20% of moral hazard November 22, 2009 at 9:52 am
Here is an interesting idea. The FDIC are suggesting that if a
large systemically important institution is put into receivership by the FDIC and there are not enough assets to cover the cost of unwinding it to the government, all secured claims would be automatically converted into unsecured loans with a haircut of up to 20%.
The original Reuters story is here, and comment from Across the Curve, based on Barclays research, is here.
This idea appears to be gaining traction. FT Alphaville reports on an amendment which passed yesterday in the House. Proposed by representatives Miller (D) and Moore (D), this would implement the FDIC proposal. In particular, as Across the Curve points out, it would have significant implications for the repo market, since even a fully secured repo would take a 20% hit in the event of FDIC intervention.
Is this good or bad for financial stability? It is frankly rather difficult to say.
On the one hand, it would encourage creditors to review the credit quality of counterparties rather better. But it would equally encourage a rush for the exit as an institution became troubled, and exascerbate funding liquidity risk. Remember it was counterparties declining to roll repos that caused the demise of both Bear Stearns and Lehman. So this rule change, if enacted, would make it more likely that secured funding is withdrawn as confidence is lost. That is pretty likely anyway, however, so it could be argued that the downside is not great. It might well encourage the development of a market in CDS on repo receiveables though…
dWj made an interesting comment over @ the Across the Curve post you are linking to. Will this proposal really impact the repo market? I am no legal expert either but are repos, from a legal perspective, secured credit? From my layman’s perspective I think a repo is distinctly different from a normal secured credit claim, especially in case of a bankruptcy.
The repurchase part, as I understand it, of a repo is a senior obligation. So any unsecured amount after the collateral is liquidated is a senior claim against the repurchaser. Clearly in order to change that, and provide a minimum 20% haircut, a new legal framework for the resolution of financial institutions would be needed. It seems that there may be the political will to do that. In effect a bank would not go bankrupt, but rather would go through a different process, with different outcomes for creditors.