The Wall Street Journal

Bailout Q&A: Fix Regulators, Liquidate Fannie and Freddie?

Given the jerky path of the bailout efforts by two administrations over the past 18 months, it isn’t surprising others would want a crack. Robert Litan and Martin Baily say the teetering U.S. regulatory system is the place to start fixing. The Wall Street Journal talked with Litan to find out why the stimulus should start with regulators.

Deal Journal: Your system starts with an overhaul of our regulatory system.

Robert Litan: Yes, but it has heavy doses of market discipline in it. We use the acronynm SIFI –we think it will be popular– to stand for “systemically important financial institutions.” We argue that all SIFIs should supported at least in some degree by long-term debt. Long-term debt holders can’t run so it’s not like the holders of Lehman and Bear Stearns who ran in an instant. They can’t sell their debt to somebody else and they can’t ask for their money back. So we should rely on them. A percentage of assets in SIFIs should be held by long-term debt holders who are risk-averse and will encourage institutions to be more prudent. And the price of the debt traded in the market will be a valuable signal to both shareholders and the government that the institution is in trouble.

Another theme of the report is that each of the parties in the loan process–from the securitizer to the broker–have to have skin in the game. If we don’t write rules like that, we will get what we got, which is people taking gambles without their own money at risk.

Deal Journal: What you say about long-term debt holders is interesting because you also suggest tighter regulations on derivatives like credit-default swaps.

Litan: We have a middle ground. We don’t want to ban them. They are valuable instruments for hedging. What you don’t want is people writing so many derivative contracts that you can’t deliver on, like AIG. It’s like going to Vegas and betting with money you don’t have. We say that a clearinghouse is a good idea for CDS, so that if you go down I won’t go down.

Point two is that not everything can go through a clearinghouse. Only standardized credit default swaps should go through a clearinghouse. Standardized securities are like a stock or a bond. If a clearinghouse has to judge each customized contract, it’s too much work for them to do. Customized derivatives are unlikely to ever be cleared through a clearinghouse. Yet none of us know how many of these are standardized. We’re going to have to think about somebody regulating that, at a minimum requiring capital of the people who write these customized contracts so that there is at least some collateral or capital backing these derivatives.

Deal Journal: You also suggest treating Fannie Mae and Freddie Mac like utilities.

Litan: We have a short-term plan and a long-term plan. In the short run, we’re not going to get rid of them. The administration is relying on them to help stop foreclosures. Within a sunset period of five to 10 years, they should go out of business and be liquidated, unless Congress feels they need them. So in the short run, keep them, and in the long run, think about liquidating them. Congress has to ultimately make the decision. But it should be compelled to do so after some reasonable transition period.

Deal Journal: Is nationalizing the banks really a solution?

Litan: Here’s an interesting factoid. When we took over Continental in 1984, the government sold it to Bank of America. Ironically, people now are debating the same thing about BofA today. So here we are today, version 2.0.

Here’s the rub of the problem. I don’t know anybody who is enthusiastic about nationalization. There are just a whole rash of thorny problems associated with nationalization: what bankers are out there that haven’t been tarnished that you’re going to trust to run the bank?

If you’re creating this super-bad bank, it would have to be really large. The problem we’re wrestling with is that we don’t have a good idea of how big that problem is and how big that bad bank would be. There’s a collective nervousness that that number is a staggering number.