitchfork-totin’ populists are unwilling to pay the bill. It’s that we want to know that in exchange for writing a very, very large check, the people that we are paying will actually deliver the goods. Given the behavior of bankers before the crisis and of shifty policymakers during, we have every reason to watch warily and to insist upon every precaution while we hand over suitcase after suitcase of freshly printed Federal Reserve notes.

I’ve been unimpressed with this oft-quoted bit from Phillip Swagel’s insider account of the Paulson Treasury.

Legal constraints were omnipresent throughout the crisis, since Treasury and other government agencies such as the Federal Reserve must operate within existing legal authorities. Some steps that are attractive in principle turn out to be impractical in reality—with two key examples being the notion of forcing debt-for-equity swaps to address debt overhangs and forcing banks to accept government capital. These both run hard afoul of the constraint that there is no legal mechanism to make them happen. A lesson for academics is that any time the word “force” is used as a verb (“the policy should be to force banks to do X or Y”), the next sentence should set forth the section of the U.S. legal code that allows such a course of action—otherwise, the policy suggestion is of theoretical but not practical interest. Legal constraints bound in other ways as well, including with respect to modifications of loans.

Today’s news (Clusterstock + source docs, WSJ Deal Journal, McArdle, Naked Capitalism, Calculated Risk, Marketwatch), that Henry Paulson, um, forced Bank of America’s near suicidal merger with Merill Lynch kind of clinches the case. Pre-Merrill, BOA was viewed as relatively healthy among large banks. What’s the statute under which a Treasury secretary unilaterally fires and replaces the board of a healthy bank? The Paulson Treasury talked up legal constraints whenever they were faced with something Paulson didn’t want to do. When Paulson, or Bernanke, really did want to do something, they were very creative about bending the law to their will. The Fed’s “special purpose vehicles” are clearly not lending in the sense that the architects of the Federal Reserve Acts “unusual and exigent circumstances” clause foresaw. The FDIC has no statutory authority to issue ad hoc guarantees of bank debt, but flexibility was read into the laws.

With respect to the banks, the Paulson Treasury could have forced any big bank into a bail-out or receivership scenario just by looking at it funny, or by having the Fed take a conservative view of bank asset collateral values under the special liquidity programs. It’s worth noting that Treasury very ostentatiously forced banks to accept TARP capital, and Geithner’s Treasury was able to persuade holders of Citi preferred to convert to common equity.

It’s not exactly right to say that our don’t-ask-don’t-tell quasinationalization policy has given us “ownership but not control”. An assertive Treasury secretary has tremendous leverage over zombie bank managers. Instead, what we have is is control without accountability. An informal, unauditable, hydra-headed set of private managers and public officials controls how quasinationalized banks behave. Neither taxpayers nor shareholders have reason to believe that decisions are being taken in their interest. The informality and disunity of control impedes the kind of hands-on, detail-oriented supervision and risk management that ought to be the core preoccupation of bank managers. Exactly as opponents of nationalization feared, America’s large banks are poorly run behemoths that routinely make idiotic commercial decisions to satisfy tacit political mandates. No one really knows who is responsible for what.

Ironically, there might be less scope for political control if banks were in formal, least-cost-resolution receivership. A bank that has already failed cannot fail. If independent boards are appointed to oversee the receiverships, politicians might have very little leverage. Incumbent private managers face collapse, sacking, disgrace, and potential civil and criminal liability for improprieties that come to light during the post-mortem. New moderately paid, high reputation board members would bear no responsibility for what came before, and could very publicly resign in protest if pushed to act in a manner inconsistent with their charter. (Resignation in protest by long-affiliated board members of a zombie bank would have different reputational consequences, and it would be difficult to recruit high-reputation outsiders to serve on zombie bank boards.) Promoting insiders or recalling retired executives to run zombie firms leaves the leadership weak and compromised. A much higher caliber of outside talent could be recruited to oversee banks in receivership than would accept responsibility for banks that are insolvent but on government life support.

