We Need to Solve Too Big to Fail

Jeremy Glaser: I'm Jeremy Glaser with Morningstar.com. I'm here at the 2010 University of Chicago Booth School of Business Management Conference. Joining me today is Steve Kaplan, a professor at Chicago Booth, to talk a little bit about the future of financial regulation and maybe some potential causes of the financial crisis that may not have had as big of a role as people may believe.

Steve, thanks for joining me today.

Steven Kaplan: Great to be here, thanks.

Glaser: So first off, as the financial regulation bill kind of winds its way through Congress very slowly, we don't know exactly what it's going to look like, but with the broad strokes of it, do you think that it's actually going to help solve the issue of keeping a crisis like this from happening again?

Kaplan: I don't know, since I don't know what is exactly going to come out of it. What I've seen is not particularly encouraging. I think the big issue that you want to solve is "too big to fail, " or even "can't fail." It doesn't have to be too big. It could be too small to fail.

It was that you had a Bear Stearns, you had a Lehman, you had a Merrill, some of the big banks, where there was a real question of the equity value of those companies. Particularly Lehman and Bear, you had a run. What you really wanted to do at that point was to get the long-term debt that those companies had and force it to turn into equity. You can call that a restructuring. You can call that a bankruptcy. But, the key thing is the equity is worth nothing, and what you need to do is restructure.

Now, the problem with Lehman is, when you put it into bankruptcy, the system froze. Why did the system freeze? Well, no one knew where anything was. It was all over the globe. And people didn't know whether they were going to get paid. Then people worried about the next bank, whether it was Merrill, whether it was Goldman, Morgan Stanley. Basically, short-term money came out and the system really froze.

Then the government had to put money in. And what did the government do? They put it into equity. The long-term debt holders got their money back, not Lehman, but all the other companies, the long-term debt holders were fine, and the government ended up paying.

What you would have preferred is, in that situation, let the long-term debt turn into equity, or do a restructuring that doesn't trigger bankruptcy. The government isn't putting any money in. The equity holders are wiped out, and rightfully so, and the long-term debt holders become the new equity holders.

You'd like the legislation to do that in some way. And there are a couple of ways you could do it. You could say, under certain circumstances, the long-term debt, if there's a run, there's some kind of systemic problem, you can turn the long-term debt into equity without triggering defaults. That would work. The other thing that would work is to just make a certain amount of long-term debt convertible into equity under certain circumstances.

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Unfortunately, there's nothing in that bill that really does either one of those things in a sort of low-cost way. Let's wait and see the details as to whether that comes out.

So that's what I would like to see there. You'd also like to see something done about the housing market.

So part of what happened is you had Fannie and Freddie making lots of loans, mandated by Congress, and also signed by the President, to make I think it was 56 percent of their loans to low and middle-income borrowers, which basically pushed them to do sub-prime. That turned out to be a big mistake. As far as I know, nothing's changed there. In fact, the FHA is still making loans to lower-income, middle-income people, with three percent equity, 97 percent debt. So, you worry that the forces that operated here are still operating, and some of the fixes aren't being put in.

Glaser: So they might be adding some new regulations, but aren't really focusing on the things that caused the first crisis to begin with.

Kaplan: That would be my sense. And then, what are some things that are in there that I think will be more costly than benefit? The Consumer Protection Agency, my guess is, will end up being bureaucratic and will, to some extent, stymie innovation, without having much of a positive impact. Particularly, if you can still get a loan with three percent down and 97 percent leverage, yahoo. I might do that all day long. The Consumer Protection Agency is going to stop that? I'm not quite sure how that will work.

I would say another thing in that bill that is troubling is restrictions on angel financing. So we all know that angel financing caused the financial crisis. Not. What is in that bill is that if you're a small company, you're going to your, maybe, family and friends, you're going to some wealthy individuals. Today you can do that financing very quickly. You just have to tell the SEC you did it after the fact and you're done.

This bill has a 120-day SEC review period, where the SEC has 120 days to review your deal. If you're starting a company and you need money quickly, that's a death knell. So, that would be really troubling because part of what makes this country great is you can start businesses easily, you can get them funded, and then you can grow them, like Morningstar did. This would be chilling.

I think you have another thing in the bill which is problematic, on proxy access, where you're mandating that a one percent shareholder can nominate a director for the board. I think that will create a little bit of havoc in some companies because it will become a distraction. I don't think a lot of those people will get elected, but it will be a real distraction to public companies, when they really don't need that kind of distraction.

So, there are a lot of things buried in that bill that I think are real negatives, and it's not clear that the bill really goes after the things that helped push us into the crisis.