Sunday Musings 1/12/14 Too Big To Fail?

Gretchen Morgenson of the New York Times has almost written as much as I have on the Great Recession causes and what is needed to prevent another one.  But whereas, I simply want good regulation on systemic issues, she wants heavy regulation and nothing to be too big to fail.

In a capitalistic economy, you cannot regulate private capital except on certain basic things such as activities being legal, prudent diversification and adequate capital in a regulated entity.  Absolute size will be a function of return on capital generated by revenue generation and expenses.  Maintaining a positive margin on that is what management gets paid the big bucks to do.

The SEC is looking at which asset management firms might be too big to fail.  The answer is none of them.  They hold their investor's money and if the asset value goes down, the investors will lose money, the Asset Management Firm will not fail unless they have borrowed money and invested it in the fund, which most do not.

But Ms. Morgenson believes the SEC should regulate these asset management firms because the Federal Reserve had to provide liquidity to money market funds in 2008.  In her mind, that made them too big to fail.

What she is missing is an understanding of the lender of last resort function.  Most of the support the government provided in 2008 was fulfillment of the lender of last resort function which only the government can provide.  There is nothing wrong with this.

When an economy suffer a systemic shock and everyone is afraid to lend to everyone because everyone is staring into the abyss of a systemic failure, only the government can provide the liquidity necessary to fund the raising of cash that will occur by owners of capital.  The government must do that to maintain the system that allocates capital to the economy.  If the assets of the entity receiving the lender of last resort capital are bad, then the institution will fail as those assets default.  Yes, the government might lose money, but the people will still trust the credit allocation firms and leave their assets in the credit worthy ones preserving the system.

Two points to make:   1st, when a system does not allocate capital freely, you have a depression, many people do not have income, and asset values become extremely impaired (even the rich lose big).  2nd, in 2008, the lender of last resort function worked well, the government lost some money in a few places where asset values were permanently impaired (AIG, GMAC), but made money other places and overall had a profit.  Even if they had not made a profit, maintaining a functional credit allocation system would have been worth the cost in order to avoid a depression.

The Regulatory system should be focused on preventing systemic risks from ruining the capital allocation system.  What are the systemic risks?  Government Debt, mortgage debt, and concentrations of credit risk in the global capital allocation system.  So China is systemic, just as the U.S. and the EU are systemic.  That is why the IMF exists.

Asset management firms are not systemic.