This is not to say that formal public control would be a panacea. The list of public and quasipublic organizations currently being gutted by politically motivated credit expansion includes Fannie Mae, Freddie Mac, FHA, FHLB, FDIC, and the Federal Reserve system. A bank in receivership managed by a weak board or not institutionally segregated from political bodies could easily join the list. But if received banks were put under strong boards, and given clear mandates to divide and sell their assets (maximizing taxpayer value subject to a scale constraint) while running off their lending books, there would be little hazard of politically directed credit or other shenanigans. That would imply that large insolvent banks would reduce their lending, contradicting the Administration’s endless exhortations that banks should lend, lend, lend. My view is that public encouragement of expanding indebtedness is very bad policy (read Finem Respice). But if you misguidedly believe that “credit is the lifeblood of a modern economy”, the thousands of well-run smaller banks in America are fully capable of taking advantage of today’s deeply subsidized lending spreads to serve creditworthy borrowers. Whether in private or in public hands, the big, broken banks are simply too compromised to lend.

Commenting on Nassim Taleb’s provocative agenda for fixing the world, Felix Salmon notes that

Looking at the rest of the list, how on earth do you stop the financial sector from… creating complex products? Derivatives are, at heart, bilateral contracts: how can you ban two consenting adults from entering in to such a contract?

The only bilateral contract is a gentleman’s agreement. Binding contracts involve an implicit third party, the state which (through its courts system) stands ready to enforce the terms of private arrangements. The state is not, and cannot be totally neutral in its role as contract enforcer: Communication between contracting parties is always imperfect; the universe presents an infinite array of unforseeable possibilities; even very clear contractual terms can be illegal, repugnant, or contrary to the public interest. The state makes affirmative decisions about how it will (or will not) enforce the terms of contracts. Libertarians may have perfect freedom to contract, if their agreements are self-enforcing or voluntarily adhered to. For the rest of us, every contract is a negotiation between three parties, the two who put a signature at the bottom the document, and the state which will be called upon to give force to the arrangement when disputes arise or someone fails to perform. I think of contract lawyers as two-bit psychics in fancy suits. Much of their job is to channel the voice of the incorporeal Leviathan, so that its quirks and predilections are taken into account whenever agreements are drafted.

This has something to do with derivatives, but even more to do with one of Taleb’s broader concerns: debt. At present, the state enforces debt contracts by permitting lenders to force nonperforming borrowers into bankruptcy. That is not a natural or obvious arrangement. Bankruptcy evolved as an improvement over automatic liquidations or men with big necks and brass knuckles. It serves to balance the contractual right of a lender to be timely paid with a broader interest in preserving the overall value of enterprises and preventing extremes of immiseration. To some degree, bankruptcy lets debtors to escape the terms of their own agreements and limits the right of contract (though bankruptcy is onerous enough that debtors don’t seek this sanctuary easily). The fact that creditors’ rights are limited is socially useful: it encourages lenders to discriminate between good borrowers and bad, reducing the frequency with which resources are lent foolishly and then destroyed.

One thing I think that we are learning from the present crisis is that the logic of bankruptcy hasn’t been taken far enough. Creditors’ rights are too strong. Creditors have insufficient incentive to discriminate, especially when lending to “critical” organizations, because the bankruptcy that would attend a failure to pay is too disruptive and destructive to be permitted by the state. We have seen tremendous resources lent to banks thoughtlessly, and then squandered or stolen rather than carefully invested. Similarly, those who entered into derivative contracts often ignored credit risk when a counterparty was seen as too dangerous to bankrupt. If it were possible for borrowers and counterparties to welsh on their agreements without provoking consequences as disruptive as bankruptcy, creditors would have more reason to be careful of whom they do business with, and potential deadbeats (like large financial firms) might not be able to take levered risks cheaply.

I think that, going forward, the state will have to limit the right of creditors to enforce claims via bankruptcy. Creditors and counterparties who go to the courts would run the risk of simply having their claims converted into something like cumulative (and maybe convertible) preferred equity. This would ensure that no dividends are paid to stockholders until the disgruntled creditors are made whole, but would not otherwise disrupt the operation of firms or affect other claimants. (Such conversions could be combined with tight compensation limits, to prevent shareholders and managers from taking payouts as wages and bonuses while failing to pay creditors forcibly converted to equity.) Judges would weigh the rights of creditors against the costs to other stakeholders in deciding between formal bankruptcy and ad hoc conversions, so that the risk to creditors would increase with the size and interconnectedness of borrowers.

