First up, Raj Date has a new paper out, titled: The Killer G’s: Resolution Authority, Financial Stabilization, and Taxpayer Bailouts. It’s definitely worth your time, as it explains how, if the Dodd Bill was in place in January 2008, our response to the Killer G’s – Goldman Sachs, GMAC and GE Capital – would have gone differently. It’s great on the topic, and pulls back to show the three types of bailouts we are worried about and what the bill does well and doesn’t do well. Highly recommended if you want to learn more.
The Bailout We Just Had
Second, we need to talk about if there are bailouts in the Dodd Bill because conservatives are not going to let this go. But before we dive into that, here’s what is incredibly important to remember: the major, serial bailouts of 2008 were not the result of some unelected, socialist technocrats hidden away in a government basement somewhere exploiting a loophole. They were the results of GOP-appointed Hank Paulson, GOP-appointed Sheila Bair and GOP-appointed Ben Bernanke, all with the support of a Bush White House-sponsored EESA going to Congress and asking that an emergency bill be passed to allow for TARP.
The Dodd Bill cannot stop this. If this all happens all over again, and it could, there’s nothing in this bill to stop GOP Team Paulson et al Version 2.0 from going to Congress and demanding more money for the financial system. Congress can always pass new laws in an emergency, even if it means overturning old laws. The only way to stop this is through prudential regulation on the front end and a resolution mechanism that is earlier and reduces uncertainty on the backend, which the Republican oppose, or by dramatically shrinking the size of the largest and most risky firms, segmenting business lines to de-risk critical infrastructure from that which can fail with less damage, and/or bringing some of the more dangerous business lines like derivatives into market-based sunlight.
The Republicans oppose all that too. I’m not trying to be a jerk – I actually read the GOP House Bill on Financial Reform and there’s nothing in it that does any of that. When the Senate GOP drops their version I imagine it will look the same – let’s just redo the problem with more bankruptcy law.
I’ve never really heard of this working and it’s predicated implicitly on the conservative’s argument that Lehman’s bankruptcy wasn’t that big of a deal (an argument that usually gets demolished by the blogosphere whenever it peeks its head). But if Keith Hennessey or other Bush administration officials who oversaw the bailouts would like to argue that in retrospect their mistake was to not do an overnight bankruptcy law change and force AIG and Bear into a bankruptcy court, and that the economy would be better off for it right now had they done so, I really hope they make their case. I’d really want to read it.
Is There a Bailout in Resolution Authority?
With that in mind, section 210(b)(4)(B) of the Dodd Bill is being called out as the bailout provision conservatives are alluding to as allowing extra payments to certain creditors. See, for instance, Nicole Gelinas, and I think this provision is what is being alluded to in this unsourced accusation by Phillip Swagel. I’m going to kick it to Raj’s paper:
4.1.3 Removing moral hazard
The mere existence of a special resolution regime for certain large firms, and not others, could in theory create its own difficulties. Orderly liquidation almost certainly preserves more franchise value than an uncontrolled de-leveraging followed by bankruptcy. Absent counter-measures, that would create a perverse preference by creditors to lend to the largest and most systemically risky firms, like Goldman, as opposed to smaller rivals.
In light of that risk, the Senate Bill crafts a strikingly punitive resolution regime. The Bill requires that the FDIC, as receiver, act “not for the purpose of preserving the covered financial company”; ensure that shareholders are paid only after all other claims are paid; require that unsecured creditors bear losses; and terminate “management responsible for the failed condition”.
Crucially, the Bill also sets out a cap on the amount that a creditor can receive from the resolution of a systemically important firm. No creditor can receive more than it would have received in a regular-way chapter 7 bankruptcy liquidation.(23) Creditors cannot be better off because of the existence of the resolution authority. Thus, the Bill effectively severs the potential feedback loop from the existence of a special resolution regime to moral hazard among creditors.
(23) – Id. at section 210(d)(2). Note that this maximum recovery also serves as a minimum recovery in those instances that the FDIC wishes to use its discretion to pay certain creditors more than similarly situated creditors, to minimize aggregate losses. In other words, the FDIC can preferentially pay a creditor, but only if similarly situated creditors are at least receiving what they would have received in a chapter 7 bankruptcy. Id. at section 210(b)(4)(B).
The repayment waterfall specifies that taxpayer money has to get returned before creditors get paid. If some creditors are paid more than similarly situated peers it can only occur if those peers get at least what they would have gotten in liquidation which occurs only if, by definition, the FDIC has already gotten its money back too. Not a bailout.
And as Raj points out in his conclusion, the real worry is twofold – that Federal Reserve expanded access to healthy firms in a crisis will disproportionately benefit larger and riskier firms, and that regulatory forbearance (that regulators will not want to pull the trigger to close a firm that is gigantic and has a huge political presence) hasn’t really been solved by this bill. These are the real problems outstanding with the current sense of resolution authority, and would make for an excellent debate on the floor.