After a generation of genuflecting when the word "market" is spoken, after ascribing to the market the wisdom and knowledge of the divinity, it is time to face the truth: The market is dumber than a box of rocks, at least when it comes to politics.
Andrew Haldane, executive director for Financial Stability of the Bank of England, just published a column with the title "Have We Solved ‘Too Big To Fail’?" He does not attempt to maintain suspense: the first paragraph of the column is the word "No."
Haldane elaborates: "That is not my pessimistic verdict; it is the market's." The biggest banks can borrow more cheaply than their small-enough-to-fail competitors because the market assumes that no responsible government would allow the catastrophic collapse of a large, complex financial institution and creditors will get paid one way or another. That assumption was worth tens of billions of dollars each year to the world's 29 biggest banks before the crisis; now it amounts to hundreds of billions of dollars a year in reduced funding costs.
The market is probably right to assume that regulatory changes since the crisis have not eliminated the possibility that a large, complex financial institution could fail with significant "negative externalities," like a collapse of the financial system and global depression. William Dudley, president of Federal Reserve Bank of New York, said in a recent speech that the first resolution plans, or "living wills," submitted by the biggest institutions "confirm that we are a long way from the desired situation in which large, complex firms could be allowed to go bankrupt without major disruptions to the financial system and large costs to society."
The market's assumption, however, that governments would not allow a large, complex financial institution to fail if the institution's failure would have catastrophic consequences is wildly unrealistic. The market assumes that would be crazy and the governments of industrialized nations that host the biggest banks would not be that crazy.
Really? Does the market watch the news?
We may never know everything the Fed and the Federal Deposit Insurance Corp. did to prevent the collapse of the financial system during the crisis. The Fed helped JPMorgan Chase acquire Bear Stearns and made extraordinary loans so AIG could pay counterparties in full on credit default swaps. The FDIC guaranteed deposits and other bank liabilities not subject to the FDIC's insurance. The Dodd-Frank Act amended the legal authority that the Fed and the FDIC used for those extraordinary interventions to assure that taxpayers will never again bail out financial institutions.
Haldane said in his column that "on paper" the Dodd-Frank Act "rules out future bailout," but "market expectations of state support for U.S. banks are higher today than before the crisis struck and unchanged since Dodd-Frank became law." In fact, Dodd-Frank may give the Fed and the FDIC some wiggle room, but they may not have time to wiggle in a crisis.
That means the market expects that Congress would act, and quickly. At the height of the financial crisis, Congress passed the Emergency Economic Stabilization Act of 2008, authorizing $700 billion to fund the Troubled Asset Relief Program. It took less than two weeks, but it was ugly. The House first soundly defeated the legislation in a bipartisan vote. The market crashed in disbelief. The Senate passed the legislation a few days later. Then-senator Barack Obama, the Democratic nominee for President, called Democratic House members who had opposed the bill to urge that they reconsider. Senator John McCain, the Republican nominee, also supported the legislation to less noticeable effect. The House reluctantly went along.