It may be hopeless to try to control what kind of contracts private parties write amongst themselves. But we can control how contracts are enforced. There is nothing natural or neutral about how we currently enforce debt contracts. We made up some procedures that seemed to work reasonably well. The current crisis has exposed some shortcomings. Nothing prevents us from modifying how we enforce contracts in order to improve the incentives of parties to manage their own risk, and to prevent collateral damage when private contracts come undone.

Divide the world into the consolidated financial sector and taxpayers. Under PPIP, each dollar a “public-private investment fund” overbids provokes a net transfer to the consolidated financial sector from taxpayers. The size of transfer to the financial sector increases with the degree to which bids are overpriced, and is maximized if the true asset value is very small relative to the price actually bid. If an asset is worth $6 dollars, and financial sector actors purchase a contract for $7 while the Treasury invests alongside, the consolidated finacial sector gains a dollar. But if financial sector actors pay $70 for the same asset, the financial sector would receive a net transfer from taxpayers of up to $118. (For more detailed arithmetic, see below.) The more financial sector actors are willing to overbid, the greater the net transfer from taxpayers to the financial sector. In theory the scale of the transfers is limited only by the quantity of asset purchases the government is willing to guarantee.

There are problems with this story. In real life there is not a consolidated financial sector, but a lot of different players who are usually in the business of competing with one another. PPIP includes rules and tools by which the government could prevent the use of taxpayer money to fund overpriced bids, and ensure that the parties who take small losses are distinct from the parties who make large gains, eliminating incentives to overbid. An important question is whether the government genuinely wishes to prevent backdoor transfers to the financial sector, or views such transfers as a desirable means of helping core financial institutions. (See Joe Weisenthal and Noam Scheiber)

It is worth noting that overcoming coordination problems so that diverse parties can collaborate on profitable ventures is precisely what the financial sector is supposed to be good at doing. Ideally, we would like the profitable ventures to be welfare-improving projects in the real economy, but there is little question that financial sector actors will gladly apply the same skillset to extracting transfers and rents when the opportunity presents itself. Attempts to regulate away intentional overbidding by cooperating parties will have to outwit some very clever professional deal makers.

A few more caveats — financial sector actors do pay taxes, so they are not distinct from the taxpayers from whom transfers are made. Qualitatively, this overlap would’t change the story very much. (Quantitatively, it’s interesting, you’d have to think hard about the realizability of “deferred tax assets” from losses the financial sector would absorb without the transfers.) The numbers I’m using are for the PPIP whole loan program. The degree of nonrecourse leverage that will be provided by the Fed towards the securities purchase program is as far as I know unspecified.

Some links:

There are way too many good links on this issue, but rortybomb’s take is my all-time fave.

Restricting to the last 24 hours or so, see also Scurvon, Carney, Sachs, Nemo, Krugman, Free Exchange, Felix Salmon, Economics of Contempt, and Cowen. See also articles in the Financial Times (ht Conor Clarke, Calculated Risk) and the New York Post (ht Yves Smith). As far as I know, Karl Denninger is the first person to have pointed out the potential for gaming. My first take on this issue is here. Mish has a very similar take (here, here, and here). I’m sure I’ve left many great posts out of this linksplatter. My apologies to the unsung pundits.

Arithmetic:

Case 1: A private fund buys an asset for $7, but pays only $1, as the rest is borrowed from the bank via an FDIC guaranteed loan. The Treasury invests along side 1:1, purchasing the same asset on the same terms. The asset is really worth $6. The private fund loses its dollar, but this becomes a gain to the selling bank, causing neither a loss or gain to the consolidated financial sector. However, the Treasury also loses a dollar, which becomes a gain to the selling bank, and amounts to a transfer of $1 from taxpayers to the consolidated financial sector.

Case 2: A private fund buys the same asset for $70, of which it pays $10 cash and borrows the rest on an FDIC guaranteed nonrecourse loan. The Treasury invests along side 1:1, purchasing the same asset on the same terms. The asset is really worth $6, so each purchase amounts to a transfer of value to the bank of $64 dollars. When the value becomes known, the FDIC (indirectly) accepts the $6 asset in exchange for $60 of loan extinguishment, bearing $54 of the private investor’s $64 loss. The net effect of the private investment is a transfer of $54 from taxpayers to the consolidated financial sector. Taxpayers bear the full loss of $64 on the Treasury’s investment. So the total transfer fronm the public to the private sector is $118.

