Too Big to Fail From the Eyes of a Specialist

By William K. Black
April 17, 2016     Bloomington, MN

Andrew Ross Sorkin has written a column lamenting that “For a Generalist, ‘Too Big to Fail’ May Be Too Tricky to Judge” about the district court opinion finding in favor of MetLife on the question of whether it would pose a system risk were it to fail.  Sorkin runs the NYT’s “Deal Book,” which is supposed to represent the paper’s specialized expertise with regard to Wall Street.  His column demonstrates that one of the areas of expertise required to understand Wall Street is legal, and that it is beyond his understanding despite having “read hundreds of pages of legal briefs from both sides, and talked to company and government officials and outside experts….”

I will start with his description of the judge, Rosemary M. Collyer, which ignores vital information and misinterprets other information.

She’s also a member of the United States Foreign Intelligence Surveillance Court and once worked as the general counsel of the National Labor Relations Board. In other words, she’s a legal rock star.

Well, no.  It does mean her specialty is employment law.  Her appointment to the FISC by Chief Justice Roberts means (1) she was appointed to the federal judiciary by a Republican president (Roberts appointed only Republicans to the FISC, which is outrageous) and (2) Roberts thinks she is disposed to vote to allow the mass surveillance of Americans by the NSA.  Republican appointees to the judiciary are materially more hostile to government actions – except in the case of supposed national security.

Similarly, Sorkin gives a naïve description of a scholar who claims that specialized economic courts are desirable.

Joshua D. Wright, a former commissioner of the Federal Trade Commission, co-wrote a 2011 study that determined in antitrust cases, a judge’s expertise had a significant impact on the validity of the ruling. “Decisions of judges trained in basic economics are significantly less likely to be appealed than are decisions by their untrained counterparts,” the study says. “Our analysis supports the hypothesis that some antitrust cases are too complicated for generalist judges.”

Perhaps, but a reader should be informed that Wright is a professor at the ultra-right wing George Mason University School of Law.  More importantly, a judge who has been “trained in basic economics” is likely to have been trained that market power is of trivial importance.  This point should be particularly clear to Wright because George Mason University (GMU) ran the leading propaganda program for the federal judiciary in economics, which focused on hostility to government regulation and antitrust enforcement by purporting to teach “basic economics.”  Wright and his co-author not only admit this point – they cite the hostility of the modern judiciary to antitrust actions as evidence of the wondrous role that economics has played in changing the law and allowing the modern economy in which market power is celebrated.

The domination of the judiciary, particularly in the appellate courts, means that the district courts who rule against antitrust cases are more likely to be upheld on appeal.  Appeals are expensive, so plaintiffs and the government are less likely to appeal such cases, which makes Wright’s empirical study circular (and demonstrates how poor empirical work is passed off as science)..  Even Wright admits that GMU’s programs are “controvers[ial].”

Judges also perceive economic training to be beneficial; as discussed below, hundreds of judges have already sought out basic economic training. One reason judges might take time away from heavy dockets to receive such training is because doing so improves their decisions, thereby reducing appeals, reversals, or other potentially deleterious effects of economic complexity that could damage their reputations. Training judges in antitrust economics is not without controversy, however. Some have even criticized educational programs designed to teach judges basic economics. The George Mason University Law and Economics Center (LEC) has been the focus of much of the criticism, at least in some part because it is the largest of the judicial training organizations. The LEC began training judges in 1976 and has trained hundreds of federal judges currently on the bench. Teles (2008) notes that, by its height in 1990, the LEC Economic Institute for federal judges had trained 40 percent of the federal judiciary, including two Supreme Court Justices and 67 members of the federal courts of appeals.⁴

Critics claim that the programs amount to junkets designed to influence judicial decision-making, and are a thinly disguised attempt at indoctrinating judges with a particularly conservative, free-market oriented style of economics. Opposition to these programs recently led to proposed legislation that would effectively prohibit privately funded training programs for federal judges (Teles 2008).

⁴ The George Mason Law and Economics Center claims that more than 50 percent of the current federal Article III bench has attended LEC programs….

The largest financial sponsor of judicial propaganda programs is the Koch brothers, and the other major sponsors are also ultra-right wing entities dedicated to their hostility to government regulation and effective antitrust law.  Note that in the quoted passage Wright and his co-author inadvertently admit the key problem with their empirical study.

One reason judges might take time away from heavy dockets to receive such training is because doing so improves their decisions, thereby reducing appeals, reversals, or other potentially deleterious effects of economic complexity that could damage their reputations.

Another reason for a district court to both take the GMU propaganda course and rule in accordance with its ideology is not to “improve” their decisions, but to “conform” their decisions to the dominant beliefs of the appellate judges – “thereby reducing appeals, reversals, or other [results] that could damage their reputations.”  That is outrageous – and specialized economic courts would make it even worse, but Sorkin spots none of the empirical errors, biases, or dangers with Wright’s proposals.

The greatest problem with the GMU propaganda, however, is that it has long been falsified by reality.  That, however, never penetrates the ideological barriers.  Naturally, the firms with massive market power love the results of the ideology.

Sorkin does not understand the legal system and its treatment of large firms.

About two years ago, I was speaking with an executive at MetLife who floated the idea that the company should sue the government to overturn its designation as a firm that was too big to fail. The company believed that it was being unfairly labeled, and that the regulations that came with the designation were hindering its business.

My initial reaction, I distinctly remember, was to say: “That’s a terribly risky idea. The government always wins.”

Boy was I wrong.

“The government always wins?”  What world does Sorkin inhabit?  In the real world, we went through an enormous legislative battle precisely because that is not true.  Any federal rule can be challenged in the District of Columbia, so virtually any federal rule can be blocked by the D.C. Circuit.  A majority of the Court had been appointed by Republican presidents and many of them were exceptionally hostile to government programs and frequently declared new rules invalid.

