November, 2009

Joshua Rosner 646/652-6207 jrosner@graham-fisher.com

Too Big to Fail: An Insufficient and Excessive $200 Billion Con The current regulatory reform approach being sold to the American public may be the biggest con captured regulators and lobbyists have yet to attempt to perpetrate. They are trying to pass legislation that avoids having to address that we should not accept: Living in a world where firms are allowed to be too big to fail or big enough to control our political process. Instead they trying to convince us they can create an industry funded fund to handle failing TBTF firms. This is dishonest, absurd and illogical: 1- If a firm is too interconnected to be wound down in an orderly way and could therefore cost counterparties to fail then the total risk is the cost of the aggregate exposures of all correlated and interconnected firms and would equal a significant part of the entire system. TBTF=TBTInsure! 2- Before we even said there were TBTF institutions we committed $187bb to AIG, and $400bb to the GSEs on top of the $3tt in guarantees and support offered by the T and Fed. Certainly not all will be lost but 20-50% will. 3- $200 bb is not enough and yet it is an absurdly large number because nobody could pay it. It is an uninsurable risk. With only about $1 trillion in TCE at the banks and insurers how can they even collect this large amount of $200bb, even if insufficient. They will also tax fund managers. 4- $200bb becomes dead money not providing any returns, how do those assessed offset the loss of the economic use of that money? Taking larger risks. 5- In truth, the fund concept is really just a tax on investors to fund the bailout of these TBTF banks? Who do they intend to assess? Banks? Advisors? Funds? If they assess the largest funds isnt that really just a tax on the investors in those funds? Shouldnt a prudent investor or pension consultant demand their money be taken out of that firm and sent to a smaller, not TTF and not assessed firm? 6- Rather than accept that TBTF firms ROEs were solely strong because of leverage we will foolishly extract $200bb from the entire industry and make our entire financial services industry uneconomic and globally uncompetitive? We should break up the TBTF firms and risk global banking deals either being syndicated by smaller firms or going to another sovereign's risky firms. 7- Even if it worked that only one firm went bust at a time and they were not interconnected let us assume a firm fails to the tune of $150bb a year after raising $200bb. Will we then go back to everyone and ask them to replenish it? Will they have the money to? 8- A fund will create a "race to zero" - disincentives to prudent risk management. Specifically, if the best managed TBTF firms know they will have to pay a significant amount of capital into a fund to insure and support their worst

Please refer to important disclosures at the end of this report.

Weekly Spew

November 2009

managed peers they will surely see economic benefit in reducing risk controls and therefore improving their returns. 9- Remember the GSEs received AAA ratings and a market distorting lower cost of capital because they were seen as government obligations. When push came to shove, even though the Fed, Treasury, Barney Frank and others regularly denied they were guaranteed government obligations, the rating agencies proved to have been correct. Should we codify this view for more institutions? 10- According to the SIGTarp AIG report, even before we codified the notion of a class of TBTF institutions we accepted them as government guaranteed: "FRBNY was further concerned as it was throughout the AIG rescue about the reaction of the rating agencies. While threatening not to support AIG might have been useful for purposes of forcing concessions by the counterparties, it could also have been viewed by the credit rating agencies as an indication that the FRBNY and the U.S. government was not standing fully behind AIG, which could have had a negative impact on AIGs credit rating" and "In addition, FRBNY was concerned that its use of a threat of an AIG default might introduce doubt into the marketplace about the resolve of the U.S. government in following through on its commitments in support of financial stability." expanding this to a list of large firms should have negative implications for our sovereign risk rating. 11- The current house bill, as amended, requires the Treasury Secretary to be informed and consent to the break-up of a firm over $10 billion in assets and requires the President to decide on the breakup of firms with over $100 billion in assets. This makes the decision, to break up these firms and commit taxpayers to ultimate risk and losses, a political process driven by the executive branch. This is a fundamental conflict with basic concepts of our government and is an abdication of responsibility by our elected legislators. 12- Maybe the correct response is: If you want to be a global bank you need to be a plain old fashioned boring bank (holding plain old treasuries and funded by deposits). Let the smaller and non-systemically important firms be the innovators and take more risks, they can only hurt themselves. 13- If there is a problem with bankruptcy then fix the bankruptcy code. 14- Create disincentives to being on the "too big to fail" or "tier one financial" company list. There should be an amendment that requires legislatively required action be taken against any too big to fail institution which becomes undercapitalized, requires any governmental or government agency guarantees of its obligations or governmentally supported purchase of its assets outside of the normal course of activities, receives funds from the Federal Reserves window with terms of more than 60 days or draws against any industry funds raised for funding the risks of these institutions. Specifically, the Directors, Officers and senior management of any institution that draws on the industry funds or receives any relief should immediately lose his/her pay and future benefits and, as soon as safely feasible, replaced by regulators. As importantly, directors, officers and all senior managers of such troubled TBTF should be explicitly prohibited from

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November 2009

becoming employed as Director, officer, senior manager or consultant at any regulated financial institution or an affiliated holding company or operating subsidiary for a period of five years. 15- By getting out of the TBTF game, we will have a more robust and economically competitive economy where no players have a governmentally conferred advantage or subsidy. Such a leveled playing field will begin the process of regaining credible markets and attracting stable foreign capital. Let other nations pursue misguided policies of protecting uneconomic and anticompetitive businesses. Such an approach will allow our taxpayers to avoid having to be part of the next banking bailout crisis. 16- Those who argue against a more proactive reduction in risk and size of TBTF institutions will, as they always do, say: Doing so would create an unleveled international playing field for our institutions relative to their international competitors. Level playing fields are a worthy goal; this is not a relevant argument. Instead, this tired line must be resoundingly dismissed on several counts: Those countries with the largest banks as a percentage of GDP (Iceland, Ireland, Switzerland) demonstrated that a concentration of banking power can cause significant sovereign risk and tilt global economic playing fields away from you. The likely breakups of ING, Lloyds and KBC suggest that it is we who seek to support an unleveled playing field where we subsidize our TBTF banks while other nations recognize the policy failures of moral hazard. If we continue down this path we will likely be at risk of violating international fair trade regimes. When the unleveled playing field argument is cited, why dont community bankers demand to know why it is ok to disadvantage the 8000+ community banks relative to our largest banks, all in the name of protecting big banks from governmentally- subsidized international competition? There is no longer any evidence that, beyond a cost of capital advantage that comes with implied government support, there are sustainable and tangible economies of scale arising from being the largest. The financial supermarket concept has been proven a failure. We must demand that our legislators no longer allow unelected officials at the independent Federal Reserve to sign international accords created by the TBTF banks through supra-national bodies like the Basel Committee. Are we to believe that if we did not have such large and globally dominant firms, US borrowers might be paying more that the 29% interest that several of the TBTF firms are now charging on their card accounts? Perhaps we should think about what advantage our population has gained as a result of our financial institutions being such a large part of our economy or being globally dominant. Since when did we accept a national strategy of following rather than leading? When we do what is right, others follow. As example, consider the bank secrecy

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November 2009

havens they made money for a bit. Now, even the "Swiss and the Cayman authorities are coming around to our view.

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