Not unusually, I was a bit incoherent in my previous post on bank size. On the one hand, I wrote…

…a sufficiently levered and inter-contracted microbank could take down the world as surely as the Citimonster.

On the other hand…

…limiting size defined by total asset base plus an expansive notional value of all derivative and off-balance sheet exposures limits both interconnectedness and leverage.

If limiting size constrains leverage and interconnectedness, how could a microbank get to be so interconnected and level as to bring on armageddon?

The key, of course, is in the definition of size. Entities that are small in terms of number of people involved and level of capitalization certainly can blow things up, by loading up on traditional leverage (debt) and untraditional leverage (derivative exposures, off-balance-sheet contingent liabilities). AIG might have been a big firm, but the unit that blew up the world amounted to a handful of people in a well-appointed London garage. The “bigness” of AIG mattered only insofar as it permitted that tiny operation to lever up, by taking on trillions of dollars in notional CDS exposure.

But if size is defined properly to mean the total scale of assets to which a firm is exposed, including balance sheet assets plus the notional value of any derivatives plus any off-balance-sheet commitments, then size is basically everything. Suppose there was a bank levered 10000:1. Sounds pretty bad, huh? But suppose the bank has precisely one penny of equity against a hundred dollars of assets. That might suck for the fool who lent the hundred bucks, but the rest of us can sleep easily. Leverage alone can’t cause crises: it’s only when an entity is levered up to some systemically troubling size that bad things happen.

That doesn’t mean we could regulate bank size and then ignore leverage: If all banks had $100 on assets against a penny of equity, we’d end up with a lot of bank failures, creditor bailouts, and sleepless nights. What size limitations do is prevent mistakes or misdeeds at any one or few firms from becoming all of our problem. Smallness also reduces the likelihood of misdeeds, since dumb gambles have a bigger payoff for managers at big banks than at modest thrifts. Some banks will always slip through regulatory cracks. If they are small and few, that’s not a problem. If they are big or many, we’re screwed.

Size limits, like leverage and risk constraints, will inevitably be gamed. There will always be fuzziness surrounding what sort of contingent liabilities should fall under a size calculation, and bank lobbyists will work assiduously to create loopholes. Adding hard limits on size and trying to police them won’t be a panacea. But faking small might be harder than faking well-capitalized. Plus, forcing banks to appear small may help to keep banks actually small, since counterparties get nervous about offering sneaky, uncollateralized leverage to banks that look like they are small enough to fail.

In the end, banks-as-we-know-them are flawed by design. They serve an important purpose, but do so in a manner that is predictably prone to failure. If your roof has a leak and water drips in, one way to handle the problem is with a bucket. That approach can be effective, but it demands constant supervision. There is always the danger of some lapse of attention, then whoops!, the bucket overflows and your floor is ruined. Resolving to watch the bucket very carefully by, say, titling yourself the integrated bucket super-regulator might help, a bit. But even super-regulators need the occasional bathroom break, and buckets are notorious for tempting super-regulators with songs of free water flows and offering cushy jobs if they look the other way. Imposing size and leverage constraints on banks is like replacing a small bucket with a big washtub: You’ll still have problems if you don’t watch the thing, but the occasional lapses in supervision are less likely to conjure the Great Flood. Of course, the best way to manage a leak in the living room would be to stop messing around with buckets and patch the roof instead. To do that, in my opinion, we’d have to separate the credit and investments function of banks from the payment and deposits function, and draw an enforceable bright line between guaranteed claims and risk investment.

But if we’re too scared to climb that ladder, I suggest we get the biggest washtub, — I mean, the tightest size restrictions — that we can possibly manage. Promising to stare very sternly indeed at the same old bucket just won’t cut it.

p.s. if you haven’t seen it, I really like James Kwak’s Frog and Toad post on the difference between supervisory and structural approaches to regulation.

Kevin Drum has nicely posed the question of whether it really is important to break up big banks. After all, he argues, even small-ish banks have proven to be too leveraged and interconnected to be permitted to really fail. He argues that maybe it’s the banking industry, rather than individual banks, whose size and reach we need to constrain.

John Hempton has been arguing for the Australo-Canadian model of an oligarchic, heavily regulated, generously profitable banking system.

