Too Big to Fail?

What, exactly, is it that’s too big to fail?  I don’t mean “How big is too big?”  I mean, what thing is it that is too big?  We have been operating on the theory, I think, that the thing is an entity - that GM or Chrysler or Lehman or Merrill or AIG is too big to fail.  But I think that’s a bad mistake. 

As I argued in my earliest posts, what matters is the brand – the USA AAA paper brand.  And if the brand is what matters, it is the brand that is too big to fail, which means that the size of the entity selling it is unimportant.  And what matters to the brand is what is being sold under it.  If subprime mortgages were sold only by smaller investment houses, would there have been any fewer of them, or would they simply have been spread among more distributors?  What difference would it have made if the issuers were not “too big to fail”?  The systemic risk would have been the same, because what has killed the credit markets is not a lack of faith in the distributors, but a lack of faith in the paper itself.

What would have happened if AIG had been allowed to collapse that would not have happened if twenty smaller companies one twentieth its size had been writing the same type of contracts?  If AIG did not have the capacity it had (or thought it had) to write the CDS contracts it wrote, would no one else have issued them?  AIG’s capital would have been somewhere in a world where AIG was not allowed to have it.  Would that capital not have imitated the business practice of industry leaders (e.g., AIG)?  If one of those twenty little firms had been allowed to fail on account of those practices, would they not all have failed?  And would it have made any sense to say that one big firm would have been too big to fail, but the many doing the same thing were not, in the aggregate, too big to fail?

The major policy error being made is the failure to think existentially.  Tradable Credit Default Swaps are, existentially, a bad idea.  It makes no difference how like any other instrument the contracts are.  A CDS allows someone to profit from the occurrence of a bad thing.  No amount of technical or formal analysis can change this simple behavioral fact.  Likewise, systemic risk arises because players may lose faith in the system itself.  The size of entities is a detail.  The question is whether the failure of any player or players of whatever size to deliver on its promises taints the system.  Just how many bad bottles of Tylenol did it take to cause a panic?

Whatever we do to limit the size of entities so that they are not “too big to fail” will be irrelevant.  We’ll feel better maybe, thinking that we no longer have institutions that are too big to fail, but we won’t be any safer.  If our ratings agencies figure out how to rate, and investors, especially foreigners, regain their faith in those ratings, things will get better.  If not, then not.  And if that faith is regained, and it is then lost again, the damage will be as severe regardless of the size of the entities involved. 

I suspect that the only effect we will see from “outlawing” too big to fail is that we will lose the economies of scale that come from the bigness.  Otherwise, the risks will remain unchanged, exacerbated by the Government’s mistaken notion that smaller companies are not “too big to fail.”

A Few Good Ideas

Traveling in Europe in the past two weeks, I saw some things that, as an American, I am embarrassed to admit we are either too dumb or too corrupt to adopt. Here are a few.

Credit card lanes on toll roads. It's so simple. You drive up, stick your credit card in a slot, and go. On "turnpike ticket" type roads, you insert the ticket in one slot, the card in another, and you're done. It's quick because you don't have to wait while the machine processes the transaction. If the machine can read the card, and the card is of a type it accepts, the card is returned and the gate goes up. Defaults are dealt with later, and just aren't a big deal, as the numbers are always small. Of course, they have an RF system like NY'NJ's EZ-PASS, too. Still, the card is a big deal because tourists don't have tags, and so many EU visitors travel freely around the continent but don't all speak the same language.

I don't know why our toll booths can't take credit cards. I suspect union opposition is an issue, but it's hard to accept that our unions are more obstructive than those in France.

Eye-level trafic signals. This one seems like a no-brainer. At intersections where it is difficult for the first car in line to see the overhead signal, the signal post has an additional, mini- signal at eye level that is easy to see. It's just a great help. Why don't we have it?

Variable flush toilets. Ever heard of "country rules"? (If it's yellow, let it mellow; it it's brown, flush it down.) Anyway, the Euros have their own version. The toilets have two flush buttons, one big and the other little. Picture, for example, a circle divided unequally into two parts. The small button produces a "small" flush, which is perfectly adequate for removing liquid. The big button produces a bigger flush. The average flush is probably less than the 6.0 liters our toilets allow, but the big flush is big enough to get the job done. Seems like a much better arrangement than our one-size-fits-all approach. Are we too dumb to use it? Too whatever to use the small button? What? (Dual-flush toilets are available here - just Google on "dual flush toilets" - so maybe they're coming to a public restroom near you. But I haven't seen one yet.)

The question isn't why we can't think these things up. Surely, we can, and even if we didn't, we could adopt them. The question is what about ourselves or our systems prevent that from happening.

Oslo Syndrome

A psychological condition in which one thinks he is the Trustee of a more fun foundation. Sometimes called “genius envy.”

BHO won a MacArthur Foundation award on Friday. That’s the one that goes to very promising people in the hopes that they will someday win a Nobel Prize. The prize was awarded by the Nobel Committee, but that’s a detail. Clearly, it’s more fun to look for people with great potential than to provide the anticlimactic icing for cakes already baked. So the Nobel Prize Committee has decided to reward aspirations. Hey, it’s their money, right? (No point in consulting Mr. Nobel’s will, which has pretty much been ignored for so long that its provisions don’t matter.)

Now all we need is a prize for major achievements. There are lots of almost-dead billionaires. Someone will step up. Not to worry.