Talking with Raj Date about Resolution.

I recently got the chance to do a quick interview with Raj Date, a former managing director at Deutsche Bank Securities and the founder of the Cambridge Winter Center, a non-profit, nonpartisan organization dedicated to U.S. financial institutions policy, about resolution authority and the resolution fund.

Michael Konczal: The Dodd Bill has a $50 billion dollar resolution fund in it, collected by systemically risky firms in advance of a resolution of a firm. Is this a bailout fund?

Raj Date: I know about the importance of finding, in the political discourse, colorful terms that resonant with people and make for a punchy argument, but sometimes those colorful terms are wholly inaccurate. I don’t think there is any fair reading of the resolution that is in the bill and manager’s amendment that admits of the idea that this is a bailout fund or a slush fund. This is a prefunded vehicle by which you’ll provided the working capital for an orderly liquidation of a systemically risky firm. It is a fact you’ll need some amount of cash as you wind down a firm from a failure into nothing. As you wind down a firm that doesn’t work anymore, sometimes you’ll need some kind of working capital.

Outside of the financial world, that’s debtor-in-financing. Inside the financial world FDIC has a deposit fund. So you need some amount of liquidity to do this in an orderly way. The only question is what can you use to provide that liquidity. I will say that the existence of the fund is kind of irrelevant to the functioning of the resolution authority. Take for instance that over the past year the FDIC fund has been on its way to negative. Depositors are not running to the hills because they are afraid that FDIC won’t be able to cover their deposits.

So the existence or nonexistence of a preexisting fund functionally doesn’t matter. Optically you might argue that it should matter, because it makes quite clear to the extent that there are costs it makes clear who is going to eat those costs. Now the bill, and I think everyone of either party would like for the industry to bear the costs, if there ever are any, with respect to the resolution of systemically risky firms. And so its not even a question of who would bear the costs. The only question is, in the moment, whether or not it would be used for something that isn’t contemplated by the statue. But that would be illegal. (Laughter)

So unfortunately Senator McConnell, and I try to be as charitable as possible with people when it comes to arcane areas, is wrong on the facts. Which is making the debate so difficult. There are people in great areas of authority who, and I’m trying to be as charitable as I can, have not done the work. We are three years into this mess. And there are people, there are very senior members of both Houses of Congress who have not done the work. I don’t know what they are doing, candidly. So that’s distressing.

To my mind the existence or nonexistence of the fund doesn’t matter. My sense is that they totally didn’t hit a number with $50 billion dollars. I think this is a little inherently confusing. I don’t think you need $50 billion dollars for the purpose for which it is intended, and to the extent that it ends up being a bigger number you need a line of credit, so why not make it smaller? Since this debate has blown up into nonsense maybe it would have been a good idea to go with $10 billion.

MK: So let’s say the Dodd Bill is in place in January of 2008. Lehman trips the final prompt corrective action trigger in June 2008, and it is time to resolve the firm. What would have happened at Lehman?

RD: So first, make no mistake. It still would have been enormously painful to have a more than half a trillion dollar asset firm go from viable the one day to not viable the next. I don’t care what regime you have, you are going to notice, and it is going to be painful.

The main thing that would be different is that you would have a more rapid resolution, a more rapid cancellation or closeout of open positions. The bankruptcy process, for all its merits, doesn’t do that. The bankruptcy code was never intended to do that. As a result, you still have a lot of positions from Lehman that are open today. So the main benefit of having resolution authority instead of the bankruptcy code is that you have quicker certainty for the status of creditors and counterparties. And at some level, it is still going to be painful, but what the market really needs in this case is certainty. So something like Lehman gets made less painful than it needs to be.

And the existence of that resolution vehicle makes easier the notion of dealing with Citi, of dealing with Bear, of dealing with Merrill. There are two variants that it doesn’t solve: One is where we’ve signaled that nobody wanted creditors of Fannie Mae or Freddie Mac to take a hit. So in cases where the firm is massively insolvent and you want to make creditors whole, like in Fannie Mae or Feddie Mac, resolution authority doesn’t solve that.

The second is GE Capital GMAC or Goldman Sachs issue, where you magically, through the action unelected officials, converted them from charters where they did not qualify for broadly available help into bank holding company charters where they did.

MK: Broadly available help through the Federal Reserve’s discount window?

RD: Yes and the availability of TARP Capital. Resolution authority doesn’t get to that. In general the deathbed conversion problem of Goldman – normally it takes a year and a half to become a bank holding company but we’ll do it over a weekend – becomes less valuable to Goldman if you are subject to prudential regulation all along by virtue of being a very large firm. So prudential regulation with respect to very large firms regardless of charter I think is an important addition.

But look the ability of prudential regulation is contingent on the ability of regulatory bodies, and to rely on superhero regulators is probably a mistake. By it’s terms in the resolution process, a creditor can’t get paid more than he would have gotten out of a bankruptcy liquidation. So, people who think that creditors are going to be made way better off by virtue of resolution rather than bankruptcy are in denial. It’s a pretty black and white feature of the bill.

MK: Yes people are worried this is a bill to pour money into a sandpit. That resolution will be used to pour money into creditors that they wouldn’t have gotten in bankruptcy.

RD: Yeah, there’s a maximum amount that the FDIC stepping in to wind down a firm; you have to pay off the various claims. People who are worried about the fund worry that people will be paid more in resolution than they would in a regular way in bankruptcy. To its credit the bill actually says exactly the opposite. The bill caps the amount that a creditor can get paid at the amount they would have been paid in a bankruptcy liquidation. Nobody will get more money as a result. You are preventing what has been colorfully described as a dying firm puking assets out into the marketplace, and getting this weird dynamic where everyone is racing for the doors with their chunk of change. That’s what you are trying to prevent, and the bill does try to prevent that. It doesn’t reward somebody for lending to a large failing firm, which is the right answer.

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1 Response to Talking with Raj Date about Resolution.

  1. David Pearson says:

    I think the questions miss the point on resolution authority.

    In a non-systemic crisis, the authority is likely to perform as advertised: that is, it will prevent “bail outs”.

    In a systemic crisis, the authority is unlikely to be used. Would a “speedier” resolution of Lehman have prevented the 2008 systemic crisis? Of course not. This is why, in the future, regulators are more likely to want to support the creditors of a failing firm than to request a haircut of them. Haircuts lead to runs, which in a levered gap-funded institution, lead to systemic failure.

    The real problem with “bail outs” has to do with the balance of negotiating power between creditors and regulators. In a non-systemic crisis, regulators have all the power. In a systemic crisis, creditors have all the power because, in a game theoretic sense, all single-period game scenarios create higher benefits for BOTH parties if the creditors are bailed out. This can be modeled before hand, and it therefore should come as no surprise. Of course, in a multi-period game, regulators (the people) lose out, and the failure of the Dodd bill to prevent that outcome is exactly what is wrong with it.

    The only way to change the outcomes is to either limit the size (and leverage) of systemically important institutions, or to prevent the Fed from lending to those firms in the event of a crisis.

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