Back-Door Resolution Authority

Tyler Cowen quotes from Robert Pozen’s yet-to-be-released book:

“In my view, the adverse repercussions of Lehman’ failure could have been substantially reduced if the federal regulators had made clear that they would protect all holders of Lehman’s commercial paper with a maturity of less than 60 days and guaranteed the completion of all trades with Lehman for that period.”

Back when people cared about these things, I wrote a couple of posts on the issue of selective protection of creditors.

The point I was trying to make at the time was that it should be at least conceptually possible for a regulator to determine what the ripple effect of default would be and impose haircuts in such away that systemic failure did not result. This would provide a middle way between bankruptcy (complete uncertainty and panic) and blank-check bailout (100% taxpayer guarantee, no losses by creditors). I was envisioning this in the context of government receivership, but I also had this tentative idea:

“I think that the government could let AIG fail, if – and this is a big if – it can first identify which creditors and counterparties would be hurt, determine which of those cannot be allowed to fail (which should not be all of them), design a program to provide them enough capital directly, and announce everything on the same day. The net cost to the taxpayer cannot be higher than under the Too Big To Fail strategy, which implies a 100% guarantee for all counterparties and creditors.”

But if I am interpreting Pozen correctly, he is suggesting a more elegant way to achieve the same objective. Once the government has determined which liabilities and exposures will have systemic ripple effects (he says short-term CP and outstanding trades), it could just announce a guarantee on those liabilities and exposures and let everything else go into bankruptcy. Now maybe they didn’t have time to make such a determination the weekend before Lehman failed (although arguably they had since March to figure it out), but by the time Citi and BAC and the last AIG bailout rolled around arguably they did. I’m not enough of a markets person to be sure this would work, but it seems like a viable proposal.

Originally published at The Baseline Scenario and reproduced here with the author’s permission.