James Kwak offers a very nice discussion of the “too big to fail” problem in light of the absence of structural rather than supervisory approaches in Treasury Secretary Geithner’s recent regulatory proposals. (And Drum responds.)

I think size does matter very much, but not because small banks are inherently small enough to fail. Drum is right about that: Like a dwarf with a suitcase nuke, a sufficiently levered and inter-contracted microbank could take down the world as surely as the Citimonster.

But in practice, a properly defined smallness could add a lot of safety to the banking system:

1. Very directly, limiting size defined by total asset base plus an expansive notional value of all derivative and off-balance sheet exposures limits both interconnectedness and leverage. (Defining size limits by capitalization would suffer from the same drawback as traditional leverage constraints — they encourage bankers to scheme secret ways of levering up.)

2. When a bank appears to be small enough to fail, creditor discipline will backstop regulatory supervision. If a bank is perceived as too big to fail, if its failure in “unthinkable”, then clients and counterparties will be lax in managing or limiting their exposures, leaving always circumventable regulation as the only bulwark against becoming too levered and interconnected to fail. (Insured depositors, of course, won’t provide discipline, and shouldn’t be expected to. But bondholders and derivative counterparties will, if a bank’s credit is potentially dodgy.)

3. Smaller banks, even very levered and interconnected ones, can be unwound, merged, or put into receivership. We’ve managed the failures of even large-ish banks like Drexel, Bear, Wachovia, WaMu, or IndyMac, and we could have managed Lehman in a costly but orderly unwind. But once banks have gone truly mega, we’re not sure we can manage it. A bank that is too big too merge without overconsolidating the industry presents special problems. From a taxpayer perspective, we are generally able to unwind smaller banks without guaranteeing non-insured creditors, while we find haircutting the creditors of larger banks impossible, because these unsecured creditors regard failure as unthinkable and fail to adequately provision for the risk.

4. Political economy considerations mitigate against large banks (arguably more deeply in the United States than in Australia and Canada). Particularly if financial firms are segregated by scope (e.g. investment banking distinct from commercial banking distinct from brokerage distinct from insurance), groups of small firms with distinct industry agendas are likely to be less corrupting than huge, critical institutions with a unified management that acts strategically in political circles.

5. Scale breeds agency problems. Earning an extra five basis points on $100B in assets amounts to $50M in extra income a year, a fraction of which can make a manager very wealthy in an eat-what-you-kill bank. Making that same five basis points on a $100M portfolio earns a small bank 50K, a fraction of which amounts to a nice bonus, but not a lifestyle change. For both managers, the downside if something goes wrong is the same: they lose their jobs. The ability to leverage a large balance sheet tempts managers at larger banks to take risks that managers at smaller banks would not find at all worthwhile. (Drum points out that managers of small hedge funds earn huge sums too, but that’s really apples to oranges. Hedge fund investors, like stock investors, are generally aware of and prepared to manage investment risk, while bank creditors expect that their money is safe. Hedge funds mostly present systemic problems when their use of leverage puts bank creditors at risk. That can and should be regulated, from the bank side and perhaps by eliminating the right of hedge funds to limited liability forms of organization.)

There are very few obvious reasons why large banks are useful at all, other than supervisory convenience if you think Hempton’s regulated oligarchy is the right model. It may be annoying to have to pay other-bank ATM fees, but besides that, there are very few services or efficiencies a large bank can offer that a small bank cannot. Large banks can provide large loans more easily, which is convenient for corporate clients. But that may be a bad thing. Lending decisions can be mistakes. It’s one thing if a lending committee misdirects $300K to a bad mortgage. It is much more costly if that same flawed body channels $3B to a crappy LBO. Raising large quantities of capital should require the separate assent of multiple independent parties. Misdirection of the resources represented by billions of dollars creates social as well as private costs.

My sense is that a lot of people think large banks are here to stay for precisely the reason they should be made extinct. Large banks feel modern, important, powerful. It seems nice, somehow, when you travel across oceans and find a branch of your own bank. It’s like you are part of a winning team. There’s that ubiquitous brand, and it’s your brand. But “brand equity” is an important means by which banks build a mystique that makes their failure unthinkable, and charms bondholders and other uninsured counterparties into offering leverage on much too easy terms. Ironically, if banks felt a bit shabby and penny-ante, and if managed failures were regular events, the banking system as a whole would be much safer.

