Too Big to Fail Red Herring

October 28, 2009

by Chidem Kurdas

The Obama administration has perfected the fine art of taking a real issue and using it to justify a policy that will almost certainly make the problem worse. Claim to control medical costs, add another trillion dollar medical entitlement to truly break the bank—that sort of thing. Looks like we have another example coming.

The Treasury and House Financial Services chief Barney Frank are apparently cooking up legislation that will allow the government to wreck havoc with the creditors of large financial companies. This is in the name of imposing “market discipline” on institutions that may have to be rescued because they could endanger the system.

“The measure would make it easier for the government to seize control of troubled financial institutions, throw out management, wipe out the shareholders and change the terms of existing loans held by the institution,” according to the New York Times report.

Scroll back to September 2008. Lehman Brothers files for bankruptcy, the credit market seizes up and stocks tank. What difference would the proposed law make in that situation? Lehman management is out and shareholders are wiped out anyway. Instead of regular bankruptcy, where the creditors exert influence, government directly takes over.

So the difference is that lenders will no longer be able to enforce their contractual claims. Oh yes, that will  be just the right remedy for a fragile credit market. You’ll tell lenders they’re toast! That will really get credit flowing.

The Chrysler bankruptcy, where the administration interfered to protect the interests of the automakers union, may be a precedent. Richard Epstein, professor of law at University of Chicago and currently at New York University, pointed out that government meddling in that process forced secured creditors to the brink, violating the priority rules that allow creditors to price risk.

“Upsetting this fixed hierarchy among creditors is just an illegal taking of property from one group of creditors for the benefit of another, which should be struck down on both statutory and constitutional grounds,” Mr. Epstein wrote.

This is the type of intervention that the proposed legislation would formalize for financial companies. Long-standing rules would no longer apply and the government would dictate the apportioning of property—judging by the Chrysler case, according to its political interests.

Rahm Emanuel does not want to let a serious crisis go to waste.  “Too big to fail” is a great excuse.  It’s being used to justify future government appropriations that can only worsen crises.

“These changes will impose market discipline on the largest and most interconnected companies,” says a Treasury official. But there won’t be a real market left after such a takeover.  As for discipline, who’s going to discipline the appropriators?

10 Responses to “Too Big to Fail Red Herring”


  1. […] bankruptcy laws and directly seize troubled financial institutions. As Chidem Kurdas points out in Too Big to Fail Red Herring: Scroll back to September 2008. Lehman Brothers files for bankruptcy, the credit market seizes up […]

  2. RickC Says:

    Can someone explain to me if this – “the credit market seize[d] up” – is in fact true? Who has done the research to prove it? I’m not an economist, just a curious onlooker, but it would seem to be a very important question considering how the justification for much of the government intervention rests on this assumption.

    I ask because I’ve come across a couple of people – Robert Higgs, the guys over at The Austian Economists and someone at Reuters – who questioned whether there ever was a credit crunch. Or, is this not as important as I think it is? Here are the links to the articles I mentioned:

    http://hnn.us/blogs/entries/55540.html

    http://austrianeconomists.typepad.com/weblog/2008/12/crisis-what-crisis.html

    http://www.reuters.com/article/email/idUSTRE4BA47420081211?pageNumber=1&virtualBrandChannel=0

    Thanks for any input.

  3. chidemkurdas Says:

    RickC– Robert Higgs has an interesting point, but I think lending did go down suddenly in late 2008, very noticeably so in some industries. I was talking to hedge fund people at the time and each and every one said credit had become extremely hard to get and you had to put up more collateral.

  4. Mario Rizzo Says:

    We have to distinguish between bank lending and securitized lending. The former is down a bit (depending from which point you measure) but the latter really went down and is still down last time I looked.

  5. Paul McMahon Says:

    It’s gratifying to know that Richard Epstein had the same take on the Chrysler bailout that I did. I wonder though if the illegality was limited to the taking from the secured lenders, or whether the entire intervention was unconstitutional. I’m very curious about this question, particularly now as they seek to codify the approach with this legislation.


  6. […] Chidem Kurdas at ThinkMarkets says, “…lenders will no longer be able to enforce their contractual claims. Oh yes, that will  be just the right remedy for a fragile credit market. You’ll tell lenders they’re toast! That will really get credit flowing. ” […]

  7. Bob D Says:

    Obama’s Chicago Gangsterism at it’s worst! We are living in crazy times, where contracts and laws are broken “for the collective good” to the detriment of the individual rights in which liberty is usurped.

  8. chidemkurdas Says:

    Gangsterism is a good word for it. Now that the Chrysler intervention looks like a possible template for future law & policy, questions about its legality are indeed key. Not being a lawyer, I can’t figure that out, but certainly would like to see an in-depth analysis.

  9. Bob D Says:

    I think that it was reviewed by a Supreme Court Justice and the Justice refused to give the case a full Court hearing and thus sided with the Lower Court’s decision to elevate the UAW’s creditor status due to it’s ability to help Chrysler escape bankruptcy. I’m not a lawyer and I’m going on memory but the reasoning sounds dubious to me. It defies logic to think that the UAW could be of assistance because they are largely responsible for Chrysler’s inability to compete!

  10. chidemkurdas Says:

    You’d think the courts would take this up, but unwillingness to limit the executive branch of the government has become so extreme, the White House faces minimal intervention. The trend toward an imperial executive ran though the Bush years, of course, but started earlier.


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