Count on Sequels to TARP
By GRETCHEN MORGENSON
Published: October 2, 2010

THE government is pulling a sheet over TARP, the Troubled Asset Relief Program created during the panic of 2008 to bail out the nation’s financial institutions. With the program’s expiration on Sunday, we can expect to hear lots of claims from the folks at the Treasury that it was a great success.

Such assertions would be no surprise from a political class justifiably concerned about possible taxpayer unhappiness, the continuing economic turmoil and the midterm elections. But if we have learned anything during this crisis, it is that the proclamations emanating from the Washington spin machine must be taken with an extra-hefty grain of salt.

Consider the claims made last summer that the Dodd-Frank financial reform act reduces the threats that large, interconnected banks pose to taxpayers and the economy when the banks are deemed too big to fail. Indeed, as regulators hammer out the rules governing derivatives transactions, it’s evident that the law has created a new set of institutions that will almost certainly be deemed too important to fail if they ever get into trouble. And that means there won’t really be an effective way to keep those firms from taking big, profitable, short-term risks that are dumped on the taxpayers when the bets fail.

Our roster of bailout candidates includes the clearinghouses, created under Dodd-Frank, that are meant to increase the oversight of derivatives trading. Because most derivatives transactions are expected to go through these clearinghouses, they will be “systemically important” under the law. As such, Dodd-Frank specifically provides that “in unusual or exigent circumstances,” the Federal Reserve may provide such entities with a financial backstop, including borrowing privileges.

Remember this: Financial backstop is just another term for a taxpayer bailout. And the major banks and brokerage firms are the members of the clearinghouses, so a backstop would essentially be for them.

According to the Bank for International Settlements, the entire derivatives market had a gross credit exposure of $3.5 trillion at the end of 2009. Obviously, even a small fraction of that amount could represent a sizable call on the taxpayers if a clearinghouse hit the skids.

So much for eradicating too-big-to-fail.

That’s not to say there aren’t upsides to clearinghouses. First and foremost, they will improve transparency in this huge market, requiring participants to disclose how much they have at stake financially. Regulators didn’t have such reports in the recent crisis and were severely hampered by the fact that derivatives trading existed largely in a black box.

In times of trouble, clearinghouses also allow hobbled firms to unwind and quickly reassign their positions to other, healthier players. Another good thing.

But clearinghouses sometimes collapse, as Craig Pirrong, professor of finance at the University of Houston, points out.

“Clearinghouses are intimately connected with the financial system and overall banking system, so the idea that clearinghouses reduce the interconnectedness of the financial system is incorrect,” he said. “They are big, interconnected and they can fail when we have big market shocks.”

In the Gold Panic of 1869, which caused New York markets to seize up, the clearinghouse for the gold exchange failed. And in the 1987 stock market crash, members of the Chicago Mercantile Exchange, the Chicago Board of Trade and the Options Clearing Corporation received emergency infusions, Mr. Pirrong said.

“It’s a dilemma,” he added. “On the one hand, it is very important that clearinghouses have the ability to get liquidity support in the time of a crisis. But if a clearinghouse is convinced that Ben is at my back, they might not be as prudent or cautious as they might otherwise be” — referring to Ben S. Bernanke, the Fed chief.

Walker F. Todd, a lawyer and economic consultant in Chagrin Falls, Ohio, was assistant general counsel and research officer at the Federal Reserve Bank of Cleveland from 1985 to 1994. He’s also an expert on the widening financial safety net — a net that offers taxpayer backstops for the institutions that got us into this mess and will most likely, alas, get us into the next one.

He says he is disturbed by the explicit backing of derivatives clearinghouses provided in Dodd-Frank. “There is no reason whatsoever for exposing taxpayers and ordinary citizens to paying for the gaming losses incurred through over-the-counter derivatives,” Mr. Todd said.

But with the backstop now firmly in place for clearinghouses, the Fed will be able to pay off derivatives players directly, rather than indirectly as it did in the disastrous rescue of the American International Group.

Given the multiple bailouts of 2008, it is to be expected that the line of institutions clamoring to join the cannot-fail party will grow longer. That’s the definition of moral hazard — if you rescue one group, others are sure to want the same treatment and behave in a way that ensures they’ll get it. The losses that taxpayers may endure in the next debacle, meanwhile, mount higher.

“THE crisis is about loss redistribution,” said Edward J. Kane, professor of finance at Boston College and an authority on regulatory failures. “In a crisis, these institutions have much more power with the government than taxpayers do and they will make it seem in the interests of responsible officials to rescue them, whether that’s Congress, the Treasury or the Federal Reserve. But the notion that you can always throw these losses on the taxpayer in the long run is very, very dangerous. There will come a time when the taxpayers will come close to revolt.”