The Cypress Precedent

For months now, Cypress has been in the top three questions my clients have asked about.  While the immediate ramifications of Cypress issue itself can’t really even be quantified as a drop in a bucket on a global scale, what we have here is precedent.  This precedent has added a new player onto the field of, “what do we do when a financial company fails?”

The Lineup – Let’s take a look at the players

-Bankruptcies and buy-outs –

This one is relatively simple, a company makes stupid decisions and goes out of business.  This happens in the manufacturing, commercial, industrial and service industries all the time.  With your goods and service companies, the people you owe money too are generally just creditors who know the risks involved.  Also, creditors generally have first crack at the assets remaining when the company has to liquidate.  These firms can either be bought out by someone else, in which agreements with existing creditors are made, or the company is sold off piece by piece and creditors get what’s left up to being paid off in full.  I recall when a local branch of a chain retail store went out of business about a year ago, they were picked clean, literally down to the shelving that was used to store and display their goods.

However, with a financial firm there are a few things that have to happen that you don’t see when a company that produces goods or services goes belly-up.  First, you generally have depositors.  In a perfect world, depositor money would be under something that is akin to a bailment agreement, meaning the company has no legal right to the assets of their clients.  In reality most companies use their client’s money for their own, as well as their clients gain.  There is nothing naturally “evil” about this, but once a company can no longer meet its expenses and can’t find creditors to help them though the tough times, this financial firm will generally not completely go out of business, but instead be purchased by another firm.  The reason for this is because of those depositor agreements.  Because those funds can be counted as assets on their balance sheet, as well as having the benefit of gaining hundreds, maybe thousands of new clients assets under management, other, larger firms will step in.  Agreements will be made with existing creditors and the clients can generally continue about business as usual.  For example, consider the slew of bank mergers that have occurred over the last eight or ten years.

-Government Intervention and bail-outs-

Up until recently, dealing with a dying company has been straight forward and limited to actions contained within the private sector.  And then along came TBTF.  Too Big To Fail is not necessarily a brand new concept throughout history, but gained tremendous momentum here in the US over the last few years.  I am currently working my way through a collection of information from author and advisor to the Reagan administration, David A. Stockman, called “The Great Deformation.”  Thus far I have gathered his premise being that TBTF was a completely unnecessary action on part of the US government and I would highly recommend this 700 page work to anyone fascinated by the topic.  In reality, TBTF is a round-a-bout function where the government directs private funds.

Bail outs often come in the way of governments dealing with other governments, simply because one government (say, Germany) can’t exactly buy out another sovereign nation (like Greece).  Bail outs always come at a price though, and using the two nations above, anyone reading the news a few years ago is aware of the situation between those two nations.  By each of their own opinions, Germany couldn’t be expected to give without getting, and Greece couldn’t be expected to meet the demands placed on them.  However, I digress as we’re discussing intervention into the private sector.

Like all things, give an inch and take a mile, this form of government intervention has encroached into the private sector.  Instead of the private sector being allowed to deal with the failure of the firm itself, the government directs public funds towards companies it deems Too Big To Fail.  Basically, our tax dollars are used to help companies in which the government assumes if it went down, the duration of time it would take to sort itself out naturally would cause an unacceptable disruption to too many lives, and therefore must be dealt with by the government itself.

-The Bail In precedent is established-

So this finally brings us back to Cypress.  As discussed above, generally creditors of a company get paid pending the results of the bankruptcy and sale of assets, or new terms may be worked out with the new company owners, and any clients of that firm is converted to being a client of the new firm.  As governments grow, their interpretation of their own talents does as well, and this, like the bail-out function, is another example of that.

A bail-in is when the creditors AND depositors bear a portion, or the brunt, or the entirety of the damage done.  In one sense, this helps cut out the middle man, the government, from intervening with public funds on such a large scale.  On the other hand, this is direct intervention into the pockets of those affected, as funds are seized.  What this function does is eliminate the market from acting naturally, and not only are creditors incapable of recuperating losses on a failed firm, but they are required to forfeit portions of their credits owed to them AND it allows the firm, which should have naturally died, to continue to breathe.  While creditors can often assume some risk when lending money, the depositors should not.  This is a change from the legal protection provided for a long time in many countries.

As I discuss this as precedent, today I read an article coming out of Japan,SEE HERE.  They too are exploring the benefits of Bail-In instead of Bail-Out.  Let’s be realistic, politics is about popularity.  And what’s easier to sell to the populous, the idea that we all need to give a little to fix a problem, or that the people closest to it need to shoulder more of the burden?  When it comes down to votes, would you rather irritate some of the people, or all of them?

So What’s the Better Option?

If you know me, you probably know that I lean towards Austrian and Free Market Theory, so my opinion will always lean that way.  But governments don’t inherently like free markets, governments like control.  While Bastiat speaks of law as a shield, not a sword, those that wield seem often swayed by the allure of power.  This is an old song, so I won’t sing it too long.  But the question remains; if you represent a sovereign government and must choose, Bail-Out or Bail-In, and you have an election coming up, which would you choose?  To Hell with free markets… to Hell with legal precedent regarding the clients and creditors…

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