Rare Finance Bill Consensus: No Bailouts

Zephyr Teachout in The New York Times Dealbook Blog, April 16, 2010

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As the Obama administration and Senate Republicans clash over the future of the financial regulatory system, there is one principle on which they agree: Taxpayers should never again have to bail out giant financial institutions, Sewell Chan reports in The New York Times.

President Obama says his legislation would let the Treasury Department, with court approval, take over and dismantle failing companies without costing the public a dime. It would resemble the process used since the Depression to take over failing commercial banks.

Republicans say the bill would make future bailouts even more likely. They worry that designating large financial institutions as “systemically important” would feed the markets’ perception that the companies have implicit government backing.

The truth is actually more nuanced than either side admits, say legal and economic experts. The bill would stop taxpayer-financed bailouts. If a company was on the verge of collapse, leading firms in the financial services industry would have to pay to clean up the mess.

While that might look like an admirable approach, there is profound uncertainty about how or if it would work in the next, fast-moving crisis. Other nations, like Britain and Japan, are also trying to figure out how to do it.

And both sides are actually in closer agreement on the basic approach than the heated rhetoric might suggest. Senator Mitch McConnell, the minority leader, seemed to acknowledge that fact on Thursday when, after objecting to the bill and drawing fierce criticism from Democrats and even some resistance from fellow Republicans, he conceded that flaws in the bill “can and should be corrected.”

The Democratic bill in the Senate would try to charge the largest financial companies for the costs — potential and actual — of dismantling their failing brethren, and it would ban the use of taxpayer money to do so.

F. M. Scherer, a professor of public policy and corporate management at Harvard, does not think bailouts can be legislated away. “The basic problem is, if the failure of a ‘too big to fail’ entity would bring others tumbling down through chain effects, the government will be virtually forced to step in and do something,” he said.

Republicans and Democrats alike would love to force reckless companies simply to go bankrupt. But the freezing of credit markets 18 months ago, after the Bush administration let Lehman Brothers go under, suggested that going through the courts could be too time-consuming, risky and disruptive for a global financial system grounded on speed and interconnectedness.

The bill the Senate Banking Committee approved last month, with no bipartisan support, would give the Treasury secretary new power to step in if a large, complex financial institution, including hedge funds and insurance companies as well as banks, were on the brink of collapse.

The Treasury secretary would have to convince a special panel of three judges from the Federal Bankruptcy Court in Delaware that the company was “in default or in danger of default.”

The Federal Deposit Insurance Corporation would step in as receiver, with the power to sell the company’s assets and liabilities, or to hold and manage parts of the business until a sale became possible. Managers would be fired and shareholders wiped out. The costs of dissolving the company would have to be recouped from a fund generated by levies on the financial services industry.

Two Senate negotiators, Mark Warner, Democrat of Virginia, and Bob Corker, Republican of Tennessee, agreed to that basic framework over months of negotiations. The principal Republican objections have been leveled at three major elements of the bill: the liquidation fund, treatment of creditors and using the F.D.I.C. to handle the winding down of such a company.

The first would establish a $50 billion “orderly liquidation fund,” financed by assessments on “systemically important” financial institutions, as well as banks with at least $50 billion in assets.

That issue does not fall along neat partisan lines. Sheila C. Bair, a Republican and the chairwoman of the F.D.I.C., which has used a similar process for dealing with bank failures, has been a champion of the idea. The Obama administration has made no secret that it does not support the idea of the fund.

Representative Barney Frank, Democrat of Massachusetts, said Thursday, “I don’t regard it as essential to the bill.”

Mr. McConnell said, “No one honestly thinks $50 billion would be enough to cover the kind of crises we’re talking about” and added that “the mere existence of this fund will ensure that it gets used.” In the recent financial bailout, the government advanced about $700 billion to stabilize the markets and the banks, though the final cost might be less.

Among finance and legal experts, however, the fund has supporters. “There is no longer any doubt that the largest financial institutions are too big to fail and will be protected during any future crisis by the federal government,” said Arthur E. Wilmarth Jr., a law professor at George Washington University. “The only question is, will we charge ‘too big to fail’ institutions for the public subsidies they receive?”

Charles A. Trzcinka, a finance professor at Indiana University, said that if a $50 billion fund “had been available early in the crisis, it certainly would have mitigated the collapse” of credit markets.

A second area of contention surrounds the treatment of the creditors of failed companies that would be seized and dismantled. Some Republican critics, notably Peter J. Wallison, a senior fellow at the American Enterprise Institute, say the proposal could potentially treat bondholders more leniently than they would otherwise be treated in bankruptcy proceedings. That would only encourage lending to troubled institutions, he predicted.

Finally, some critics say the F.D.I.C. is more accustomed to garden-variety bank failures and is ill-equipped to deal with the nation’s biggest financial institutions. While Mr. McConnell’s criticisms have received the most attention this week, critics from the left say the legislation does not go far enough. The Obama administration has ruled out forcing giant banks to break up, for instance, although it has proposed curbs on expansion and risk-taking.

“We can’t trust banks not to risk the entire economy for their own greed, so we need to limit how big they can be, and what risks they can take, in hard, legislated limits,” said Zephyr Teachout, a Fordham law professor.

The Federal Reserve, which under the bill would be given the task of overseeing the biggest financial institutions, has kept a low profile as the debate rages.

Bernard Shull, an economist at Hunter College, said the bill was probably imperfect but better than inaction. “Just saying no to bailouts is not an approach that has worked in the past, and I don’t think it’s going to work now,” he said. “Whether or not the newly proposed legislation will work is another matter.”