Size isn’t everything: Bankers are famous lemmings, and a whole lot of small banks who pile into the same poor investment can fail together like one really big bank. But a thousand little banks are at least a bit less likely to make correlated mistakes than megabanks, which can turn a bad investment idea into a firm-wide mission. One goal of bank regulation, besides restricting size and leverage, should be to encourage independent lending decisions and supervising the diversity of the aggregate banking system’s portfolio. Regulators should “lean against the wind” of booms that homogenize banks’ asset base by restricting growth of overrepresented asset classes. If there is a good economic reason for a boom, nonbank equity investors can take advantage of the opportunity.

Note: Ideally I prefer a complete separation of the depository and payments function of banks from the lending and investment function. That is I’d prefer we create “narrow banks” that invest only in government securities, and define a new kind of explicitly at-risk investment fund to serve the traditional purposes of bank lending. But this piece is written under the pessimistic assumption that we’ll leave the familiar structure of banking intact.

Is that it, then? You know, the “Public Private Investor Partnership” that the Treasury Secretary introduced on Monday. Are we doing that?

The plan involves the Treasury, FDIC, and Federal Reserve putting hundreds of billions, perhaps more than a trillion dollars, at risk. That should require some sort of Congressional approval, right?

I remember the whole TARP debate last fall. I thought that was a terrible plan. I faxed my senators and representative several times, and urged them not to pass it. I was gratified, and for a brief moment optimistic, when the bill was initially rejected in the House. I felt like it was a miscarriage of democracy that Congressional leaders staged a do-over on that vote, reintroducing substantially the same plan and passing it just a few days later. That battle was lost, but this is a democracy and I am an engaged citizen. There would be other battles, I thought.

In my view, the Geithner’s PPIP includes two mechanisms intended to ensure that “private investors” offer substantially inflated bids for “legacy” assets, and the net cost of the plan will be comparable to that of TARP. I might be wrong about that, but I might be right. Much of the risk will be due to loan guarantees offered by the FDIC. Is there any legal basis for using the FDIC this way? Aren’t the laws describing how the FDIC is and is not supposed to behave?

And isn’t Congress supposed to have the power of the purse? A loan guarantee is a contingent liability, a cost in real terms. Can the US Treasury spend money without Congressional approval, as long as it promises to spend only if a coin flip comes up heads? That’s exactly what the Geithner plan (along with the scandalous but already active “Temporary Liquidity Guarantee Program” program) does. Is that even Constitutional?

FDIC is a full-faith-and-credit agency of the Federal government. There’s been a lot of commentary trying to explain the recently high CDS spreads on US sovereign debt. After all, wouldn’t the government just print money to pay its debt rather tha default? Well, here’s a scenario: Suppose the FDIC’s loan guarantees come badly acropper, putting taxpayers on the hook for hundreds of billions of dollars. Suppose FDIC is short the cash, and has to come to Congress for an allocation. Given that neither Congress nor the public ever signed on to all these guarantees of bank assets, and that in fact FDIC is behaving in a manner precisely contrary to the laws under which it is chartered, the level of anger might be high enough that the public might just say no. Welcome to the world of full-faith-and-credit default.

Maybe that’s why Chris Dodd wants Congress to give the FDIC a $500B loan commitment. Maybe it explains the apparently limitless appropriation of “such sums as are necessary” to the FDIC that Justin Fox noticed in a proposed bill that would actually authorize these sorts of liability guarantees. (The bill would also authorize FDIC receiverships of systemically important non-banks — yay! But it leaves out the “least cost resolution” stuff from the traditional FDICIA, and would give the Treasury Secretary and the FDIC complete discretion over whether firms are to be taken over or just bailed out in any of a number of ways.)

It seems to me that committing hundreds of billions of taxpayer dollars should still be considered a serious business. It seems to me that if Congress wouldn’t approve the Geithner plan, in a democracy, that ought to have some meaning, and not just get written off as populist outrage and then extralegally ignored.

So I’ll ask again, who passed the Geithner plan? What deliberative assembly gave the plan a pass? What’s that you say? The stock market went up by nearly 500 points when it was announced on Monday? Oh. I guess the buys have it, then.