SPOE: Backdoor Bailouts and Funding Fantasies?

I'm thrilled that Jay Westbrook has finally come into blogosphere with his posts on Single-Point-of-Entry.  I've blogged a little on SPOE already, but I want to highlight what I still think are two critical problems with SPOE.  In keeping with Jay's spirit, let's call them "Backdoor Bailouts" and "Funding Fantasies". 

Is SPOE a Bailout Under Another Name?

There is a fundamental tension in financial institution resolution between minimizing disruptive spillovers from firm failure and avoiding the moral hazard and taxpayer expense of government picking up the tab. To wit, if the US government were to simply guarantee all obligations of financial institutions, we wouldn't really care about bank failure. All bank debts would be equivalent to claims against the government. But the idea that the US government would explicit guarantee the entire financial system seems preposterous (except that we basically did that a few years ago).  It seems preposterous because we know it would engender enormous moral hazard and put taxpayers on the hook:  privatized gains and socialized losses.  

And here lies the real conceptual problem with SPOE. SPOE is a pretty good approach to minimizing disruptive spillovers. The only bank counterparties that would be effected by SPOE would be the investors in the structurally subordinated debt of the firm's holding company, and they will, presumably price for that risk (more about that later).  None of the other counterparties would take a haircut. All of the derivative trades, for example, would be backed by the US gov't. That's kind of nuts. 

Again, let's be really clear about this because this is the key to why SPOE would work and also the key to what's wrong with it:  in SPOE, ALL counterparties of the failed institution get paid 100 cents on the dollar except for the subdebt investors. 

One could try to remedy this by ex ante surcharges of some sort--basically a pre-funded insurance fund--but I don't think it's possible for regulators to properly price the risk ex ante on the full range of bank product lines, and all the money will flow to the underpriced areas. It's just arbitrage. There were attempts in the Johnson-Crapo GSE reform bill do to something like this and I just think it's wishful thinking. If regulators aren't capable of preventing excessively risky behavior, even when they have the tools, what makes us think they can price for it? 

Alternatively, one could try to remedy the moral hazard by having ex post haircuts (see my gavage proposal for making the bailout beneficiaries eat their own cooking), but that requires serious political stomach and will only price for losses, not actual risk. 

Is There A Market for SPOE Bank Subdebt?

There's also a key operational problem with SPOE:  there might not be any market for the holding company's structurally subordinated debt.  For SPOE to work, there has to be enough of this sub debt to absorb all of the credit losses.  But is there any market for the hold co sub debt?

I'm skeptical that there's a lot of money that's willing to purchase that sort of black swan risk on any terms, much less enough to provide the capital buffer necessary for the financial system. The hold co sub debt looks a lot like, well, the junior tranche of a CDO:  incredibly toxic, concentrated risk. There wasn't much of an organic market for those junior tranches. Instead, the market had to be created by resecuritization (sort of a self-fueled pyramid scheme). What's more, the moral hazard that is created by the implicit guarantee of most of the firm's liabilities will only increase the risk borne by the sub debt investors. There's no way for the sub debt investors to adequately price for risk because it will inevitably increase, but at an unpredictable rate. Hmm, maybe if this stuff were auction rate, with monthly auctions.  Now what could go wrong there....

What's more, there are all kinds of institutional buyers that we shouldn't let buy the subdebt because of their systemic importance. So where are we at?  Some hedge funds that buy subdebt? Is that going to be enough to fuel SPOE? 

Now, I might be wrong in my assessment of the market appetite, but here's the thing:  no one really knows if there's a market for the sub debt, and we won't until its sold. If we switch to an SPOE system, what happens if the banks can't get the subdebt fully subscribed? Do we have to go straight to resolution? There's sort of a leap of faith in the market involved here. 

This market-leap of faith is not a phenomenon isolated to SPOE. It's appeared in other contexts recently. Chapter 14 proposals blithely assume that the market will somehow be able to provide tens or hundreds of billions of dollar in DIP financing on the turn of a dime, during a financial crisis. And proponents of privatizing Fannie Mae and Freddie Mac seem to believe that there's a pool of investors ready to take on the credit risk on a $10 trillion market. In all of these cases, if the market-leap of faith is wrong, we've got a major crisis ensuing.