On April 18th, the FDIC released a paper, The Orderly Liquidation of Lehman Brothers Holdings under the Dodd-Frank Act, which explains how it could have used the resolution authority in Title II of Dodd-Frank to taken down Lehman Brothers with no losses to taxpayers and without collapsing the financial system.
It’s always good to remind ourselves what we want our law to do in terms of failure. Failure is a legal concept, and our laws reflect our values on how we want failure to proceed. We want those who benefit the most from risks to take the largest losses. We want to preserve the ongoing value of the firm if there is any. We want to coordinate the behavior of creditors – so value is based on legal rights, not the speed of action – and ameliorate the hardships caused to debtors and provide a fresh start to the entity.
The bailouts shredded these values – those who took the biggest risks also got huge upsides. Creditors were rewarded in all kinds of ways that were unfair. The firms weren’t stripped down to the core ongoing value but instead left with all kinds of bad zombie debts that needed to be recapitalized through earnings and squeezing consumers. We need better laws capable of handling failures of things we hadn’t traditionally expected to fail in a spectacular way, and the FDIC is arguing that Dodd-Frank gets us a lot of the way there. How does it do that?
So what are the new powers, and what would have been different? The paper lists five new powers the FDIC has over financial firms which are not banks, powers similar to what it can do for banks, with Dodd-Frank as law. Here are the five, with notes from me:
(i) the ability to conduct advance resolution planning for systemically important financial institutions through a variety of mechanisms similar to those used for problem banks (these mechanisms will be enhanced by the supervisory authority and the resolution plans, or living wills, required under section 165(d) of Title I of the Dodd-Frank Act).
This is a real battlefield. In bankruptcy court the judge will have little to no knowledge about financial institutions and would have to rely on the management. Dodd-Frank clarifies and enhances regulators’ ability to heighten supervision, require extra capital as firms weaken, and write resolution plans. If FDIC finds that the plans in question aren’t credible, they can permit increasingly stringent requirements.
(ii) an immediate source of liquidity for an orderly liquidation, which allows
continuation of essential functions and maintains asset values;
A firm in bankruptcy raises funds to continue operating its business while the court figures things out through debtor-in-possession financing. Raising DIP financing is uncertain from the point of view of whether or not it will be there in the market and/or whether a judge will allow it. Dodd-Frank allows the FDIC to borrow from the Treasury to provide liquidity necessary for the orderly resolution of a covered financial company. These funds are prioritized by law to be recouped by the continuing assets of the firms, and if they are not recouped they’ll be recouped by subsequent assessments on the industry.
(iii) the ability to make advance dividends and prompt distributions to creditors based upon expected recoveries;
This allows the FDIC to give creditors partial satisfaction of their claims. In the case of Lehman, there’s been no distribution to general unsecured creditors, and its been more than two years since the bankruptcy filings. Quickly handling paying out advances based on expected recoveries, values less than the estimated value of assets so the FDIC isn’t on the hook, allows for the mitigation of systemic risks.
(iv) the ability to continue key, systemically important operations, including through the formation of one or more bridge financial companies
Instead of immediately shutting out the lights, causing good and bad assets to collapse in the failed financial institution, Dodd-Frank resolution authority allows the FDIC to establish a bridge company where they can transfer assets. Like bridge banks used in the resolution of regular banks, this bridge company allows the FDIC to stabilize key operations by continuing systemically important operations. Board of directors and senior management are replaced (required by Dodd-Frank), but operations continue. This gives the FDIC flexibility to try and maximize the value of the operation while making shareholders and creditors eat genuine losses.
(v) the ability to transfer all qualified financial contracts with a given counterparty to another entity (such as a bridge financial company) and avoid their immediate termination and liquidation to preserve value and promote stability.
Under bankruptcy, counter-parties can terminate certain “qualified” financial contracts, forcing cascading unwinding of positions. Each counterparty will race to unwind positions, which can cause a tremendous loss of value outside the failed company. Contracts that were collateralized would not expose the receiving company to risks. Contracts that were undercollateralized would be transfered based on where it maximizes value for the entire receivership.
How Would Lehman Have Been Different?
How do they argue that Lehman would have been different? A year ago I argued that resolution authority should be understood as a relationship of deterrence, detection and resolution.
Their argument is very much centered around early detection, making losses credible, which deters and thereby forces management to be more serious about resolving problems earlier, which can involve taking a weaker deal than they’d normally take when it comes to being sold or accepting capital.
So what’s the timeline? Starting in March through July the FDIC and other regulators would have been on site, beginning due diligence to plan for potential Title II resolution authority action. Management would become much more serious about weaker options because Dodd-Frank has losses to be borne by equity holders and unsecured creditors with management being fired. FDIC could set a deadline on when to sell the company or raise capital. With regular banks, FDIC stepping up due diligence has pushed senior management to become more aggressive with finding capital.
If all that didn’t work out, FDIC could have gone to resolution. Barclays is chosen, through a bidding process, to acquire Lehman. FDIC would then transfer the assets and select liabilities to Barclays, with a minimum of disruption. The derivative trading would be transferred.
FDIC estimates that equity and subordinated debt could absorb $35 billion of losses, and that total losses are around $40 billion. This wipes out those who get the most upside, and still hits those further down the waterfall, eliminating moral hazard. So $5 billion in total losses, giving a 97% recovery rate to creditors (significantly more than what they are getting in bankruptcy).
I’ve been wanting to see something like this for a while, and I’m glad it is now part of the public discussion. It’s not done – this needs more public vetting, the international component needs to be cleaned up, there should be more about what specifically is included in a living will to make it “credible”, how do you do bigger institutions that are more “universal”, etc. but its a start. And the ultimate plan is for FDIC fulfills its mandate to preserve financial stability and serve the public interest.
I think it’s absurd of the FDIC to posit that they could have had a public “we’re going to go to resolution in X months unless …” and there wouldn’t have been a run on the bank before those X months were up. Remember by definition these are systemically important institutions. Who would extend credit to them in that interim with the threat of a haircut only a few weeks away? Ridiculous.
There is a related fallacy, which is to ignore the simultaneous Fannie / Freddie problem and pretend that it was a Lehman-centric problem. Whereas Lehman’s September liquidity problem was heavily exacerbated by the credit crisis caused by the Feds wiping out the Fannie and Freddie preferred that had theretofore been counted as Tier I capital by banks, causing said banks to have to sell assets and call in loans to pay down liabilities during the month of September, which withdrawal of liquidity cascaded throughout the entire financial system.
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