Republicans viewed this judicial hostility in the D.C. Circuit to be of such extraordinary value to their Party and its corporate donors that Republican Senators refused to allow President Obama to fill vacancies in the U.S. Court of Appeals for the District of Columbia.  This was outrageous, and the Democrats (to their shame) put up with it for years before adopting a version of the so-called “nuclear option” to allow a Senate majority to approve the appointment of members of the judiciary.

Why the District Court’s MetLife Decision is in Error and Dangerous

Sorkin shows that he does not understand the statute or the concept of what the statute provides as to when the Financial Stability Oversight Council (FSOC) designates an institution as systemically dangerous.  (In a telling euphemism, they are actually designated “systemically important.”)

I have no idea if MetLife is too big to fail. I’ve read hundreds of pages of legal briefs from both sides, and talked to company and government officials and outside experts, and I’m still not sure. I’ve tried to make sense of it, but it is a highly complicated puzzle and to make such a determination with any degree of certainty requires mathematically projecting how money will flow between hundreds of institutions around the globe.

Well, no.  The first and last sentence quoted above make no sense.  Let us begin with reality.  MetLife reported that at yearend 2015 it had total assets of $878 billion.  That means that it poses a massive risk to the global system should it fail.  Maybe, if it had $500 billion less in reported assets it might be worthy of debate.  It has over $200 billion more in reported assets that Lehman claimed when it failed – and Lehman triggered a global crisis.

The last sentence demonstrates Sorkin’s failure to understand the legal test and the concept of posing a systemic risk.  Sorkin thinks the regulators must “make such a determination” with “certainty” through “mathematically projecting how much money will flow between hundreds of institutions around the globe.”  The statute does not require any of that.  No one can predict, perhaps a decade in advance, any of these elements.  Indeed, the impossibility of knowing any of these things is one of the reasons why it is essential to get rid of the systemically dangerous financial institutions.  What one can determine is that the financial institution is so massive and so interconnected with the global financial system that its failure would create a substantial risk of causing substantial disruption.  The regulators amply demonstrated that point.

The judge’s opinion is premised on a very different statute, the one MetLife’s lobbyists wished Congress had enacted.

Judge Collyer’s decision may well be entirely valid, but at least in certain places she appears off base. For example, she said the government “never projected what the losses would be, which financial institutions would have to actively manage their balance sheets or how the market would destabilize as a result.”

Well, the government appears to have done much of that in its report, but you’d need a pretty sophisticated understanding of finance to understand exactly how their numbers were calculated.

Judge Collyer either decided to ignore those numbers or decided they were chosen arbitrarily.

The conundrum in the case of the oversight council is that determining which companies pose a systemic risk can’t be done with a straight formula. The nature of financial crises means that, as a regulator, you’re playing against a 100-year storm that you can’t fully foresee.

Sorkin’s discussion of Judge Colyer’s decision shows that she and he do not understand the statute or the concept of systemic risk.  It is, of course, impossible for FSOC to “project” (a) the losses that MetLife will sustain over the next decade or (b) the losses that MetLife’s failure would impose on other entities during some year over say the next decade.  How can the FSOC know the counterparties that MetLife will have three weeks from now, much less a decade from now?  Only a fool would believe that they could predict the mechanism three or ten years from now by which MetLife’s failure would destabilize a particular market, particularly because MetLife may be a critical counterparty to an entity three years from now that does not even now.  I am a strong critic of Dodd-Frank, but that does not mean that every (or even most) provisions of the Act were drafted by fools to be absurd.  The Act does not require the impossibility that Judge Colyer demanded – that FSOC quantify “the actual loss” that would result from MetLife’s failure.

But Sorkin and the judge are also wrong (as are the FSOC officials who make the systemic risk determinations) in their reliance on statistics and probabilities – and in the absurd belief that we ran, randomly into the equivalent of “a 100-year storm.”  The probability of a global crisis is increased enormously if (a) we continue to create and make worse the criminogenic environments that produce the increasingly severe fraud epidemics that drive our financial crises and (b) if we continue to allow systemically dangerous institutions to exist rather than shrinking them.  The econometric techniques being relied on by FSOC (and demanded by judges) are based on statistically invalid assumptions of a fixed distribution of risk.  When we create perverse financial incentives to engage in widespread fraud we create a vastly increased risk of systemic failure.

Sorkin and other readers should read Better Markets’ analysis of the district court opinion.  It would have allowed him to understand the issues and the district court’s two other major errors in addition to its inventing a requirement that FSOC divine the future and quantify the “actual loss.”

First, the court erroneously held that FSOC had to prove that MetLife was “vulnerable” to failure.  The statute has no such requirement for a logical reason.  If you could not designate a financial entity as systemically dangerous until it had a demonstrated, major problem that could lead to its failure it would be far too late to do the things that the statute is designed to do to reduce the risk of failure and the severity of the failure.  The statute asks: if the entity fails “could” that failure pose a material risk of disrupting the economy?

Second, the court invented a requirement for a cost-benefit study.  The statute has no such requirement, because doing so would require a farcical exercise.

The three central errors that the court made have nothing to do with her lacking specialized finance training.  They are all easily understood errors of law and they all arise from extreme ideological hostility on the part of the judge against government regulation of the systemically dangerous financial institutions that will again blow up the global economy unless we shrink them to the point that they no longer create that danger.  The issue is when the next systemically dangerous entity will fail – not “if.”

One of the reasons we, the Bank Whistleblowers United, proposed getting rid of the systemically dangerous institutions through the use of banking regulators’ powers to set individual minimum capital requirements is that it allows vastly quicker remedial action than the cumbersome FSOC procedure that took over two years to designate MetLife as posing a systemic risk.